Wednesday, August 4, 2010

David Stockman on GOP Tax Policy/Bought 100 MBC at 9.78/ADM EMR FE BKMU/Sold BKMU at 5.93

David Stockman, a former GOP Congressman and Reagan's Director of Management and Budget, wrote an interesting article in the NYT. He claims that the GOP has changed its stripes from a party of responsibility and fiscal conservatism, and I would certainly agree with that view. The GOP now is simply unrecognizable from the party that I knew as a young man, and the changes are not for the better. He regards the current GOP push to extend the Bush tax cuts as tantamount to filing a Chapter 11 bankruptcy petition for the U.S.

Since the next Governor of Tennessee is likely to be a Republican, I will vote in the August 5th Republican primary for the GOP Mayor of Knoxville, Bill Haslam, as the least objectionable candidate, the criteria used to make almost all of my voting decisions. And Howard Baker endorsed him, and Howard is more of a traditional Republican than the current ilk.

The personal savings rate rose to 6.4% in June, the highest rate in a year. News Release: Personal Income and Outlays, June 2010 The rate for May was revised up to 6.3% from the earlier estimate of 4%. Real disposable income rose .2% in June and .4% in May. During the Age of Leverage, the savings rate steadily declined as consumer's debt load increased as a percentage of disposable income. Eventually, the savings rate went into negative territory as debt soared to over 130% of disposable income at the start of the financial crisis. The ultimate causes of the financial crisis were too much debt and the improvident extension of credit which fueled the creation of a bubble in housing prices.

One of the most interesting series of charts which explain intuitively what happened can be found in this publication: I have previously referenced those charts on many occasions throughout this blog. Of course, money saved is not spent, but consumers have to repair their balance sheets by spending less and saving more before a sustainable economic recovery can take place. So, an increase in the savings rate may have short term negative impacts on the U.S. economy, but it will be a positive over the longer term.

1. Added 100 of MBC at $9.78 on Monday (see Disclaimer): I previously bought 100 MBC at 9.84 and I received the 3% annual guarantee for the first coupon period in May. Item # 8 MBC I will just copy my earlier discussion about this principal protected note and then add a few comments.

" MBC is another Citigroup Funding unsecured senior note that matures on 6/9/2014. This security has a similar structure to the others which I have recently purchased and discussed in this blog.

Par value is $10 which will be paid upon maturity provided the issuer is still solvent. I view the issuer's credit risk to be the main risk of this security.

Citigroup will pay annually a 3% guaranteed interest rate calculated on that $10 par value or $30 per year for 100 shares. As with the other Citigroup principal protected notes previously discussed, it is possible for the investor to receive more than that 3% guarantee. This particular note will pay up to 30% based on the increase in the Russell 2000 index from the starting value for each annual coupon period, with the usual proviso. I call this proviso the reversion clause. If there is one day when the Russell 2000 index closes above that 30% maximum amount, there is a reversion to the 3% guarantee and the closing value of the index is no longer relevant for that coupon period. The index could end up 28% for that period but the investor would still receive that 3% due to a maximum level violation."

When I bought the first 100 MBC, there had already been a maximum level violation and a reversion back to the 3% guarantee. The first coupon period ended on May 21, 2010. Final Pricing Supplement MBC is currently in its second annual coupon period. I believe that the starting value of the Russell 2000 index for this second period is 649.29, the index value on the closing date for the first annual period and the starting date for the second. ^RUT The second coupon period ends on 5/20/2011. MBC will pay the greater of 3% or the percentage gain in the Russell 2000 from the Starting Value to the closing date, but only up to 30%. And, as previously discussed, there will be a reversion to 3% irrespective of the increase if the Russell 2000 has just one closing day above a 30% increase from the Starting Value of 649.29. This places the maximum level at 844.077 in the Russell 2000 index. If there is one close in the Russell above 844.077 between 5/21/2010 and 5/21/2011, then MBC pays the guarantee of 3% again.

By way of example, assume there is no maximum level violation and the Russell has a closing value of 825 on the closing date of the second coupon period. The percentage gain over the starting value of 649.29 in that hypothetical would be 27.06%. That would mean an annual payment for the second period of .2706% x. $10 par value or $2.706 per share and $270.6 for 100 shares.

The ultimate downside for all principal protected notes is the bankruptcy of the issuer. Since this is a senior unsecured note, such an event would cause a loss of most of my investment. Assuming Citigroup survives to pay off the note in 2014, then my downside is the receipt of the minimum guarantee of 3% for each of the remaining coupon periods (2011, 2012, 2013, 2014). The maximum upside is 30% per year plus a small profit on the shares at maturity. A more realistic maximum upside is one year of 3%, one year over 20%, and two years between 10 and 20%.

I also own MOU, which is also tied to the Russell 2000, but has a higher maximum level of 37% and a lower starting value for its second annual period. Bought 100 MOU at $10.12 This one had a reversion to 3% in its first coupon period too. The next closing date is 2/23/2011. It was a tough call whether or not to buy another 100 of MOU or the MBC bought Monday. One reason for buying MBC was that shares were available at a discount to the $10 par value on Monday, which was not the case for MOU. Still, at some point, I might sell 1/2 of MBC and buy another 100 of MOU, depending how the situation develops over the next few months.

2. Archer-Daniels- Midland (ADM)(Owned): ADM reported fiscal 4th quarter net income of 446 million or 69 cents a share, a major improvement over the 9 cents earned in the linked quarter. For the fiscal year ending 6/30/2010, ADM earned $3 per share. The consensus estimate was for 52 cents.

ADM saw improvements in operating profits from all of its business segments. The operating profit in the oilseeds processing unit increased 132 million "due to improved margins and higher volumes". The corn processing unit operating profit rose 151 on "stronger bioproducts results". The agricultural services unit saw an operating profit surge of 195 million on "good global supply of grains and oilseeds and modestly improving demand, particularly in Asia".

3. SOLD Bank Mutual (BKMU) AT 5.93 (See Disclaimer): When discussing this bank's last quarterly report, I mentioned that its efficiency ratio was a pathetic 98.03. Item # 4 BKMU This indicates to me that the managers of this bank need to be replaced. Generally, investors want to see this ratio below 50 and certainly no higher than 75. Efficiency and Operating Ratios The efficiency ratio is arrived at by dividing operating expenses by the sum of net income income before loan losses and non-interest income. The abnormally high expense ratio was one reason for placing this bank in category 1 of the Regional Bank Stocks strategy.

Another reason for my low regard was the bank's negligible profitability which did not support the current dividend payout. I mentioned that I would not be surprised to see a dividend cut. Item #2 Bought 50 BKMU at 5.51. The Board just cut the dividend from 7 cents to 3 cents. This does not bother me except on a couple of levels. The bank did not mention in the press release that it was cutting its dividend. I abhor that practice. And, while shareholders take a hit, I am confident that management will not do the same for themselves or do much to improve the bank's efficiency and profitability in any meaningful fashion. The only way for that to improve is for another bank to acquire BKMU and then do what needs to be done.

After writing the foregoing, RB said BKMU needed to be sold before LB's negativity infected the Old Geezer requiring a transfusion of a cocktail of anti-depressants. OG did not care one way or the other about BKMU, a typical response, and went ahead and sold the 50 shares at $5.93 to avoid having to listen to more of LB's criticisms.

4. Emerson Electric (owned): My last purchase of Emerson shares, other than through reinvestment of dividend, was at $33.33 in November 2008. EMERSON Emerson beat the consensus estimate for earnings per share by 10 cents and raised its guidance for FY 2010 to a range between $2.60 to $2.7. Emerson reported net income for its 3rd fiscal quarter of 585 million or 78 cents per share, an increase of 53% from the 51 cents earned in the linked quarter.

After initially popping to $51.8 in trading yesterday, EMR shares closed down 1 cent at $50.84.

5. FirstEnergy (FE) (non-core electric utility holding): FirstEnergy beat the consensus estimate by 4 cents and raised its guidance for 2010 to a range of $3.6 to $3.7. The consensus for 2010 had been $3.54 prior to this report. FirstEnergy reported net income of 256 million on a GAAP basis or 87 cents per share, and 82 cents on an adjusted basis. Distribution sales increased by 8% compared to the 2nd quarter of 2009 "driven by a 13 percent increase in usage from industrial customers, particularly in the steel and automotive sectors."

FE shares closed at $38.6, up 16 cents in trading yesterday. I recently sold 50 of my 150 FE shares and invested the proceeds in an ETF: Sold 50 FE at 38.77 & Bought 100 DHS at 35.32.

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