How and When to exit Mr Bernanke?

Independent of whether the Feds Chairman will receive his confirmation vote for a second term in office or not, the Fed will have to think about how it should eventually exit from unconventional monetary policy. Story in short: Since August 2008 the Fed balance sheet has increased from $874bn to $2,190bn, with most of the increase financed by creating bank reserve. The Fed has in total accumulated assets for more than $1000bn and at the same time interest rates have been slashed to almost zero. Other central banks (e.g. the Swedish Riksbank) have taken a different route to improving liquidity and issued short-term loans with very low, fixed, interest rate. In this case the exit will take care of itself; the loans will mature (in most cases after one year) and as long as no further loans are issued things will return to normal. Not so for Mr Bernanke, who has to think about if he should tighten policy by selling back Fed’s assets before increasing the interest rate in order to curb inflation and prevent the formation of excess bubbles.

When contemplating these $1000bn and the low interest rate, it is easy to see that demand is manipulated and that the stock market has been on steroids for the last 10 months. Owning shares right now feels a bit like being in a chicken race. When all the fiscal stimulus around the world is being pulled back from the markets, share prices are going to be shaky for some time. If this exit isn’t handled with extra care, it can also severely hurt real demand in the economy and pull some countries back into a recession. But this is actually a good reason for staying in the chicken race for some time. Who wants to end the stimulus sooner rather than later if the stakes are so high? If you move slowly and save the world economy, who cares if you create a few asset bubbles along the way?

Project Management Case Study Part 1: Background and Assignment

Background

Back in 2000, Infineon Technologies was the world market leader in chip-sets for Cordless Phones, also known to many as DECT Phones. Infineon had reached that position thanks to fruitful combined efforts with its one time owner, Siemens, which then had the no 1 position in the market for these consumer products. At this time, the Vice Presidents at Infineon’s Business Group for wireless communication (WS) decided to stop all new product development in the Cordless segment in order to be able to invest in future technologies with higher growth and profitability prospects such as Bluetooth and Wireless LAN.
In the beginning of 2005 the WS Business Group was in trouble. Its most important segment, that for cellular communication (GSM, UMTS, EDGE, etc), was still very dependent on one customer: Siemens. And Siemens was losing market share. Fast. In this environment, the newly appointed Head of the Business Group, Kin Wah Loh, decided to prioritize serving customers in segments where significant revenue and profits were generated and where Infineon in the short term could grow with its customers. This meant, amongst other things, a restart of product development efforts within the Cordless segment in order to send a very clear signal to the customers who by now were at the limits of their own imagination and engineering skill when it came to develop new phones based on Infineon´s old chip-sets. Why, you may ask, were these customers still using archaic Infineon products when there were plenty of others to choose from? The answer is twofold: Firstly, the Cordless Phone market (especially in the low-cost segment) is volume driven and margins are low. Since Infineon had decided to stop investment in the product segment, it could of course offer an attractive price and still be profitable. Secondly, the customers had developed software based on Infineon´s HW architecture that could not easily be ported to other platforms without significant effort. This effort comes at a price too high for a producer of low-cost phones were feature sets anyway were only slightly more advanced than they were four years ago.

The Assignment

Once the decision to restart the Cordless programme was made, a Programme Manager was announced to take care of the current business, strategy, etc. Shortly after that I was, as the second person in the programme, assigned to head up the development of the new platform for cordless phones.

How to become very successful

If you’re a very successful person, you’d probably like to think of yourself as a gifted but self-made and hard-working individual. In his latest book Outliers, Malcom Gladwell takes a slightly different view and describes, by looking at e.g. differences in circumstances and timing, how social factors interact with sufficiently intelligent, devoted and hard-working people to make them exceptional, to make them the outliers.

UK cover version

In a nation where the idea of the American Dream still prevails, this book has ignited some heated discussions. It often seems like readers have interpreted Gladwell as giving the social factors too much weight. My interpretation of Gladwell’s point of view is that while there are many who possess the intellect, skills (not always the ones we think of) and devotion to become true outliers, not everyone can become one. These are necessary but not sufficient criteria. The circumstances and timing also have to be such that the skill set and devotion pays off. A person with Bill Gates’ skills and build wouldn’t have particularly successful if born in a medieval village in Scandinavia when the Viking leaders were raiding and fighting for power.

Read the book, it’s full of insight and can alter your view of the world. Here are some comments from Malcom Gladwell himslef and from others.

Scania AB post Q2: Analysis and valuation

After the Q2 report from the Swedish truck and bus manufacturer Scania AB, it’s time to have a another look at the valuation of the company. First some brief statements from the report itself and a comment on our estimates.

Scania posted a Q2 loss, all results worse than expected and management expects a tough Q3

After competitor AB Volvo reported lower than expected sales due to a weak market, we lowered our estimates for Scania Q2 and the FY2009 in an analysis (Swedish only) one day prior to the report. Expectations were reduced in all areas: sales, gross margin, operational and financial result. However, the report still came in lower than expected.

Net Sales were 14429 MSEK (1331 MEUR), 12% lower than our estimates, the gross margin came in at 19% (we: 21,9%), and Scania recored a 150 milion SEK loss after tax where we expected a 420 milion SEK profit. The difference was majorly due to weaker market conditions (i.e. lower sales). ,

In terms of outlook, the management team was adding to the pain when it concluded that

“The demand in Q3 is likely to be on the same level as Q2. Come September, we’ll know better where the market is heading.” (Leif Östling, CEO)

and regarding credit losses in financial services Jan Ytterberg (CFO) commented that

“We haven’t seen the worst yet. I believe that Q3 will be difficult for the transportation industry.”

Two different ways to assess the company value

In order to figure out if Scania is traded at a fair value, we have carried out a DCF analysis based on two different scenarios.

1) Using the median value of analyst estimates

Scania AB publishes an overview of analyst estimates on its company homepage. For each year of the years 2009, 2010 and 2011, we have used the median EPS estimate in our DCF analysis. These predict that Scania will earn 1,88 SEK per share this year, increase it (by 104%)to 3,8 in 2010 and (by 51%) to 5,8 in 2011. For the years 2012 and onwards, we have used an average growth rate of 5%. This DCF analysis yields a Fair Value (FV) of 69 SEK.

2) Using the past to predict the future

Scania has been through downturns before, (although this one is tougher and more sudden than any of the downturns after 1945), the last one in 2001. We have used past sales and operating margin growth data from the four years after the 2001 downturn in order to predict the EPS for 2010-2013. We have also compensated for the fact that this dip is bigger than the 2001 one, by exaggerating the EPS growth for 2010 compared to the historical data. This analysis predicts an 2010 EPS of 3,76 SEK and growing by 27%, 17% and 12% for the three years thereafter before turning to the long term growth estimate of 5%. This DCF analysis produces a FV of 66 SEK.

It should be mentioned that these EPS estimates are by no means conservative. Given the current market situation, it is very doubtful that Scania will reach 1,88 SEK this year, not to mention a 100% EPS growth in 2010. I believe it  is fair to say that these levels suggest a quite rapid market recovery during 2010. In this context we also note that CA Cheuvreux today increased its recommendation for Scania from underperform to outperform (target level 106 SEK from 60 SEK earlier), in an analysis entirely based on the assumtion that Volkswagen will sell its part of Scania to MAN and thus triggering a mandatory public offer. The Scania share rose 4,6% to 85 SEK on these speculations.

Conclusion

It may be tempting to speculate on a mandatory offer from MAN and buy the Scania share on the basis of such speculation. However, even on the basis of aggressive EPS estimates (as above) the Scania share trades above its fair value and so is fundamentally overvalued. Based on the current company performance and the market developments, Scania is a clear cut sell case. We took at short position at 85 SEK in todays closing trade.

H&M - Analysis prior to Q2 report

This analysis will be one of a slightly different character. To begin with it is, in response to popular demand, written in English. The target of this analysis is to evaluate what position to take prior to H&M’s Q2 report due on June 25, 8:00am, CET.

From a shareholder’s perspective, H&M is a tremendous company which has delivered consistent sales and net profit growth over the last 20 years or so. The average sales growth over the last four years has been 13% and EPS growth is even better: it has risen 110% from 8,8 SEK in 2003/04 to 18,5 SEK in 2008/09. These are truly impressive numbers.

From a purely financial point of view, the reasons behind this performance are the following:

New Stores

Almost all of H&M’s growth comes from opening new stores. During the last four years, H&M’s store growth rate has been on par with the growth in sales (see table 1). The company target for this FY is to open another 225 stores, adding 13% to the total. But in equivalent H&M units, the average growth rate over the last three years has been a meagre 2%. Last year the sales per equivalent unit shrunk by 1%.

Table 1: H&M past performance and estimates for 2008/09

Currency effects

During the three years up to July 2008, the USD depreciated in total roughly 25% against the SEK (H&M’s reporting currency) and even more against the EUR. Since most of H&M’s purchasing volume is in USD and sales in the Euro zone account for more than 60% of the total, these currency effects have been favourable for H&M and are one big part of the explanation behind the stunning margin improvements.

Q1 report

Some highlights from the Q1 report (Dec-Feb):

• Gross margin was 56,6%, down from 59,6% in Q1 07/08. According to H&M, unfavourable currency effects (e.g the USD rallied against the SEK during Sept-Dec 2008) knocked 4,2 percentage points off the margin.
• Sales in Q1 were up 18% year on year. Most of this growth came from the Euro’s appreciation vs. the SEK; in local currencies sales only grew by 4% and shrunk by 5% for comparable stores. Unfortunately, currency effect is also visible in the gross margin, as most CoS items are paid for in USD (see the first bullet).
• Germany, which accounts for 25% of the company’s revenue, is by far the biggest single market. See Table 2.

Table 2: H&M top markets Q1 2008/09

Market expectations for the Q2 report

According to SME Direkt, a market research firm, estimates from 20 analysts expect on average 20% sales growth and 3% EPS growth for the fiscal year 2008/09.  Injecting these figures into a DCF analysis, assuming  zero growth next fiscal year and a long term EPS growth of 5%, the FV turns out at 400 SEK.  The H&M share was down 2% on Monday June 22, from 365,50 to 358.  So are investors beginning to doubt the consensus estimates? Let’s have a look at an alternative view.

Stretch Target alternative view

In light of the performance in Q1, I would argue that the estimates above look rather optimistic. In Q1, the gross margin was 3 percentage points lower than last year. Due to currency effects, sure, but these are likely to remain. It is in the current financial environment not very likely that the SEK, which is a relatively small currency and hence sensitive to risk aversion, will gain massively against the USD during the next 6 months. It is instead reasonable to assume that the USD will remain around 8 SEK during this period. This would decrease the gross margin by three percentage points to 58,5%.

A more conservative estimate of the sales figure would be 18% year-on-year due to currency effects. This would result in sales of 104,5 and resulting in an EPS of 16,7. Assuming the same EPS development as above, this yields a FV of 349 SEK.

Conclusion

I find the alternative, more conservative, estimate to be more likely that the anayst consensus.  I believe that we may see the first signs of lower-than-expected margins and possibly sales in the Q2 report. A report lower than expectations is of course likely to have a negative effect on the H&M share price. I will sell H&M short down to 350 SEK (only 2,2% lower than now) prior to the report and close the position at 340 SEK if given the opportunity.