He Who Laughs Last

The Daily Reckoning Presents: A rather caustic response
to the Daily Reckoning’s treatment of Sara Lee. (At
least they make good cheesecake…)

HE WHO LAUGHS LAST…

by Alan Myers

2001 has been a stinker for investors.

But there are individual stocks that are doing quite
well, this year, thank you very much. Among the highest
fliers for the year are two fine examples of why you
shouldn’t let the popular media or Wall Street analysts
pick stocks for you – H&R Block, up nearly 102% and
Office Depot, which is up over 135% year-to-date.

As is typical for the Fleet Street Letter, we started
buying these stocks up when everyone else was
badmouthing them. Office Depot appeared to be a disaster
after expanding faster than it should have. H&R Block
was, supposedly, a one-trick pony with taxes as their
only business.

Now, we have bad press on another of the Fleet Street
companies. It was recently tossed out in the Daily
Reckoning that Sara Lee might be “the next Enron.” (For
the record, I hope we do find the next Enron because
Lynn shorted Enron in our trading service, Contrarian
Speculator, and bought two profitable puts on it this
summer.) But back to Sara Lee. The source that was
quoted was Christopher Byron, a commentator for MSNBC…
who has a noon web-cast opinion show.

Recently Mr. Byron blasted Sara Lee (in addition to
Deere & Co and IBM). His basic premise is that investors
should be wary of companies who use what he lovingly
calls “Enron-type financial engineering gimmicks.” As
best as I can decipher, he is talking about companies
taking on large debt to finance earnings growth. I don’t
think that Sara Lee’s CFO has any private financial
scams on the side.

Well, he is partly correct about one thing. Sara Lee has
taken on more debt recently. Lots more, in fact.
However, it becomes obvious that Mr. Byron merely ran
some sort of quick financial screen and did not bother
to do any homework, digging for explanations. It makes
you want to grab him and smack him in the forehead,
screaming “Hello! McFly! Anybody home?!”

It turns out there is a very simple explanation for Sara
Lee’s increasing debt load. Earthgrains. Yes, the bakery
company that Sara Lee just finished purchasing. It seems
Sara Lee financed a portion of the purchase with debt.
Additionally, Sara Lee assumed the $935 million in
outstanding debt of Earthgrains.

Mr. Byron tosses out the statistic that “Sara Lee now
has five times as much debt on its balance sheet as
equity, whereas five years ago there was twice as much
equity on the books as debt.” Actually, it was 1.7 times
as much equity as debt on the books, but who’s quibbling
with Mr. Byron’s poetic license?

And forget five years ago, how about one quarter ago? In
the June quarter, Sara Lee had twice as much debt as
equity. Sure, this is more debt than it had five years
ago, but the real question is “what happened?” It turns
out that four years ago, Sara Lee repurchased $1.6
billion worth of stock. Additionally, the company has
continued to buy back stock, reducing its total shares
outstanding by 20% over the past five years. That makes
each shareholder’s stake 25% more powerful than it used
to be. But, this certainly has an effect on the debt to
equity ratio. If you lower the equity portion, you raise
the ratio.

Ever since the stock repurchase, Sara Lee has been
operating with a debt-to-equity ratio of around 2.5 to
2.8 times. Is this too high? Well, the company does
generate about $1.5 billion in operating cash flow each
year. It does have the ability to service this level of
debt.

Now comes the Earthgrains purchase and its debt level
soars. Is this worrisome? Well, in the short term, it is
certainly something that any prudent investor would want
to keep his eye on. We expect to see Sara Lee pay down
this debt fairly quickly and get back to the debt/equity
ratio it has held now for several years. We expect it to
do this through a combination of continuing to sell
extraneous businesses (it has sold off 20 non-core
enterprises so far), consolidating the Earthgrains
operations, and strong cash flows.

But if you want the real story on Sara Lee’s debt, you
need to look at its return on assets, a measure of how
well it puts assets, including debt, to work. Sara Lee’s
ROA is an unusually high 16% – that is more than four
times the ROA of its competitors and a number to be
proud of on any terms. By comparison, the two largest
companies in its universe, Kraft and Unilever, return
only 3.9% and 1.6% on their assets. Borrowing and using
debt so well – considering it can repay – is much better
for shareholders than financing growth by issuing more
shares and diluting current owners stakes, any day. As
for return on equity, the number most shareholders
watch…off the charts! It has been over 100% for the
past three years. Anything at 15% or better is a solid
performance.

The bottom line is that to toss out scary statistics
without the knowledge and research to support the
argument is irresponsible. But that’s what makes stocks
cheap for those who have the courage to buy low and sell
high.

It’s not easy going against the crowd, but it is
profitable if you’re not in a hurry to day trade.

Alan Myers,

for The Daily Reckoning

After working variously as a stockbroker (during the
market crash of 1987), a manager of pension plans for
small businesses and spending four years in the trenches
with mutual fund powerhouse T. Rowe Price, Alan Myers
has joined the team at the Fleet Street Letter. Mr.
Myers has an MBA from Washington University in St. Louis
and recently earned the right to use the title Chartered
Financial Analyst.

As you can see, Mr. Myers rather vehemently defends the
picks in the Fleet Street Letter’s portfolio…for more
on how a $5,000 investment soars to $65,813 see:

The 10-for-10 Wealth Recovery Portfolio

“The rate reduction exercise – like an execution
by injection – seemed so unremarkable that it elicited
no sense of awe or shock,” reports Eric Fry from
Manhattan. “It was expected, it happened and folks went
back to doing what they were doing before: buying
stocks. But this latest rate cut was both awesome and
shocking. For the first time in its history, the Federal
Reserve slashed interest rates eleven straight times in
eleven months…”

Thus does the Harry Potter of central bankers –
Alan Greenspan – continue his march to zero. For why
stop at a Fed Funds rate of 1.75%? There is little
evidence that any of the other 10 rate cuts has helped
things. Real rates were already negative. What’s worse,
recently, the bond vigilantes have begun to cause
trouble – driving up long-term rates in the face of
declining short ones. And bankers, though they can
borrow at less than the rate of inflation, are making
fewer loans.

Instead of getting better, the key measures of the
economy – jobs and profits – are still going in the
wrong direction. Profits as a share of national income
have gone down every year since ’97 and new factory
orders hit a 20-year low in November. Companies will
continue laying people off…we predict…until profits
recover. And Greenspan will cut rates down to zero. What
else can he do?

Here’s the rest of Eric’s report:

*****

Eric Fry In New York…

– The Dow fell for the third straight day. Perhaps this
Hanukah sell-off merely paves the way for a “Santa Claus
rally.” Tis the season to be jolly, after all.

– The Fed cut interest rates yesterday, just like it was
supposed to. Then the stock market – hewing to protocol
– rallied about 100 points, just like it was supposed
to. But then Merck barged in on this happy little affair
like a brutish, uninvited guest.

– The blue-chip pharmaceutical company shocked investors
by announcing that its earnings next year would be less
than expected. Within minutes, the Dow plunged into the
red – finishing 33 points lower at 9,888. The Nasdaq
eked out almost 10 points to close just above 2,000.

– Merck’s “indiscretion” was not just another routine
earnings shortfall announcement; it was a genuine
shocker. Lesser companies may have these kinds of
difficulties, but not Merck. What’s more, the surprising
announcement raises a disturbing question few (fully
invested) investors wish to ask themselves right now: If
there is no recovery in 2002 for the mighty Merck, what
kind of a recovery can lesser companies possibly expect?

– Until Merck did its wet-blanket routine, the trading
day had been proceeding swimmingly. The Federal Reserve
policy makers cut the benchmark federal-funds rate by a
quarter point to 1.75%, down from 6.50% a year ago.
Accompanying the rate cut were the usual Delphic
utterances like, “weakness in demand shows signs of
abating…” tinged with cautious Fed-speak: “…but
those signs are preliminary and tentative.”

– Despite this Herculean effort to date, the economy
remains very sluggish and the stock market remains well
below the levels it held when the rate cuts began –
that’s shocking. I know, I know, the economy is
improving…everyone says so. Still, I have to ask, “If
the economy is really recovering so nicely, why is the
Fed pushing so hard?”

– Everyone seems to be looking for a recovery in 2002,
even if they cannot exactly explain why that should be
so. The conventional wisdom seems to be that interest
rate cuts by the Federal Reserve somehow guarantee
renewed economic vitality. Maybe the conventional wisdom
is correct. Maybe cooking up a recovery is, in fact, as
easy as boiling water – just light a fire and wait for
the bubbles to appear. But come to think of it, hasn’t
Greenspan created enough bubbles already?

– There are some legitimate reasons to expect some kind
of economic bounce before too long. The ISI Group
reasons, for example, that business inventories have
fallen so far over the last several months, that merely
replenishing them will cause GDP to grow by 1.4% in
2002.

– Interesting theory, but if consumers aren’t buying,
will businesses replenish inventories anyway? Seems
unlikely. What seems likely however, is that consumers
in 2002 will be thinking a lot more about how to save
money than about how to spend it. The reason being that
U.S. consumer installment debt as a percentage of
disposable personal income stands at an all-time high of
21.9%.

– That fact is stunning all by itself. What makes it
even more stunning is that this debt reading stands at
an all-time high near what most economists now believe
to be the END of a recession! ISI points out that at the
end of the 1970, 1974 and 1982 recessions, this
indebtedness measure had fallen to below 16%, as
consumers paid down their debts. Not this time…not
when our nation’s leaders have so successfully schooled
us that the road to perpetual prosperity is paved with
perpetual debt. We have learned our lessons well. Now if
everyone will simply take out their credit cards and buy
something, we can get this recovery started.

– If Nathan Hale were alive today, would he proclaim, “I
regret that I have but one life to consume goods for my
country”?

*****

Mr. Bill in Baltimore…

*** People with big bills to pay and without jobs make
poor consumers.

*** But what about all that money “on the sidelines” we
keep hearing about. My friend Rick Ackerman sent this
note:

“Plain and simple, the “more than $4 trillion” of
supposedly surplus cash has been offset to a significant
extent by the ongoing and still largely invisible crash
in home equity…I explained why in my last essay for
the Daily Reckoning: “Homeowners are refinancing based
on appraisals that reflect last Spring’s peak in home
prices rather than their current, recessionary prices.
In my neighborhood, for instance, homes appraised as
recently as August for $450,000 are actually selling for
around $350,000. Multiply that times a thousand
neighborhoods across the U.S. and the $4 trillion is
about as real as the Social Security surplus.”

*** Meanwhile, the mortgage delinquency rate is at a 10-
year high. Thanks to the lower short term rates, “Savers
[are] Getting Crushed,” the Arizona Republic tells us.
And “Retail Sales Slump in Holiday Season,” adds a
Reuters article.

*** “It does not take a rocket scientist to do the
math,” adds Greg Weldon. “U.S. personal disposable
income FELL 1.7% in October while U.S. personal
consumption ROSE 2.9% in October.” Consumers are running
out of money to spend.