18 May 2007 Private Equity Still Snapping-up Wall Street ‘Bargains’
Despite another week of lackluster news from the economy, the S&P 500 and the Dow Jones Industrial Average are headed for their seventh straight week of gains. The Dow has declined only 5 days out of the last 30. Record takeovers so far this year are steadily driving stock prices higher. Today’s prices are up on two more takeovers and a surprise increase in consumer confidence. The Reuters/University ofMichigan’s preliminary index of sentiment rose to 88.7% this month from 87.1% in April. It was the first increase in four months as strength in the labor and stock markets overcame record gasoline prices.
The average price of a gallon of regular gasoline rose to a record $3.13 yesterday, about 30 cents more than the average for April, according to the American Automobile Association. Crude oil jumped above $65 a barrel inNew Yorkon speculation thatU.S.gasoline supplies won’t be adequate to meet demand this summer. The Energy Department reported that gasoline inventories last week were 7.5% below their five-year average for the period.
Bloomberg reports that the profit margin for turning crude oil into fuels has more than tripled this year. It rose to $30.292 today, the highest since at least 1989, based on closing futures prices inNew York. Refiners are doing all they can to get up to full capacity to take advantage of these high spreads and may be cutting back on basic maintenance. Energy traders expect that the system could break down more than once this summer under such high capacity demands.
Homebuilder sentiment dropped to a 16-year low this month as reported by the National Association of Home Builders. An index reading of 30 was three points below last month’s level and a full 20 points below the 50 point benchmark where builders foresee “good” sales in the coming months. The WSJ reported that David Seiders, the NAHB’s chief economist, said the subprime crack-up “has infected other parts of the mortgage market as well as consumer psychology” and that the outlook for housing has further darkened as a result. Seiders’ comments and others in the industry contrast Fed chairman Ben Bernanke’s supposition that the subprime woes would be contained within that sector of the industry.
In a Chicago speech earlier this week Mr. Bernanke said a tightening in sub-prime mortgage standards will hurt theU.S.housing market and foreclosures will rise through 2008. “Curbs on this lending are expected to be a source of some restraint on home purchases and residential investment in coming quarters. We are likely to see further increases in delinquencies and foreclosures this year and next as many adjustable-rate loans face interest-rate resets.” But he maintained his forecast that the slump in housing will not harm the greater economy. In fact the consensus of policy makers seems to be that the downturn in housing is unlikely to cause consumers to cut spending. Today’s confidence report seems to support that view.
But many retailers suggest otherwise. The giant home improvement retailer Home Depot reported that its first quarter earnings dropped by 30%. Chief Executive Frank Blake said that “we continue to see headwinds in our market and are not planning for any near-term market improvement.” Earlier in the year Home Depot said it expected to see some improvement during 2007. Lowe’s reports earnings next week.
Numerous retailers beyond the housing industry reported difficulties during the first quarter as well. This week Wal-Mart, the world’s largest retailer, said that first-quarter sales at older stores rose 0.6%, the smallest gain in at least 10 years. The company cited higher fuel costs, and it predicted second-quarter profit may miss analysts’ estimates.
The Conference Board added to the drumbeat of retreat as they reported an unexpected drop in the index leading economic indicators by 0.5%. It represents the third decline in the last four months. The gauge indicates the economy’s direction over the next three to six months.
While investors worry over whether a soft or hard landing is ahead for the economy, the face of Wall Street is changing before their eyes. Mega public companies are going private or consolidating in record numbers. Chrysler was recently won by the private-equity firm Cerberus. Bausch & Lomb agreed to be acquired by private-equity firm Warburg Pincus for about $3.7 billion. The private-equity juggernaut Blackstone Group broadened its expanding array of financial services by acquiring marketing-services and data-processing concern Alliance Data Systems for about $6.4 billion. That price represents a 30% premium to Wednesday’s closing price. General Electric Co. rose today on expectations that they will sell their plastics unit to Saudi Basic Industries Corp. for about $11 billion.
Hedge-fund manager Fortress Investment Group announced its acquisition of Florida East Coast Industries for about $3 billion plus assumption of $500 million in debt. Before this year, Fortress was private, but recently offered shares to the public. This week they reported a 52% earnings slide illustrating the risks of this privatization trend. And it’s not just investors who are at risk according to Mr. Bernanke. In response to a question regarding the Fed’s concern about risks for banks in this wave of large private-equity deals, he responded there are “significant risks associated with the financing of private equity.”
According to Bloomberg, announced mergers and acquisitions involvingU.S.companies this year total $993 billion, 62% greater than at the same time last year. Microsoft’s acquisition of aQuantive, Inc for $6 billion announced today puts that number effectively at a trillion dollars of acquisitions so far this year.
The continuing elevation of stock prices is not in and of itself worrisome. Stock prices relative to earnings are within comfortable ranges compared to bond yields and relative to themselves. It’s the rush of private capital to get their deals done before the door slams shut on attractive values that driving indices ever higher. How high will they go? There’s still plenty of capital sloshing about in the global economy and values are still pretty good, so there’s no telling.
Our focus on large and mid-cap high quality dividend payers has kept us in the market’s sweet spot, and we have participated nicely in the advance. But we have carefully maintained our strategic allocations in other asset categories for diversification’s sake in case some event comes along to knock the pins out.