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Due for a Fall?

Thu, 6 Sep 2012

Morningstar markets editor Jeremy Glaser reports on European high hopes, former highfliers, and more in this week's roundup.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar, and welcome to The Friday Five.

After reaching certain heights are some stocks due for a fall? Here to offer the roundup is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for joining me.

Jeremy Glaser: Jason, glad to be here.

Stipp: So what do you have for The Friday Five this week?

Glaser: We're going to talk about the ECB, FedEx, Realty Income, smartphones, and finally Netflix.

Stipp: Stocks in general rallied after news of the ECB's actions. Rallied, some might say, maybe too much? I'm wondering what your take is on that. Are we due for a fall after this rally, or was that a meaningful statement that they made?

Glaser: Certainly, ECB action has been in focus for a while now. We've talked about how the promise of action had kept markets somewhat placid during August, and the details we got this week, I think, were generally pretty satisfying. I think that they hit a lot of the boxes that investors were expecting, but certainly it doesn't solve all of the problems, and I think that when we see a rally of that size, that kind of assumes that the worst of the crisis is behind us, might be a little bit premature.

Taking a closer look at the action: I think three big points really jumped out of me from the statement. I think the first is that of conditionality, which is the idea that the ECB is only going to be buying back bonds from countries that have agreed to a bailout from one of the EU bailout mechanisms and is also in line with all of the terms of that bailout. So the ECB will only act, will only continue to be buying those bonds in unlimited amounts to keep rates low, for countries that are on one of these programs and that are agreeing to do everything that the rest of Europe says.

So, if you run into a situation later where someone, say Greece or Spain, decides that those terms are too onerous and wants to walk away from it, that could just make it even more difficult because they will lose both the bailout money and ECB support at the same time. I think that's a really important point there.

The second is how they're going to really think of themselves as creditors. In earlier actions, the ECB was clear that they were going to be the senior creditor, that they were coming in with a super-senior level above the existing sovereign debt, and if there needed to be a restructuring, they would get repaid first. In this new round, they're going to be treated the same as any private creditor. I think that's crucial because it shows that they really do want to get that private market open again, and they want people to feel that they could buy a Portuguese bond or could buy a Spanish bond and not feel like they're going to be undercut in some deal, maybe a year or two down the road. I think that's really critical.

Finally, the idea of sterilization, which is that the ECB doesn't see this as a quantitative easing program. So unlike what we're talking about in the U.S., where the Federal Reserve might buy a bunch of bonds in order to ease monetary policy even more and to increase that money supply, the ECB is going to try to sterilize what they're doing. So they're going to try to keep that amount of money out there basically stable, while trying to also bring down those rates.

So, I think that means they're really trying to work within the bounds that particularly Germany is putting them in, and not to be too easy with the policy and not to stoke inflation too much, and I think certainly that's going to be a crucial point here.

But really, even though this kind of buys some time and could be very useful for countries that need to get their short-term borrowing under control, it doesn't solve those major structural problems, it doesn't get rid of these giant debt loads that some of these countries have, and it doesn't really create that fiscal union that's going to be needed to keep these problems from cropping up in the future. So a good first step: I think they made a lot of important decisions and difficult decisions, but certainly not all the way.

Stipp: Sounds like it certainly also doesn't close the door on potential volatility down the road if we some of these issues flair up again.

Jeremy, in corporate news, FedEx warned on its results. This is a company that may be seen as a proxy for the broader economy. Does this bode poorly for economic results? Are we due for some kind of a fall in our economic metrics?

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Glaser: It certainly doesn't bode well. FedEx really touches so much of the economy, both in the United States and across the entire world, but when they warn that things are slowing down, people really listen.

Certainly the reduction of guidance is not catastrophic for FedEx itself. It is still going to be a profitable quarter for them, but it shows that there very well could be some slowing across the entire world. I think when you add that into some data we got from ISM about the manufacturing sector and you look at some of the other data points, it shows that there really could be some slowing. Certainly we're not seeing that across the board, and I think it's way too soon to be sending out the alarm bells, but I think it's another data point that shows that we still need to be vigilant, we still need to be thinking about the world economy as potentially slowing, particularly as we talked about those issues in Europe aren't going away, and as we still worry about exactly what growth in Asia is going to look like.

Stipp: In the real estate sector, Realty Income, this is a pretty conservatively managed real estate investment trust, pays regular dividends, made a pretty big acquisition in the market. We know that acquisitions can be risky for companies at times. Do you think that this big deal bodes poorly or could mean that Realty stockholders should be due for a fall?

Glaser: It's probably too soon to issue any kind of final verdict, but it looks like the approximately $3 billion deal for American Realty Capital Trust is one that's going to work out for shareholders.

Like you mentioned, Realty Income is very conservatively managed. It's a management team that we like a lot. Our analyst Todd Lukasik gives that team an exemplary Stewardship Rating, really one of the few companies in the entire universe of stocks that we cover that gets that very high rating, and I think it shows that they're very careful about how they use shareholder capital. They pay a monthly dividend. They're laser-focused on keeping that dividend strong.

I think they saw this portfolio of buildings, which are leased to more investment-grade tenants, as a way [to diversify] some of the more non-investment grade tenants that they have right now, and saw it is a good way to diversify their portfolio. They got it at a fair price. It certainly wasn't a steal, but I think they felt like they were paying a fair price for the properties they were getting, allowing them to continue to bring more income in, and to be able to turn that around to shareholders.

So, I think it does show that when you have a strong management team that really is thinking about the future and not just thinking about expanding their empire, you can have deals that really are accretive to shareholders. Now, it's going to be years before we know if this actually works out exactly how they expected, but certainly the early signs are promising.

Stipp: In the smartphone market, we know there have been some definite winners and losers so far. As an upgrade cycle gets ready to kick into gear here, who is due for a fall?

Glaser: We used to talk a lot about the PC upgrade cycle. This idea that when a new Microsoft Windows operating system came out, people would rush out and buy new PCs, and that's really been supplanted with us talking about the smartphone upgrade cycle, that as the technology gets better, consumers, whether they're off-contract or not, are going to run out and buy those new phones, and that really has been driving a lot of growth in the tech industry, and I think that's one of the reasons we've been talking about smartphones so much.

We got an announcement this week, and we're going to get an announcement next week, that really paint how important getting people excited and getting people to upgrade their phones has truly become.

Nokia, this week, launched their Windows 8 devices or the Windows 8 Phone devices that will really be their next step and really be integrated into that Microsoft infrastructure, since they ditched their homegrown solution for Microsoft a bit ago. And these phones do not excite anyone. The stock sold off more than 10% after the announcement, and I'm not sure if a lot of investors were expecting something flashier or something newer, but really they issued a couple of new phones that are going to be in some different colors, that have nice screens, that are pretty good products, but they didn't really show how they're going to be compelling enough to get people to move from iPhone, move from Android, and to really create that third platform.

On the other hand, next week, on the 12th, we're going to see Apple release, or almost certainly release, their next iPhone, which is expected to be one of the hottest-selling products ever--not just for the iPhone--and a lot of that is that you have people already locked into that ecosystem, something that we've talked about a few times before, and that even when they made relatively modest improvements, like from the iPhone 4 to the 4S, they're still able to drive huge sales. And now that this is expected to be a much more comprehensive update, those sales are expected to do even better.

So right now, it's not just enough to come out with a phone that's competent, which is certainly what Nokia is doing, you have to come out with a phone that's really going to be disruptive and really going to get people to break out of those patterns. It's not something that's going to happen quickly; anyone who thought that the turnaround could happen quickly is going to be sorely disappointed. Certainly Microsoft and Nokia have the resources to keep at it, to keep iterating and get people excited about a potential third platform, but as we saw this week, it's going to be much easier said than done.

Stipp: Former highflier Netflix has had several drops in the market. What was behind their most recent fall-off?

Glaser: This week the concern about Netflix surrounded the idea that they lost exclusivity to the Epix content, which is a joint venture between some media firms that offers more of those first-run streaming movies that consumers always say that they want and say that they're willing to pay for.

I think this just stresses how difficult Netflix's situation is as they move from the disc world into the streaming world. Our analyst Michael Corty has been talking about this, it seems like, for years now, but it's a very difficult transition to make. When you go from a business that you have sustainable competitive advantages in--it's very difficult to build that network to get discs to people next day and to then turn them around so quickly--versus streaming, where really anyone with a bunch of servers and some connection to consumers is able to launch a service.

And Amazon with their Prime shipping added these videos onto it. It seemed at first to kind of be an afterthought and now is growing and growing as they try to feed content into their new ecosystem of new tablets and into set-top boxes. And it's going to be very challenging for Netflix to really exert a lot of pricing power if you can get the exact same content across a lot of different providers.

On the flipside, I think certainly Netflix has a strong brand. I think people like that it's integrated into a lot of their devices already. I think it's certainly not the end of Netflix by any stretch of the imagination, but they're going to probably have to take some hits to probability, as they have been, as they make this transition, and I think you're going to see a lot of competitors offering something very similar, and [Netflix] is going to have to continue to show that they offer a value proposition versus going with Amazon or going with someone else.

Stipp: Jeremy, no fall-off in your news coverage this week. Thanks for all the insights.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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