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The Friday Five

Fri, 13 Dec 2013

This week: Baby steps in D.C., lululemon takes a hit, a wide moat gets wider, and more.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar, and welcome to The Friday Five: five stats from the market this week and the stories behind them.

Joining me as always with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for joining me.

Jeremy Glaser: My pleasure, Jason.

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

Glaser: Well, the numbers we're going to look at are 2, 978, 5%, $2.35 billion, and 30%.

Stipp: Two years is the scope of the budget proposal that came out this week. There wasn't a market crisis this week, so Congress actually got something done on its own?

Glaser: They did. We had some good news out of Washington with this bipartisan budget deal. It really is very much a status quo deal. There certainly are some changes--sequestration changes a bit, we add some money back into defense, there is some more flexibility. But for the most part, it really sets the stage for the status quo, like I said, over the next two years and eliminates these constant budget battles that we've been having.

I think that's the big positive that comes out of this deal. Not so much anything in the legislation itself as much as [the fact that] it actually got done.

It doesn't tackle any of those big-picture issues, the "grand bargain" issues we discussed previously. Things like tackling health-care spending, tackling Social Security, the kind of entitlements that really drive the deficit over time. Those still need to be addressed. But at least we won't be lurching from funding crisis to funding crisis.

I think it also has implications for the Federal Reserve. They've said in the past that they're concerned about fiscal policy and potentially the taper hasn't happened yet not only because of weak economic data or middling economic data, but also because of worries about another [government] shutdown in a couple of months. Taking that [risk] off the table probably gives the Federal Reserve the space to begin their taper, if not in December, then potentially in March. We all know that's something the market has been waiting for, the Fed's been waiting to do. So, I think the [budget] deal also has some ramifications there.

Stipp: The 978-page Volcker Rule was approved this week. This is part of Dodd-Frank and is meant to take some big risks out of banks. But what does it mean for those financial institutions from a business perspective?

Glaser: Probably not a lot right way.

Mike Wong who covers a lot of banks for us here at Morningstar says that most of these big banks have already changed their business model to get rid of a lot of this proprietary trading with insured deposits. They reduced those investments pretty considerably after the financial crisis, reducing some of this risk already, and the Volcker Rule is just taking these things that have already happened and enshrining them in these rules in the law.

There are still going to need to be some changes, probably some divestments of things like hedge funds and private equity, in order to get it below that de minimis level, but they'll have a couple of years to do that. So, there won't be any fire sale. They'll be able to get probably a fair price for these assets, which is good news for bank investors.

And also the final Volcker Rule, as it was written, ended up with some pretty big carve-outs for things like market-making, where firms like Goldman Sachs make a lot of their profit. That's not going to go away or be a problem under this new regime. That's not going to have an impact on investors there.

Now, in terms of whether this will actually reduce the systemic risk or not, that's an open question. It's really hard to measure that over time. If there is not another financial crisis, it would be hard to point to this as the reason why. If there is another one, I think it would be hard to say, well this just wasn't strict enough, and if it [had been stricter], that financial crisis wouldn't have happened. I think on balance it seems like it's a step in the right direction.

Stipp: 5% was the same-store sales increase reported by lululemon this week. That was OK, but their outlook was disappointing--the market didn't like that--and they've had some other issues they've been dealing with. The question is, is this a rough patch for lululemon or a big warning flag for long-term investors?

Glaser: The market did not like their outlook at all.

This was a big week for lululemon. First, they announced their new CEO; it's the gentleman who used to run TOMS, which is the alternative shoe brand. That's probably a good fit. Jaime Katz, who covers lululemon for us, thinks that he is the right person for that job. Chip Wilson who is the founder, stepped down as chairman. He has been generating a lot of controversy over some comments and a sort of non-apology he made recently. The company says that those things were unrelated. But having him stepped down is going to reduce some of that noise and allow the board and the business to focus on continuing to grow.

But in a lot of ways, the big story was that guidance, and how it was so much below expectations, below consensus, and it really raised some fears that maybe lululemon and the excellent growth prospects they've had might be deteriorating.

It's probably too early to say that. They obviously have had these short-term issues. We don't know if it's just that affluent shoppers in general are cutting back for this holiday season. We've heard from couple of retailers that this isn't going to be the best season ever. This could just be part of that broader trend.

Or it could be that some of the other competitors out there are starting to introduce high-quality products, their marketing is being effective, and that consumers are looking at some other options when they want to buy that next pair of yoga pants.

That being said, Jaime Katz does think that lululemon shares are slightly undervalued right now, [possibly meaning that] some of these potential issues are already baked in. So, it will be a good story to watch.

Stipp: $2.35 billion is the size of Hilton's IPO this week. Blackstone took Hilton private in 2007 at the height of enthusiasm for real estate. So, what does it say about where we are now that they are finally able to bring Hilton back to market?

Glaser: It's really a sign that the hotel market is getting back to normal, and really is back to, if not quite where it was before the recession, it's looking like a much healthier business.

The recession really killed a lot of different travel-related businesses. Leisure travelers were not there, business travelers were not there, and hotels were hit pretty hard because they have high-fixed costs. And even a business like Hilton--which predominantly is trying to franchise hotels, sign management contracts, and do things that don't have a lot of capital investment--it still was a challenging environment for them.

They were taken out, like you mentioned, in 2007 at a very high valuation. The fact that they were able to come out again shows that investors are still looking for the hotel industry to continue to do well, for the economy to continue to do well, because obviously this is a very economically sensitive type of business. I think that's interesting to see.

Seeing more of these private-equity exits, how private equity is going to handle some of the big deals that were done, what their exit strategies look like through this IPO, is another interesting piece of this. I think it speaks well for the health of market, and for the normalization of the financial markets, that this IPO was so successful.

Stipp: Food distribution firm Sysco will have 30% of the U.S. food distribution market if it closes the acquisition with U.S. Foods. Sysco is a wide-moat company, so what does this acquisition mean for that moat?

Glaser: They're widening that moat. Sysco already controls a substantial portion of the food distributor network, [and is] spending about $3.5 billion to buy competitor U.S. Foods, [which will] take them up to close to 30% [market share]. Their next biggest competitor will be around 5%.

It's still a fragmented market, but we think that they'll have that commanding lion's share of it. This is a business where the network effect is important, and that's going to help them wring out, they think, about $600 million of synergies. We think that's a reasonable number for them.

Erin Lash, who covers Sysco for us, raised her fair value on the news. We think the shares are a little bit undervalued--certainly, nothing incredible--but given where valuations are across the entire equity universe, having a wide-moat firm that's in the process of widening its moat trading at discount is unusual and probably something investors want to take a closer look at.

Stipp: Jeremy, in my book you take 100% share of investing insights every Friday. Thanks for joining me.

Glaser: You're welcome, Jason.

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

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