Tuesday, November 10, 2009

Why Buffett Finished Off Burlington: It’s the Inventories, Stupid


Well, what the heck: why not use a great line, slightly altered, to make a point?

The point being that what Pink Floyd once called “what the fighting’s all about” (at least as far as capital markets go) is not, strictly speaking, the economy.

Sure, everybody has an opinion on whether we’re going to have a V-shaped, U-shaped, W-shaped or L-shaped recovery (what happens in China: do they have sinographic recoveries?).

Even my dog Charles has an opinion: he thinks it’s going to be shaped like his giant plastic red dog bone.

But the issue that will determine the near-term course of the economy is simple enough, and has nothing to do with letters or ideographs or even giant red dog bones: it’s the inventories, stupid.

And inventories are probably as low as they are ever going to go.

Here’s how the CFO of 3M put it on their October 22 earnings call:

Heading into 2009, in the face of such a significant economic collapse, we set very aggressive cash flow targets for each of our businesses. Ground leaders and their teams have responded with great results. Third quarter free cash flow is $1.6 billion, up $769 million versus last year's third quarter. This represents a 97% year-on-year increase. The improvement was driven by many factors, but most notably by lower capital expenditures, improving that working capital, lower cash tax payments and also reduced cash pension contributions. Net working capital declined by $415 million year-on-year, with inventory down $443 million....

Lest anyone think we cherry-picked a particular industrial conglomerate in the form of the famous Post-It notes maker, we did not. Pick any company in the same SIC code as 3M and you ’ll hear pretty much the exact same story.

And it is not just old-line conglomerates that have brought inventories down to can’t-go-lower levels.

Bob Wachob, the CEO of Rogers Corporation, which makes, to be technical about it, stuff that goes into cellphones, told listeners last week that his company’s hi-tech customers have not much in the way of surplus inventory:

Our customers are continuing to order with a request for extremely short lead times. That is a good indication they don't have any inventory.

As for Rogers’ own inventories, Wachob said, without mincing words:

I think we are as low as we can go without impacting our customers.

Even a homebuilder as bruised and battered as Beazer has begun running low in inventory at the very moment orders are increasing, as reported earlier today:

As of September 30, we had only 270 unsold finished homes and 417 unsold homes under construction representing declines of 34% and 27% respectively from year-ago levels. With a cautiously optimistic outlook, we do not contemplate further significant reductions in our unsold home inventory levels but rather the resumption of more normal seasonal patterns.

Net new home orders of 1012 for the quarter represented an increase of 2.4% year-over-year.


Most striking of all, however—just as far as being emphatic about it goes—was Jeff Siegel, the CEO of Lifetime Brands, a kitchenware maker that sells to the Bed, Bath and Beyonds of the world, when he was asked by one of Wall Street’s Finest to size up the inventory reduction at that firm’s major customers:

It's shocking. Honestly, it's sometimes a shocking number. And I don't -- I can't get at the numbers by retailer, but we do get it from -- like one retailer we're down about 6% on point of sale at one retailer. Our inventories are down over 30%.

In other words, while sales of Lifetime’s products at this unnamed retailer are running 6% below last year, inventories of those same products at that same retailer are down by one-third.

The response to Siegel’s comment from the member of Wall Street’s Finest who asked the provocative question?

“Wow.”

Wow indeed.

So what happens when somebody actually needs to order a pallet of new flexible circuits for a rush order of cell phones, or an extra gross of Post-It notes not available on the loading dock, or a set of kitchen knives not sitting in the warehouse…or, heaven forbid, a whole new house?

Now, we’re well aware that Warren Buffett doesn’t make short-term bets on markets or economies.

But given the fact that he stands at the center of an economic supply chain that stretches from a candy maker in South San Francisco to a high-tech machine tooling supplier in Israel, we think it’s no wonder Warren Buffett decided the time was right to buy the rest of Burlington Northern.

There’s going to be a lot of—to be technical again—stuff that will need to be getting moved around in the next twelve months.

It’s the inventories, and Buffett isn’t stupid.



Jeff Matthews
I Am Not Making This Up



© 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

15 comments:

dre said...

Inventories as % of sales are unchanged. If we see a sales rebound we will see an inventory rebound, but what if sales continue to be punk? People are buying stocks like BC and PII based on their low inventories, without regards to the secondary market or valuation.

Aaron said...

Jeff:

Berkshire Hathaway's purchase of Burlington Northern Santa Fe is a "classic" Buffett buy: an easy to understand business, trains hauling "stuff" over railroads, in an oligopolistic industry with "moat-like" characteristics, such as its network of railway lines and operational scale in intermodal shipping, and smartly allocating capital over the last four years for cap ex on net PPE, share repurchases, and dividend increases .

I get your post that BNSF's future earnings power should come from U.S. companies replenishing their inventories and shipping both hard and soft goods via BNSF's intermodal operations over time.

I'm concerned, however, that because commercial banks have curtailed their lending, both retail and manufacturing businesses will not be able to access needed capital so they can expand their operational activities.

In addition, because credit card companies cut back consumer credit and increased the interest rates which they charge their card holders, consumers will not be able to spend and jump start a future economic recovery because they are too busy saving.

What I'm getting at Jeff, is this: Yes, BNSF is a great business but don't you think Buffett jumped the gun on this purchase, given the current headwinds railroad companies face with declining demand for railcar loads of items such as coal, automotive products and other "hard goods" relating to the housing sector?

Just wondering out loud, and I never dreamed I'd be thinking about macro-economic fundamentals when studying a stock like BNSF.

John said...

It's amazing what happens when we are willing to send the bill to the next generation, isn't it. Even more interesting is how the people in power are spending the next generations money to stay in power. Watch how some of those tax dollars are returned to Washington in the form of campaign donation or spent on K-Street. Its a perfect circle. The only real fuel needed is a new generation and that happens instinctively. Like i posted under the story in Barron's about the for-profit , publicly held schools..The Adam Smith , John Locke types would be proud. Wall Street and Washington have created a new political / economic system based on a Jules Verne like cold fusion, perpetual motion machine , power perservation system thats based on a circle and the sex drive and our willingness to pass the bill on to our kids ( i have none ) Nothing like a
Wall Street induced meltdown to put the financial troubles of medicare and Social Security on the back burner. ....Can you guys tell me who was the first to realize there was big money in directing that goverment revenue stream ( your tax dollars ) to a publicly held company and call it privatisation..Oh yes. the miracle of stock options ! Here is a hint... Years ago George F. Wills said the federal government has become nothing but a money transfer station .

"מר רפי נלסון" said...

Judging from 00-09 experience, Jeff, total Inv/Sales ratios are not quite yet at trough levels:
http://www.census.gov/mtis/www/mtis_current.html
Can you comment on a wider historical context?

Siddharth said...

Interesting analysis. Reached here from business insider. Is Burlington also going to play a part in possible increase in public transport due to a possible push to reduce overall fuel needs?

Jeff Matthews said...

Aaron: Actually, what I'm saying is he didn't 'jump the gun.' He fired the gun.

He made a $44 billion total capital committment to BNSF, and he didn't do it because he thought next year was going to be terrible.

He sees something, and I think he sees the inventories, and the start of the up-cycle, and it's now or never...until the next crisis.

donnie deutsch said...

a bold call indeed

Jeff Matthews said...

Call it a Big Idea.

Cheers,

JM

John said...

I'll give ya bold call. Bernie Kerik arrived home last night. The house looks like its locked up tighter that a drum. No real sign of life except one huge American flag flying on the front lawn. Its the size of one you would expect at the Whitehouse

Tom said...

After selling a gazillion long-dated S&P puts that blew up in his face, WB really doesn't have any choice besides "all-in." The question is why so much on Burlington--I thought diversification was the only free lunch in asset management? Why now and not 6 months ago? And why $100, who else would pay $90 or even $80?

Could management have walked away from $80 without risking their careers?

PhillipCharles said...

Mr. Matthews,

In all of the stories and commentary I have read on this topic (BNI) over the past 7 days, your post is the first to offer what is the most practical and insightful angle I have yet reviewed, and it makes excellent sense.

Until someone creates the very lucrative technology that transports dry goods through fiber optic cables, manufacturers will be 'stuck' using railroads, railcars, and other more traditional methods to deliver what are likely to be, over an extended time horizon, significantly increased outputs.

PCM

smithycroftman said...

Jeff,

I think this is more about succession planning than anything else. Buffett knows he is a born asset allocator but the next guy most probably will not be. I am not saying he will not be a good to great investor but the chances of another Buffett are slim.

Buffett himself said that railways were a good business but not a great business because you keep having to reivest in the business, and that's where it all comes together.

Insurance throws off cash like there is no tomorrow, that cash has to earn a positive spread, so investing in capital intensive businesses such as MidAmerican and the railways solves a lot of the problems of what the next guy in the chair will have to do with the float.

BBL Jr said...

The railroad cannot be duplicated in this day and age of environmental and other legal obstructions. It is one of the greatest inflation hedges of all time.

Anonymous said...

Jeff,
the inventory theme is by now well established and common, but it was here that I saw it early on - just to say I appreciate your blog.

Now there is little question that rebuilding inventories will be good for railroads - at least short term. I am not sure I agree that is Buffet's motivation - he seems to think mostly long term, but OK.

But I also often see the inventory rebuilding process being touted as something that will contribute to recovery. But isn't it true that while firms live off inventories, their proft margins are artificially increased, while as they start rebuilding that is no longer the case? I wonder once the rebuilding really has to start, will it be strong enough to offset the lack of savings effect that came with inventory cuts?

This is all probably standard stuff, but new to me. If you could drop a line or two of your thoughts on it, I'd be grateful.

Jeff Matthews said...

Good questions. Companies have rebuilt their balance sheets by reducing inventories and receivables--exactly what consumers have been doing, too.

Economic growth will resume when inventories need to be replenished, and companies start to make more--to use that technical term again--stuff.

You have stumbled across one of the dirty little secrets of capitalism: cash balances tend to shrink during upturns, because you need capital to open plants, build inventory and extend terms to customers; cash balances tend to grow when growth slows.

What's unusual this cycle is how quickly companies cut costs and generated cash. I think companies see what's happening so much more quickly now, with supply chain software, that they're able to adjust to downturns faster.

We'll see what happens if and when they need to adjust to an upturn.

JM