I hope that these people are right and that we are coming out of the recession. There are fears of a “W” (not Bush) or a “double-dip” recession and these should not be discounted. But, we don’t really want the recession to carry on in any form; we really don’t want the risks associated with the down-side.

Even though we may be at or near the bottom of the recession there are still plenty of concerns to deal with. My continued concern is that the collapse in the economy was primarily due to a supply side shift and was not initiated by a fall in aggregate demand. This I have tried to capture in posts like my June 22 effort: http://seekingalpha.com/article/144508-structural-shift-in-the-u-s-economy-is-really-in-supply. If the recession was, in fact, initiated by supply shifts then there are structural dislocations in the economy that need taking care of that cannot be satisfied by just increasing aggregate demand to put people back in the jobs in which they were formerly occupied. We cannot just return to factories that are only being partially used or have been cvacated. Trying to push things back to where they were just postpones the restructuring of the economy that needs to take place.

In the past twenty years or so, we, in the United States, have experienced two credit bubbles or credit inflations. These bubbles have created excess growth first in information technology in the 1990s and then in the housing sector of the economy in the 2000s. But, these credit bubbles were not just restricted to the United States.

There was a credit inflation throughout the whole world. Evidence of this has just been released in a report by Close Brothers Corporate Finance in the UK. (See “UK is Europe’s capital of distress” in the Financial Times: http://www.ft.com/cms/s/0/aba06ea2-758e-11de-9ed5-00144feabdc0.html.) The report claims that “The UK has western Europe’s highest percentage of financially distressed companies after being the leveraged buy-out capital over the past decade.” But, the report goes on to show that the credit bubble resulted in the serious collapse of the European manufacturing sector, as well as in the retail and leisure sectors. And, of course, there is the case of Japan in the 1990s and 2000s.

The problem created by credit bubbles or credit inflations (in addition to the excessive amounts of debt created) is that too much capacity is created in areas of the economy that cease to be needed any more once the bubble has burst. The normal response of the economy is to restructure so as to eliminate the excess capacity that exists and re-deploy resources into areas that are experiencing growth and development. A Keynesian effort to “pump up” aggregate demand is just an effort to re-employ resources in the same areas that formerly prospered but that now need to be “down-sized.” This does nothing to get rid of the excess capacity and postpones the restructuring of the economy. Furthermore it retains the misallocation of financial capital that evolved during the period of the credit inflation or credit inflations.

The drop in capacity utilization in the United States since the start of the recession has been extremely dramatic. Firms have gone from using about 81% of their capacity to using only 68%, a drop of 16%. This is the steepest drop for the longest period of time in the data series. But, even more important in my mind is that capacity utilization has been dropping steadily since 1967. Obviously, capacity utilization drops in periods of economic recession. Yet, in the United States, capacity utilization, after a recession, has never returned to the peak level it reached in the previous period of economic expansion.

Capacity utilization in the United States has been falling since the 1960s. This can be seen in the accompanying chart.

Although the United States has grown around 3% compounded annually over the last forty years and employment, through most of the period, has been at relatively high rates, there are still two pieces of information that are rather unsettling. The first is the continuing decline in capacity utilization just mentioned. The second is the decline in the civilian participation rate. For the United States, this rate peaked in the 1990s a little above 67.0% and has declined through the late 2000s remaining below 66.2% since 2004. This may not seem like much of a fall but it indicates that a lot of people have left the labor force!

The latter problem can be confirmed by figures from the Bureau of Labor Statistics. There are major sectors of employment in the United States that have experienced significant reductions in jobs and employment. These are in industries that one could seriously argue were in substantial need of restructuring. (I will return to this topic soon in another post.) The question is, should people to be pushed right back into these jobs again by a government stimulus program of increasing aggregate demand? Instead, it seems as if there needs to be a significant education of a large portion of the civilian population that would like to participate in the labor force again.

If there are structural problems in the United States and in the world that result from the existence of excess capacity in industries that are declining or less technologically relevant, shouldn’t we let these industries decline or try to become technologically relevant rather than stagnant? Should we try and keep people producing buggy whips when there are means of transportation evolving other than buggies?

So, to reclaim full economic health there is a need to reduce the excess capacity that has been built up in industries that are not so relevant any more and a need to deleverage financial structures. Unfortunately, a large portion of the needed financial deleverging is connected with firms that have excess capacity. Furthermore, there is a need to restructure U. S. manufacturing and business, and train more of the workforce to fit into twenty-first century jobs so as to get the labor participation rate up.

In my study of the Great Depression, this is one of the reasons why it took so long for the United States economy, and the world economy, to recover through the 1930s. The structural change in the United States taking the country from an agricultural society to an industrial society did not really take place until the beginning of the Second World War My concern is that the needed current economic restructuring will be delayed if Washington continues to focus on companies with redundant capacity by stimulating the re-employment of the same workers that used to work in them. The economic statistics (the leading economic indicators) may continue to improve in such cases, but the economic recovery will continue to languish.

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What Kind of Economic Recovery?

The company provides services to a broad range of commercial, industrial, utility and institutional customers. They report operations in six market segments: (a) electrical construction and facility services within the U.S.; (b) mechanical construction and facilities services with the U.S.; (c) U.S. facilities services; (d) Canada construction services; (e) United Kingdom construction and facilities services; and, (f) Other international services. The electrical construction and facilities segment involves systems for electrical power transmission; premises electrical and lighting systems; low-voltage systems, such as alarm, security and process control; voice and data communication; roadway and transit lighting; and fiber optic lines. Mechanical construction and facilities services include systems for heating, ventilation, air conditioning, refrigeration and clean-room process ventilation, fire protection; plumbing, process and high purity piping; water and waste-water treatment and central plan heating and cooling.

Consensus estimates for sales ending 12/09 are projected to be $7,246.88 million. Consensus EPS estimates for the same period range from $2.28 to $2.65.

Sales growth is 24.8% YOY and EPS growth is 45.1% YOY. The historical five year growth rate for sales is 8.4% and for EPS it is 13.2%. The company reported positive earnings surprises for the quarters ending 10/08 and 07/08.

At its recent price of $20.72, EME is selling at 7.9X next year’s estimated earnings. Operating margins have steadily expanded from 0.9% in 2004 to 4.2% currently. Similarly, net margins have grown to 2.5% from 0.7% in 2004. The company does not pay a dividend.

Our estimate of fair value is $29.97 to $48.96 with a mean value of $41.97. Using consensus EPS of $2.58, EME is valued at 11.6X to 18.9X earnings; the average fair value multiple is 16.27X earnings. The low end of our estimate provides a PRG ratio of 0.88, based on historical growth rate.

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EMCOR GROUP, INC. The Rebuilding Of America

To be sure, Fisher never advocated the use of price/sales as a stand alone indicator of value. It is just one tool to use when in conjunction with other tools to estimate a company’s value. The PSR is particularly useful when looking at a company without earnings as the more commonly used P/E ratio is meaningless.

According to Fisher, the underlying strength of the PSR, when compared with the P/E ratio, is its consistency or predictability. Earnings can fluctuate widely as we know today. Sales, on the other hand, are more stable. Sales also have the advantage of being less likely to be manipulated. Earnings are, after all, estimates based on accounting assumptions. They fluctuate with one-time expenses, write-offs and short-term changes in margins.

Fisher has been a long time contributor to where he has advocated the use of the Price/Sales ratio. In a 1984 article in Forbes, Fisher provided an important and frequently overlooked modification to the PSR. In this article he introduced what he called the “Debt Adjustment Factor.” As the name implies, Fisher found it necessary to adjust the PSR to reflect both short term and long debt. His DAF can profoundly effect our understanding of the basic PSR. For illustration purposes, we can look at some companies in the aerospace industry and compare PSR’s with debt adjusted PSR’s:

Company PSR Debt Adjusted PSR
Alliant Techsystems (ATK) 0.62 1.93
Boeing (BA) 0.46 3.29
Ceradyne (CRDN) 0.84 0.30
Honywell Int’l (HON) 0.63 1.98
Locheed Martin (LMT) 0.75 15.00

Fisher developed a range of PSR values to measure a company’s popularity in the market. The ranges vary by size of company and between high margin businesses and companies operating industries with inherent thin margins such as supermarkets. Accordingly, small growth companies are unpopular if their PSR is under 0.75 and very popular when the PSR is over 3.00. Similarly, companies with multibillions in sales, such as LMT mentioned above, are unpopular when their PSR is below 0.20 and popular when they are over 0.80. Thin margin businesses are unpopular at the 0.03 level and popular at 0.12.

While the PSR is a key factor in Fisher’s approach, it is clearly not the only factor to consider. Terrible companies can have a low PSR simply because the market sometimes recognizes a badly run company. The other things we need to consider are profit margins, earnings growth and free cash flow.

There is any number of ways to determine if a company’s common shares are priced for positive future returns. Fisher offers us an insight to one such method.

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The Price Sales Ratio Revisited

For over a year I have been arguing that more attention needs to be given to the supply side of the equation. Yes, the growth rate of real GDP has been going down and the rate of employment has been going up. But, the rate of inflation, as measured by the rate of increase of the GDP price deflator has not declined since the fourth quarter of 2007. If it were just a demand side problem, this would not be the case.

I focus on the rate of increase in the GDP implicit deflator because of some of the measurement problems associated with the Consumer Price Index, such as the treatment of housing expenses and energy. Certainly, the CPI should be watched, but in dealing with economic aggregates, I prefer the former.

My point has been that if the problems in the economy were all tied to a substantial fall in aggregate demand, then there should have been a more substantial lessening in the rate of price increases. Consequently, my argument has been that something has happened on the supply side of the economy for the numbers to have been reported as they have been.

I would like to point to two areas of the United States economy that indicates that the problems of recovery may be more difficult to overcome than if the dislocation in the economy were just one of inadequate aggregate demand. The first area is that of industrial output; the second area is the labor market.

In terms of the industrial base of the economy I would like to focus upon industrial production and the industrial utilization of capacity. Industrial production has been declining steadily since the start of the recession in December 2007. At that time, industrial production was growing at about a 2.0% year-over-year rate of growth. By April 2008 the year-over-year rate of growth had become negative. The figures for 2009 are
January -10.8
February -11.3
March -12.6
April -12.7
May -13.4

This certainly shows a continuing weakening in the economy. However, taken by itself I don’t think that it carries more meaning than does the decline in the rate of growth of real GDP which has been declining as well.

Combine this performance with the figures on capacity utilization and one gets a different picture. As expected, total industry capacity utilization has dropped substantially in this recession. In December 2007, the figure stood at a little over 80.0%. In May 2009, capacity utilization had fallen to about 68.0%. This is the largest 18 month decline in the post-World War II period.

But, this is not all. The peak in capacity utilization in the past ten years was only slightly more than the December 2007 figure. But, this peak of the last ten years was substantially below the level of capacity utilization for most of the 1990s which was below the peak utilization in the 1970s which was below the peak utilization in the 1960s. That is, it appears as if we have been using less and less of our capacity on a regular basis since the 1960s.

The structure of our industrial base is changing. We can see that in autos, in steel, and in many other parts of our manufacturing base. It appears as if the weakness in our economy is composed of two things: first the cyclical swing in business; but this weakness is on top of a secular decline in our productive ability. The economy is in the process of restructuring!

This shift is also showing up in labor markets. The civilian participation rate in the labor force for the United States rose from the late 1960s into the 1990s when it peaked a little above 67.0%. The civilian participation rate has declined since late 2000 and has remained below 66.2% since 2004. In terms of the number of people who are not participating in the labor market any more, this represents a large number. People have left the labor force in the last five or six years and this trend has, of course, been exacerbated by the recession. Over the past forty years the rise in the participation rate has slowed down or stopped during recessions, but at no time did it decline as it did in the in the past six years.

Of further interest, the Labor Department reported that separations from jobs in April remained relatively constant as they have for the past two years, but the rate of hiring continued to be quite low. In early 2008 the percentage of the labor force that were separated from their jobs was about equal to the percentage that were being hired. Since then separations have exceeded hirings, as might be expected, causing the unemployment rate to rise.

In terms of those that were separated from their jobs, there was a dramatic shift between those that quit their jobs and those that were laid off or discharged from their jobs. The percentage of layoffs and discharges rose dramatically from April 2008 to April 2009 whereas quit levels dropped substantially. That is, although separation rates did not change much at all during this time, the composition of those being separated from their positions experienced a tremendous shift. This is an indication that there is a structural shift in what is happening in the labor markets.

This information leads me to believe that there is a substantial restructuring taking place in the United States economy. And, a structural shift is a supply side issue and not a demand side issue. In fact, demand side responses can just make a bad situation worse by trying to force people back into positions that companies and industries are attempting to eliminate because the world has changed.

The figures on industrial production and capacity utilization seem to indicate that industry is changing and the numbers from the labor market reinforce that conclusion. Pumping up aggregate demand is an attempt to stop this restructuring or, at least, slow it down.

The problem that policymakers’ face is that they, or we, do not know what the new industrial structure is going to look like. It is impossible for anyone to know. People can make guesses, but that is all they are—guesses. And, in situations like this, it is more likely that the guesses will be wrong rather than being right. It’s just that the future is unknown. The need for the United States economy to restructure just adds another “unknown, unknown” to our list of “known unknowns” and “unknown, unknowns.” My guess is that this restructuring is going to take some time and could be sidetracked by huge government deficits and a supportive monetary policy.

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A Walk on the Supply Side

In the world of finance we can innovate and change and find ways to get around regulation. This has been the modus operandi of the financial system during my entire professional career. Consequently, the financial system of today in substantially different than the financial world that existed in the 1960s. I have called the last fifty years or so the age of financial innovation. Regulation and oversight of the financial system does have to change. But, we need to be careful about the change in regulation and oversight that results and not just give in to populist calls to “put a stop to the greed on Wall Street”.

The characteristic about finance that fails to be taken into consideration when people believe that they can “control” finance is that finance is about nothing more than information. Finance is numbers, nothing more, and numbers can be packaged in any way that a person wants to package them. On our currency we read that “This note is legal tender for all debts, public and private.” That is, people and governments can pay you for things in this script and you must take it. And, what more is a check, or a bank deposit, or a bond, or a stock certificate? In most cases today, these are nothing but 0s and 1s in a computer system. Finance is nothing more than information and how information is handled and transformed.

The unique thing about information is that it spreads and, as we have found out historically, information cannot be contained. Of course, its spread can be postponed or stymied for a while, but eventually its spread takes place. All human history is a record of this fact.

We see this trend also works in non-financial areas. Information relating to modernity and science and democracy is spreading throughout the world. In some areas this spread is being resisted by some who are attempting to keep the world mired in the ideas of the 7th or 8th century (C. E.) This attempt to prevent the spread of the idea of the modern world has resulted in violence and tremendous pain to many. But, the spread continues. It has all through recorded history. In the end, the resisters cannot stop it and their efforts to slow it down do nothing but cause unhappiness and dislocation.

The financial system over the past 50 years or so has been an engine of new creations. In the 1960s, we saw the movement of banks from being asset managers to becoming liability managers through the creation of instruments like the negotiable certificate of deposit and Eurodollar accounts. This broke down the geographical limitations on banks and helped them continue to evade government rules and regulations. In the academic world increases in computing power combined with the vast amount of data available on the stock market allowed for the development of ideas relating to portfolio management and risk control, which culminated in the creation of CAPM and the efficient markets hypothesis. A third innovation related to the growth and development of venture capital that put money into the hands of more and more innovators starting up small businesses. All of these developments had to do with information and how that information was bundled and traded.

In the 1970s we saw the development of the mortgage backed security, the junk bond, and the leveraged buyout. The creation of the mortgage backed security by the federal government was the test case for “slicing and dicing” up cash flows into tranches that could be packaged in ways that met the specific needs of different investors. And, as they say, the rest is history.

The development of the junk bond? The legend is that Michael Milken, sequestered in the bowels of the Lippincott Library of the University of Pennsylvania discovered information about the performance of “fallen angels”. These were high quality bonds issued sometime in the late 1920s or early in the 1930s whose companies had had financial difficulties. The bonds fell out of favor and hence yielded very high returns. Milken discovered that because of the lack of interest in these securities their actual performance substantially exceeded the performance exhibited in their market pricing. This information, which was confirmed by more current information, led Milken to develop the junk bond, the first such issue coming to market in 1976.

In addition, fund managers arose, like KKR, which discovered information concerning the value of assets that were on the books of many corporations. Often, these assets were undervalued because they were recorded at historical values and were substantially below current market values. Previously, these companies were “out-of-reach” of corporate raiders, but with the creation of the junk bond, all companies in the United States came within the reach of well-funded organizations. So, finance could now reach the largest, as well as the smallest, businesses.

This evolution, of course, continued into the 2000s. The point is that as information becomes available it can be used in many different ways to serve many different purposes. “Slicing and dicing” the information known as cash flows is not new, but is a part of a process that has a long history. And, due to the nature of information this process is not going to go away.

The Obama administration is now making its attempt to re-regulate financial institutions and financial markets. The proposal offered yesterday is much watered-down from what the “more progressive” wing of the political spectrum had wanted: its thrust is not sufficiently “Rooseveltian”. Still others express concern that the administration is going too far in some areas.

My take on the Obama proposals for financial regulation: it will make little difference in the end. Obama needs to take some kind of action and look like he is attacking the problems faced by the society. In the longer run the new regulatory scheme will make very little difference.

Financial innovation is going to continue. If some efforts are constrained in the United States, they will pop up elsewhere in the world. The incentives to innovate are still there. If we force the innovation to go off-shore, then we are, in my mind, the losers. This innovation will help others but provide little benefit to us.

What is needed? To me the most important thing that is needed is openness and transparency. We need to know what is being done and by whom. As derivative securities and hedge funds grew and prospered, we heard over and over again that they could not tell anyone what they were doing because, if they did, the narrow spreads they were working with would go away. Well, guess what! Most everyone knew what deals were being struck and the spreads went away anyway. That is why these organizations needed to use more and more leverage to take on riskier and riskier deals.

Highly competitive markets where there are few if any barriers to entry cannot continually provide exceptional returns. “Trading” is not the source of sustainable competitive advantage and keeping things secret will not salvage trading schemes. Openness and transparency will result in financial institutions focusing on what really creates competitive advantage and what is sustainable. This is necessary for the existence of a strong and healthy financial system.

Secondly, we need methods to close or put-out-of-business in a more timely fashion financial institutions that are troubled or are insolvent. Re-instating and improving mark-to-market accounting is a must. Increased openness and transparency should help the market place carry out this function, but, the regulatory system needs to have more FDIC-type efficiency to move quickly into institutions and shut them down. (The Federal Reserve is not the institution to do this. It needs to keep its focus on the conduct of monetary policy.) Moving quickly to resolve problems has always been the best policy. Managing institutions based on wishful thinking, a major trait of the banking system, is not a good policy.

We need financial regulation and oversight, just as we need periodic checkups and advice from doctors. However, there is only so much that regulators can do. Unlike our physical systems, our financial systems are going to innovate and change. My guess is that in the future with the continued advancement of information technology financial innovation will continue to increase rapidly and will serve as the model for more and more of our non-financial markets. “Information markets” is the model for the future. This innovation will, in one way or another, get around whatever regulation that is imposed. That is why openness and transparency is so important. But, that is also why the system of failure and bankruptcy should be enhanced and enforced. These, to me, are the major requirements we should impose on the financial system.

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Financial Well-Being and Regulation: the Obama Effort

This is just one more piece of information that the banking system still has major problems.

This is the case even though banks are posting first quarter profits. The latest, Bank of America posted a $4.25 billion net income figure for the quarter. (See http://online.wsj.com/article/SB124021187032334351.html#mod26articleTabs%3Darticle.) But don’t get overjoyed: Apparently, excluding merger costs, Merrill Lynch contributed $3.7 billion to the posted number which included a $2.2 billion gain related to mark-to-market adjustments on certain Merrill Lynch structured notes. The results also included a $1.9 billion pretax gain on the sale of China Construction Bank shares. What does this mean? I don’t know. Who has any trust in the financial reporting of banks anymore!

What information do we have that indicates that the banks still have massive problems? Let me suggest several bits of information that add up to an exceedingly weak banking system.

First, let it be noted, again, that the Monetary Base, the aggregate money figure that is defined as all bank reserves and anything that can become bank reserves (currency in circulation) has doubled in the past year (97.5% increase year-over-year using non-seasonally adjusted data). This measure was increasing at a 2.0% annual rate in August 2008.

The in-bank component of the Monetary Base, Total Reserves in the banking system, in March, was increasing at a 1,722% annual rate (again, year-over-year using non-seasonally adjusted data). We have never seen figures like this before!
In August 2008, the annual rate of increase was -1.0. Yes that is a negative one percent year-over-year rate of increase.

And, what are the banks doing with these funds?

They are holding onto them!

Excess reserves in the banking system (non-seasonally adjusted) were right at $2.0 billion in August 2008. These are funds in the banking system that are just sitting idle on the balance sheets of banks in the banking system—not earning interest or anything. In the banking week ending April 8, 2009, excess reserves totaled $724.6 billion.

Let me put this in perspective. On September 4, 2008, the assets of the Federal Reserve System totaled about $945 billion. So, in the first week of April 2009, the banking system was keeping, in cash, a little less than the total amount of funds that the Federal Reserve had put into the banking system in the first week of September 2008!

If I look at the Federal Reserve Release H.8, I see that commercial banks in the United States, non-seasonally adjusted, had Cash Assets on their balance sheets in March of $915 billion, again quite close to Federal Reserve assets in early September. One year earlier these banks had Cash Assets of only $300 billion, so Cash Assets rose by 205% in the past year.

Now, the total banking system, in aggregate, is lending some. Total bank credit outstanding rose at an annual rate of 3.2% from March 2008 to March 2009. Within this category, Commercial and Industrial loans rose by 4.3% and real estate loans rose by 4.7%. Consumer credit rose by about 9.0%, of which credit card debt rose by 13.0%. So lending in these categories were increasing, but not by major amounts.

The interesting thing to note, security lending—Federal Funds lending and Repurchase Agreements with brokers—dropped by a third, -33.0% and Interbank loans remained basically flat. Banks reduced their lending to other financial institutions, including other banks, during this time period. Talk about risk averse.

The major story that these data tell is that commercial banks are afraid to lend, especially to their own kind. Delinquencies continue to rise, write-offs continue to rise, and banks continue to increase the provision they set aside for future charge-offs. The banks have gone back to lending only to those that don’t need to borrow, the way banking used to be. They are afraid to lend to anyone else and they are still uncertain about the value of the assets that they already have on their books.

This situation is not going to change overnight. There is not much that the Federal Reserve can do if banks won’t even lend to banks!

We see that “U. S. May Convert Banks’ Bailouts to Equity Share.” (See the New York Times article, http://www.nytimes.com/2009/04/20/business/20bailout.html?_r=1&hp.) Still the question remains, “How deep is the hole in bank balance sheets?” We cannot provide the answer to this. Ultimately, the bankers, themselves, will have to provide that answer, and my guess is that bank lending will not start to pick up again until these bankers have that answer.

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The Banking System and Bank Lending

Globes Online reported that three investment houses downgraded their recommendations for Amdocs due to the company’s reported results and forecast for continued difficulties. The investment houses, Oppenheimer, Cantor Fitzgerald and Wedbush Morgan all expect second quarter rwesults to lag.

Oppenheimer changed their recommendation from “Buy” to “Hold” and reduced their target price to $34. Cantor Fitzgerald also cut its recommendation to “Hold” from “Buy” and slashed its target price to $16 from $16. Wedbush Morgan had previously changed its recommendation from “Strong Buy” to “Buy.” The latest change brings the recommendation to “Hold”.

Amdoc’s shares rose yesterday 1.8% to $17.35.

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Amdocs Downgraded

‘The global semiconductor industry is going through one of the steepest corrections in its history,’ said SIA President George Scalise. ‘While it would be premature to conclude that the sales have hit bottom, there are some indications that the rate of decline has moderated from the final quarter of 2008.’

‘Demand for semiconductors is likely to continue well below 2008 levels for the next few quarters with a gradual recovery to follow as the global economy recovers,’ Scalise concluded.’

There are similar problems within the semiconductor materials market. The materials market was flat in 2008 as compared to 2007. Semiconductor materials market sales reached $42.7 billion globally in 2008. The industry group for the semiconductor materials market, SEMI, reports that “the wafer fabrication materials and packaging materials $24.1 billion and $18.8 billion, respectively.” These sales figures represent a decline from 2007.

“The global wafer processing equipment market segment decreased 31%; the assembly and packaging segment decreased 28%; the total test equipment sales decreased 32 percent. Other front end equipment sales declined by 32 percent”

We believe the market is discounting the recovery somewhat ahead of itself. It remains to be seen if the global economy will pick-up before 2010. Even if it does, the semiconductor market may lag the recovery. The companies we have on our watch list, Altera Corporation (ALTR), Analog Devices (ADI), Intel (INTC), QLogic Corporation (QLGC), Taiwan Semiconductor (TSM), Texas Instruments (TXN), and Xilinx (XLNX), are priced as though the recovery is already here. Sales and earnings will continue to decline through 2010. We would wait until there are signs of recovery before being buyers of semiconductor stocks.

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This is not time to own semiconductor stocks

The company is financially strong; sales growth is exceptional and earnings continue to surprise. Baxter has a solid balance sheet.

Over the past twelve months, sales grew by nearly 10%; significantly better than its five year growth rate of 6.76%. Earning grew by 21.19% as compared to one year ago and this was also stronger than its five year growth rate of 14.03%. Gross profit, operating profit and net profit margins are all above their five year averages. The consensus EPS estimate for FY09 is $3.74 compared with reported FY08 EPS of $3.16.

So what is there not to like? The medical equipment, supplies and distribution business is one bright spot in an otherwise dismal market. I believe the market has driven prices in this industry to unsustainable levels; momentum has displaced the fundamentals.

Herman Saftlas, the Standard & Poor’s analyst that covers Baxter sees continued growth ahead and higher margins. He gives the company a twelve month target price of $65. Alex Kolb at Zacks Investment Research also sees a bright future for Baxter. Barron’s also makes a strong case for Baxter.

Changes are coming to the healthcare industry. Medicare and Medicaid reimbursement rates will be cut under the Obama administration’s healthcare plan. Hospitals and other healthcare facilities will tighten inventories. How material these reductions will be to Baxter are hard to quantify.

Baxter is certainly a strong company and I take no issue with the analyst’s predictions of the future. However, my analysis pays more attention to free cash flow than it does to earnings. Growth needs to be paid for with cash and free cash flow is, in my opinion, the best metric to use in this regard.

I estimate that Baxter will generate $1.97 in free cash flow over the next twelve months as compared to $1.43 in FY08. I note that long term debt and other long term liabilities total $5,541 billion.

My value estimation, based on the fundamental factors I consider important, leads me to conclude that Baxter’s fair market value is approximately $37.56.

Disclosure: I have no position in Baxter International.

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A Short Story: Baxter International

Sales for the most recent quarter (MRQ) vs the quarter one ago are down from $9,831 billion to $9,089 billion or 7.5%. Sales, on a trailing twelve month (TTM) basis, are up about 5.2%. Standard and Poors projects a sales decrease of 9% in FY 09 reflecting the weak global economy.

Similarly, EPS for the quarter ending January 09 were down to $0.25 from $0.33 a year ealier. This represents a 23% decline. EPS (TTM) vs TTM one year ago are down 2.9%. S&P forecasts FY 09 EPS of $1.15. First Call reports consensus estimates of $1.25 for FY 09 with a range of $1.18 to $1.33.

Of greater concern to us, is margin contraction. Gross margins have been contracting since 2004 when GM stood at 68.6%. S&P forecasts FY 09 gross margins of 64%. Operating profit margins have also contracted. Reported FY 04 operating profit margins were 28.5%. For the TTM, operating profit margins contracted to 22.3%. On the plus side, net margins have held fairly steady at 20%.

Cisco’s balance sheet is strong. It has about $5.04 in cash per share on hand and generates $2.03 in free cash flow. Long term debt to equity is about 0.17 and total debt to equity is about 0.19. The current ratio is a healthy 2.79.
Return on equity is a respectable 23.8% and ROA is 14%. These are very solid numbers and compare very favorably with industry averages.

Standard and Poors has given CSCO a twelve month price target of $16.00. First Call reports a mean price target of $19.20 with a range of $13 to $33. Price targets were lowered 14 times in the past four weeks.

Value staocks are most often defined in terms of low P/E or low P/BV ratios. Cisco is trading at 13X trailing earnings and in-line with the S&P 500. Its P/BV is 2.55; not low. In a recent post, I wrote about the use of the Price/Sales ratio. In this case, the PSR is no bargain at 2.4X.

Our preference is to use a less common measure to determine value; the Price/Free Cash Flow ratio. We think FCF is a better metric to use than earnings. Free cash flow can be used to fund growth (organic and through acquisition), reduce debt, pay a dividend or repurchase debt. Free cash provides value to the shareholder, if it is wisely invested.

Cisco has a current P/FCF ratio of 10X. A year ago, it was 16X. The five year average P/FCF for CSCO is 19X. Going back a few more years, the seven year average is 22X.

Cisco reported $1.72 in free cash flow for the TTM ending January 09. Over the next twelve months, we project CSCO to generate $1.96 in free cash. At current prices, the forward P/FCF is about 8.25X. Our target value for CSCO is $28.96, representing a forward P/FCF of about 14.8X. This is less than year-ago levels and reflects continuing weakness in the global economy.

Disclosure: I hold a long position in CSCO.

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The Bargin Bin: Cisco Systems