MarketVVizard's Market Thoughts: Barron's Round Table Jan 2004

» Jen_ - Barron's Round Table Jan 2004

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Barron's Round Table Jan 2004 continued:

Q: PBMs could be a lightning rod when the pressure comes to cut down Medicare expenses.
Witmer: The stock is 32. Fast-forwarding to the numbers, Ebitda could be about $1.4 billion in 2005. At that point Medco should have no net debt. Depreciation and amortization are running about $283 million, so reported EPS will be $2.40. We estimate Medco's capital spending to be about $130 million, giving it an incremental 54 cents of free cash per share. Call it $2.90 in after-tax free cash in 2005. A business like this deserves a 16 to 18 multiple, because of the trends working in its favor, including a big move toward generic pharmaceuticals. Medco makes about half its earnings from mail-order generics. The growth of generics spending should lift earnings by about 30% over the next four years. Also, the baby boomers are aging. The older we get, the more medication we seem to be taking. I have a target price of 47 to 52 in about a year, from 32 now. Now, do you want some shorts?

Q: Sure.
Witmer: I mentioned Mattel in the mid-year Roundtable ("Happy Daze," June 23, 2003). The stock fell 7% through yearend. Mattel has lost its innovative spirit. It is knocking off other companies' toys. Its major product is Barbie, and Barbie has become irrelevant. She has run into the Bratz doll, which is edgier and cooler. In our store checks, parent after parent says the same thing. Girls are embarrassed to be seen playing with Barbie. Licensees are dropping Barbie right and left. In mid-2003 Mattel came out with Flavas, a Bratz knockoff, and Mattel's much ballyhooed savior. But Flavas can now be found in discount bins nationwide. Industry rumor has it Toys "R" Us was left with a lot of Mattel product after Christmas. Barbie is losing shelf space, but MGA, owner of the Bratz brand, says its space at major retailers is increasing four to eight times. Now Bratz is moving to Europe, where it will be distributed by Hasbro. In a small but telling sign, Mattel was listed as the second largest creditor of FAO Schwartz. Mattel was selling on credit, when most other toy companies had COD [cash on delivery] terms. Mattel is trading for 18.50. I see the company making 80 to 90 cents, and trading around 9 to 10.

Q: What proportion of Mattel's business is Barbie?
Witmer: They don't break it out, but I believe it's 40%. My next short is Investors Financial Services, IFIN. It's a trust custody bank that provides back-office services to large financial-asset managers. It's largest client is Barclays Global Investors, which constitutes over half of IFIN's $1billion trust-custody assets. There are 66 million shares outstanding. The base business is good if you ignore the concentrated client base. But we are short the stock. We believe IFIN borrows money and plays the yield curve.

In the third quarter IFIN reported 40 cents in earnings, which implies a $1.60 annualized rate. But compensation expense declined sequentially in the quarter, when core revenues were growing during the same time frame. We didn't understand this because there wasn't a large head-count reduction. Upon further questioning on the conference call, management stated that it had loaded compensation expense into earlier quarters. They said, "We accrue bonuses when we have the room in the EPS that marries up with it." An amazing comment.

Q: Was there any response on the call?
Witmer: Astoundingly, no. If you normalize the compensation expense, we get earnings of $1.38. We figure 50 cents of that comes from the core business, and we give it a 20 P/E. The rest of the earnings, which come from ballooning up the balance sheet, get a 10 P/E. That adds up to a target of 19 a share, and the stock is 38. There are other red flags, too. Average borrowings in each of the last three quarters grew from $3.9 billion to $4.3 billion to $4.6 billion, while period-end borrowings were flat sequentially. This is important because equity to assets is stretched thin.

My last short is any Verizon New York debt with a life of more than five years. I'll pick the 7[frac38]s of 2032. The spread over Treasuries is 1.38 percentage points, and the yield to maturity is about 6%. I view this as junk paper, that should demand a yield of 10%-plus, and trade at 70, not 113. Verizon New York experienced line losses of more than 5% in 2003, on top of a 4% loss in '02. There have been 11 consecutive quarters of decline. Moody's has the debt on watch for a multiple-step downgrade. Ebitda looks to have declined to an annualized $1.6 billion from $2.4 billion in early '02. Verizon New York is virtually powerless to cut costs. Its labor force is unionized, and the company has to maintain land lines. Ebitda minus capital spending nets you $400 million of free cash flow. Debt is over $6 billion. There was a $4 billion employee-benefit obligation on the balance sheet at the end of the third quarter. A December report from Standard & Poor's suggested 10% of Americans plan to abandon their land lines and solely use wireless phones.

Schafer: Are you shorting the common, or just the bonds?

Witmer: Only the bonds of the Verizon New York subsidiary.

Q: Are they going to default on these bonds?
Witmer: The million-dollar question is, will the parent step up and guarantee this debt? Not for a long time. Verizon has $15 billion debt it needs to refinance by the end of '06. And the rating agencies are watching it like a hawk.

Q: Does Verizon have a choice?
Witmer: Yes. If I ran the parent, I might fund the subsidary for a while, see if it got regulatory relief. But the Verizon parent would be a creditor in the event of a bankruptcy filing. It would end up controlling the sub anyway, after settling the outside debt for cents on the dollar. To take out the interest-rate risk and help with the carrying cost of the short, we've gone long equivalent-length Treasuries.

Black: What is the rating on the bonds?

Witmer: Moody's has an A2 rating, but has it on watch for a multiple-step downgrade.

Q: Thank you, Meryl. And everyone.

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....Jen

-- posted by Jen_