<Show: BLOOMBERG SURVEILLANCE>
<Date: August 02, 2010>
<Head: Jeffrey Sprague, Founder, Vertical Research Partners LLC>
<Sect: News, Domestic>
<Byline: Tom Keene, Ken Prewitt>
<Guest: Jeffrey Sprague>
<High: Jeffrey Sprague, Founder Of Vertical Research Partners LLC, Talks
About Corporate Outlook On Bloomberg Surveillance>
<Spec: free cash flow, dividends, companies>
(This is not a legal transcript. Bloomberg LP cannot guarantee its accuracy.)JEFFREY SPRAGUE, FOUNDER OF VERTICAL RESEARCH PARTNERS LLC, TALKS ABOUT CORPORATE OUTLOOK ON BLOOMBERG SURVEILLANCE
AUGUST 02, 2010
JEFFREY SPRAGUE, FOUNDER, VERTICAL RESEARCH PARTNERS LLC
TOM KEENE, HOST, BLOOMBERG SURVEILLANCE
KEN PREWITT, CO-HOST, BLOOMBERG SURVEILLANCE
TOM KEENE, HOST, BLOOMBERG SURVEILLANCE : And now we welcome from Vertical Research Partners, Jeff Sprague. Jeff, good morning.
JEFFREY SPRAGUE, FOUNDER, VERTICAL RESEARCH PARTNERS LLC: Good morning, Tom. How are you doing?
KEENE: Well, I'm great and we're thrilled to have you on. The precursor to this, folks, is a real focus on free cash flow. We've got a couple shows coming up on Bloomberg On the Economy on this. John Carey will give us the buy side perspective here in a bit. Right now we get the sell side perspective.
What's - Jeff, you've been doing this for years. I knew you following industrial stocks ages ago. What is different now about the way managers look at free cash flow?
SPRAGUE: Well, one of the things that has really changed, Tom, and it has been half a cycle or so evolution I would say, but when we came out of the downturn of '01 and '02, many of these companies that I covered would still call themselves conglomerates to some degree, nevertheless decided they wanted to be more focused. So over the course of I would say '03 to '05, '06, so even '07, they were actually selling businesses, and very focused on return on capital and improving their cash flows.
And what has happened now, which is very interesting, is around about '07, '08, when their acquisition appetite was starting to maybe come back, I would say private equity crowded them out in a sense. It maybe kept them from overpaying at the top of a cycle.
And so they went into this downturn with great balance sheets, great cash flow, and literally, Tom, they are loaded for bear here. There is a lot of earnings power on the balance sheets of these companies, and a lot of cash flow to be put to work.
KEENE: I read this weekend, Jeff Sprague, and it is off your watch of industrial companies, but the IBM annual report and the unique focus of their team on free cash flow. Have all the gains from free cash flow been made now? Is all the easy money been gained? Or is there more work to do in terms of managing and working capital, of just managing a large international company?
SPRAGUE: No, there is more to do, Tom. I would say that probably the easier things have been done. But absolutely there is a focus on streamlining supply chains and moving away from businesses that are less capital intensive and really trying to squeeze cash from companies.
We will have a cyclical dynamic, which I'm sure you are aware of, is that kind of in '08 and '09, when we were going down - balance sheets are getting liquidated and so you have kind of these massive, massive cash flows that come off the company. So as we get a little bit of expansion, the numbers actually will look nominally not quite as good. But when we look at it in terms of free cash to sales - what I call free cash flow margin or free cash flow to net income - we are seeing exceptional numbers.
KEN PREWITT, CO-HOST, BLOOMBERG SURVEILLANCE : Are dividends going up? Are we going to see more M A activity, share buybacks?
SPRAGUE: I think it is going to be all of the same. It is a huge investment call for these companies now because obviously capital that can be put to work could be a good thing or a bad thing. In other words, it could be deployed productively or it could be squandered.
And I think given what I said earlier about many of these companies wanting to move towards maybe a more focused diversity, if that's not some kind of oxymoron, they are not going to go off on some crazy tangents and reconglomerize themselves. But they are going to look to do acquisitions. It is clear the acquisition -
SPRAGUE: - market is picking up. But we saw United Technologies a couple weeks ago, things not coming together on the deal front the way they liked, and they literally said we are backing up the truck and we are buying back the stock. And Tyco -
SPRAGUE: - Tyco a couple of weeks ago, the same thing, really aggressively buying back the stock. Tyco bought back three percent of its market cap in a two month period between June and August.
KEENE: Right, there was that kind of anecdote we love. Jeff Sprague with his Vertical Research Partners. And just to announce, Jeff, I don't how you knew this, it is oxymoron August.
SPRAGUE: It is? Okay, well -
KEENE: Yes, we had math July and it is oxymoron August.
SPRAGUE: Well, perfect.
PREWITT: Let me ask you kind of an inside securities analysis question. SPRAGUE: Yes.
PREWITT: You cover industrial companies.
PREWITT: And in there is GE -
PREWITT: - which is basically a bank that does a bunch of other stuff. How do you handle the numbers out of GE Capital?
SPRAGUE: Well, it has been a challenge for a long, long time. I would say that I have been fortunate enough to do it for 20 some odd years and over time you get your arms around these things. But it is one of the things that makes my coverage interesting. You know, I can genuinely say I learn something about my companies every week and that is really where the intrigue is.
GE is challenging from a financial standpoint because it was a non- bank through this time frame. Actually their disclosure was not as thorough, so it was hard to get your arms around all the ins and outs of the numbers. But although I cover industrial companies, really they are conglomerates, right, so, Ken, I'm going everything from financial service, to medical, to aerospace -
SPRAGUE: - defense, the whole nine yards.
PREWITT: Light bulbs and stuff.
PREWITT: Yes, you've got GE as a hold. Why isn't it a buy?
SPRAGUE: Well, it is a matter of kind of relative alternatives. I think as I look over the next year or so, actually to this GE Capital question, GE Capital is now on the mend and they are kind of downsizing the business as I think they should.
But as I look at what is going to play out over the next year or so, I actually have their industrial earnings down slightly. I have got them earning about $0.91 industrially in 2010 going to about $0.89 next year. I have got overall EPS up almost $0.20 next year.
It's all GE Capital and there is nothing quote/unquote wrong with that to some degree, but I do not think investors and industrial stocks are going to pay a lot for GE Capital earnings and reserves coming down and that sort of thing. So I can find equal or better growth in 3M, in United Technologies, and companies like that that really have the leverage to the industrial cycle at really relatively similar valuations.
KEENE: Jeff Sprague with us, folks, Vertical Research Partners, with Brian Konigsberg, Mark Barbalato, Ryan Edelman, and Nicole Parent as well.
Jeff Sprague, you mentioned 3M there. To be polite, they've hit the ball out of the park. What is the 3M distinction?
SPRAGUE: Tom, it's really a growth machine. And I think one of the things that has caused this stock to kind of sneak up on people is usually when you have restructuring stories in this group there is a bit of a big bang, - a new CEO comes in, divisions are getting sold, big layoffs, maybe an acquisition - and it is readily apparent to everyone that something has changed and it may or may not succeed. But it is apparent something is going on.
This was kind of a stealth turn around. A new CEO George Buckley came in five years ago. The growth culture of the company had kind of worn down. The focus on innovation had slipped.
And he really kind of put the - put some of the power of the company back into the labs, gave people the freedom to tinker, which was kind of always part of the 3M culture, but also brought a lot of commercial focus to what the tinkering was. And they've really got it clicking now from a growth standpoint. So this is an exceptional company. It's -
SPRAGUE: - it's got the highest ROICs in the group - 25 percent type ROICs. This cash flow margin metric I mentioned about 15 percent. So 15 percent of sales is converting to free cash flow.
KEENE: Well -
SPRAGUE: That's an extraordinary number.
KEENE: Well, let's come back and talk about this. Jeff Sprague with us, Vertical Research Partners.
KEENE: We continue with Jeff Sprague, Vertical Research Partners. Jeff, what is the new metric for organic revenue growth? It used to be nominal GDP. GE made a big deal about it. And yet here is 3M just blowing it away - six percent sequentially versus nominal GDP, which is three or four percent. Is there going to be a new normal - a better normal for revenue growth at industrial companies?
SPRAGUE: I think for some companies there may, in fact, be a new normal that is better, which to some degree sounds like a pretty bold statement while we are kind of navigating this environment where we are not sure what the economy is really doing and talk of double dip.
But what I've seen across this group of companies and 3M in particular is the restructuring has been very successful. The margin troughs are higher this cycle, despite the fact that it was a more violent down cycle than we have had previously.
And we are, in fact, seeing a very nice carry through to the upside now just on modest revenue growth. And when you get a company like 3M that can actually put up some big revenue growth, there is very, very strong drop through.
I think there is some inventory restocking in a few things in here, so the 19 and 18 percent that 3M has done on a year over year basis the last couple quarters is not the normal run rate. But I think this will settle down to being kind of a high, single digit organic grower, which is pretty good.
SPRAGUE: And actually the last cycle, this was about a 3.5 percent organic grower. So that's a huge difference for a company this size.
KEENE: Are they going to create jobs in America? $13 - make it $14 billion in revenue abroad; only $9 billion here. Are the jobs going to be here or are the 3M jobs going to be abroad?
SPRAGUE: Well, I would say you will have probably more job growth abroad just proportionately. That is where their growth is going to be.
But they will be creating jobs in the U.S. I think it is pretty clear that when you look at the demand now that they see on their supply chain, they are going to have make investments to debottle neck. Again, some of that will be offshore. But I would expect some jobs to come back.
And, you know, actually on that point, Tom, it's interesting. In the gloom of 18 months ago, a lot of companies were saying I'll never hire anybody in the U.S. again and this is horrendous. And, in fact, we are seeing some selective rehiring in some places.
Cyclically the air conditioning markets have come very strong. We are seeing some people get brought back there. Some of these energy retrofit type end markets, we are seeing a little bit of hiring. Obviously it has kind of been a drop in the bucket relative to the kind of macro situation we are dealing with, but it is grudgingly coming along I would say on the hiring front.
KEENE: Jeff Sprague, thank you so much, Vertical Research Partners. They are on what we've - Ken and I have witnessed certainly with all the earnings. Whether it is Colgate or 3M, a little bit of money being minted in American companies.
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