Shrink to fit

The U.S. auto industry resembles a game of musical chairs with the song about to stop. Already running around in circles, it looked earlier this year like big reductions in overheads had bought Detroit’s Big Three time to emerge in 2010 as smaller, leaner companies. But the tune has changed. A plunge in sales amid the credit freeze has put Chrysler, controlled by private equity firm Cerberus, into play. A deal may be weeks away.

Chrysler’s preferred suitor, General Motors, also does not have the luxury of time. With the credit crunch possibly pushing annualized U.S. auto sales to a multi-decade lows, GM could burn through enough cash to breach minimum working capital levels by next spring. Existing plans for raising $15 billion, which include selling Hummer, now appear unrealistic, which is why it covets Chrysler’s $11 billion cash pile. A deal could save billions more in the long-run, but it would also have high upfront costs for redundancies and dealer compensation. Banks, the government, Cerberus or some combination of the three would have to stump up the cash to make a deal possible.

A deal with Renault/Nissan has more obvious synergies but also requires cash to keep Chrysler viable. The Japanese end of the alliance already has agreements to provide small cars to – and source large pick-ups from – Chrysler, so Renault/Nissan may not buy the cow when it has the milk already.

Meanwhile, Ford is the least distressed of the Big Three due to massive secured debt issuance before the credit crisis began. That casino mogul Kirk Kerkorian has taken his chips off the table at a steep loss, together with departures in the executive suite and boardroom, do not necessarily presage a near-term crisis. Ford may even benefit from its rivals’ shake-out. This is not the end of the road for the U.S. auto industry, but it may look very different by Christmas.

NRG Energy (Ticker: NRG)

Exelon bids for NRG Energy

It took less than five months for NRG Energy (Ticker: NRG) to go from being the hunter to the hunted. Utility Exelon (Ticker: EXC), already the largest independent power producer in the U.S., now seeks to acquire it and become even larger. On Monday, EXC made an unsolicited $6.2 billion stock-for-stock bid, worth $26.43 a share, for NRG, which closed today at $25, up $5.67, or 29.33%. 

In May, NRG tried and failed to buy gas-fired giant Calpine in an audacious bid for dominance in wholesale power. Much has changed since then and little of it has been good for NRG, helping to slice 55% off of its value and make its assets, particularly coal and nuclear plants, ripe for the picking by less-leveraged Exelon.

But it looks unlikely that NRG’s board will roll over, despite the proposed 37% premium to Friday’s close. Unless NRG faces the same type of problems financing collateral that pushed Constellation Energy into the arms of Warren Buffett’s Berkshire Hathaway at a bargain price last month, it is better-served toughing out the nasty period that has seen weak wholesale power prices crush its margins. Future projects will be harder to finance for the junk-rated company, but this is no reason to sell.

If Exelon must mount a hostile bid, one problem it faces is that a recovery in natural gas prices this winter would embolden NRG shareholders to vote against a deal as power margins recover. This might happen months before affected states grant regulatory approval.

Another problem is that the new company would have to divest about 6% of its combined capacity in a weak market and that a change of control would force Exelon to repurchase several billion dollars of NRG’s debt. Exelon has not yet secured financing and a deal would dent its own credit rating.

Even with these headaches, Exelon reckons the all-share deal is an attractive one. NRG’s shareholders, though, would be selling out below fair value and would likely opt to stay independent.

Google (Ticker: GOOG)

Alive and kicking

Before yesterday’s third quarter results, shares in Google (Ticker: GOOG) had more than halved this year as patience with the Internet search provider’s peculiar approach to doing business wore thin. While trust ebbed from every crack in the financial system, naturally it became harder for investors to rely on management always doing the right thing.

However, a solid set of numbers has bought more time for Google. After hitting a three year trough in normal market trading yesterday, the stock rallied sharply after hours to reach levels 25% above the day’s low point. Revenues up 33% on the year before, and a cut in capital spending levels that boosted cash flow generation, were sufficient to soothe nerves.

Questions remain. Retail sales are a big driver of search inquiries, and consumers are retrenching. On Wednesday Ebay predicted dire times ahead for ecommerce. So it is inconceivable that a company reliant on advertising revenues will be able to pass through a mighty downturn without sharing any of the pain suffered by its customers. Yet by refusing to give any form of forward guidance, or even to divulge more than the bare essentials of financial information, Google ducked this question. Management acknowledged the rapid deterioration in the global economy, but insisted that it will run the company for the long term, cutting costs as necessary.

Growth rates must eventually slow. While still rapid, the pace of top line expansion has declined from a year ago. And the group cannot continue to simply release new services without it being clear how they will generate revenue. But for all that infuriating uncertainty, the group takes almost two-thirds of the market for search inquiries and challengers remain distant. On a reasonable 17 times consensus forward earnings, investors can more than afford to give Google the benefit of the doubt. 

Harley-Davidson (Ticker: HOG)

Christopher Davis’ funds go for a ride 

Sixty one years ago, about 3,000 motorcyclists broke the peace of a tiny town lying between San Francisco and the San Joaquin Valley. Over the July 4 weekend, they roared up and down San Benito Street and in and out of Johnny’s Bar. Led by a band of hellions calling themselves the “Booze Fighters”, they had come to watch a motorbike competition at the Veterans’ Memorial Park, and they stayed to drink beer and explosively enjoy themselves.

Over three days, Hollister’s handful of policemen lost control and the bikers cruised as they pleased. Alcohol was consumed by the gallon, the town center became a dragstrip, and female pillion-riders shed their clothes. Six years later, in 1953, Stanley Kramer guaranteed the weekend’s infamy by recalling it in his movie “The Wild One”, starring Marlon Brando in his first lead role. At one point “Johnny” is asked what exactly he is rebelling against. “What’ve you got?” Mr. Brando sneers back.

Sixty one years on, time has changed the town’s feelings about motorcyclists, and the bikers themselves have changed just as much. With new Harley-Davidsons – the only acceptable bike for true aficionados – beginning at about $15,000 for no-frills models, the owners are not likely to ride them into bars or practice slalom runs through rows of parking meters. The rebels of 1947 were mostly demobbed soldiers looking for thrills. Many of today’s motorcycling hordes are doctors, lawyers, dentists and architects.   

Wall Street, which was early to spot the potential for $6.20 billion (market cap) Harley-Davidson (Ticker: HOG), has recently worried that the wheels might come off early with the motorcycle-maker, though Christopher Davis’ New York Venture Fund and Davis Selected Advisors remain big holders of the stock. As house prices cracked, pessimism abounded about a product that is essentially a luxury good for upper-middle class, middle-aged American men – one costing as much as an entry-level luxury car. Quarterly earnings confirmed the trend. Revenues sank nearly 8% versus 12 months ago and earnings per share fell by one third. Last year was the first time sales declined since Harley went public in 1986.

But with its share price down by two-thirds since the beginning of 2007 – the lowest level in nearly a decade – concerns about Harley’s future seem overdone. At eight times prospective earnings, the price no longer extrapolates the pace of growth that saw unit sales double and revenues triple over the past decade. An admirable focus on profitability and a firm grip on inventory also are cause for optimism. Harley’s financing arm is a source of mild concern but the manufacturing business is far healthier than those of four-wheeled vehicles in Detroit. If there were a need to conserve cash, annualized dividends and buybacks combined amount to about $475 million, or about half of last year’s net income. Lost market share this year to Japanese manufacturers such as Honda says more about high gas prices than customer loyalty.

Since the early 1980s, when its bikes were referred to pejoratively as “Hardly Ableson”, the brand’s value has risen steadily. The only problem is that loyal buyers are no longer rebels without a cause. Typically males in their late 40s, with half having owned a Harley before, they are being slowly augmented by international buyers. The recession will hurt but this 105-year-old American icon is selling for a bargain and still has plenty of road ahead. 

Plastic pricing

Only a hermit or a North Korean could claim ignorance of the credit card’s ubiquity. And, it seemed, neither record commodity prices nor falling wealth could put a dent in American consumers’ propensity to pay with plastic. But the moment of frugal reckoning is now finally here. August had the biggest drop in revolving debt on record and the last several weeks were probably even worse.

The fall in spending and rising late credit card payments have naturally weighed on the financial sector. Lately though, companies such as Visa and MasterCard that depend on transaction volumes rather than creditworthiness have been hit nearly as hard as those facing delinquencies. The largest issuers of credit cards are big banks, but they have many other businesses and have gyrated recently on separate concerns. Three that come close to being pure plays on cards while still having credit exposure are Capital One, American Express and Discover Financial Services and they are off by an average of 51%from their 52 week highs. Visa and MasterCard’s drops of 35% and 46%, respectively, are better but still an overreaction.

The future of the two big processors lies in developing markets. These have wobbled recently, but if future penetration rates climb anywhere near their expected pace, processor shares still look attractive. In the not-too-distant future, developed market revenue will merely grow in line with nominal output. In the U.S., for example, checks and cash already have dropped from three fourths of spending in the early 1990s to a little over a third today. Worldwide though, these represent an $80,000 billion untapped market for cards.

At around 27 and 20 times prospective earnings, respectively, Visa and MasterCard might seem expensive in a bombed-out financial sector, but they can still grow earnings respectably if revenue rises in the low teens, several percentage points lower than consensus forecasts. Even if global recession looms, plastic cards are one American export with a bright future.