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Forced Hands

Jason Stipp

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

We didn't force you to watch the Friday Five this week, but we did see several examples of hands being forced to act sooner rather than later.

Here with me to offer the details is Morningstar's markets editor Jeremy Glaser.

Jeremy, thanks for joining me.

Jeremy Glaser: You're welcome, Jason. Hopefully you won't see too many unforced errors here.

Stipp: Hopefully not. What do you have for the Friday Five this week.

Glaser: We are going to take a look at Clorox, at E*Trade, Apple, American Airlines, and finally at the debt ceiling talks.

Stipp: So, Clorox got a letter at this week from Carl Icahn, sort of forcing them to action. What did that letter say and what do you think is going to happen?

Glaser: Carl Icahn offered to buy Clorox, to take it private. He is largest shareholder already, but he really doesn't think that Clorox management is doing everything that they need to do in order to bring their brand portfolio to penetrate international markets and to grow domestically.

He offered to buy it. Clorox rejected his offer. He's raised his offer again, but interestingly he also said that Clorox really should go out and look at other suitors who potentially could have more of a synergy play, other large consumer-packaged good producers who'd be able to bring Clorox into their stable and really help establish their brands across the globe.

It's interesting that he ... doesn't have a lot of faith that management can handle it as a standalone company, but he is happy to either take it private or push them into the arms of another suitor, but either way it seems like he wants some action; he wants a better return on investment that he's made in the company. It's really going to make Clorox management make some tough decisions and figure out what they're going to do.

Stipp: E*Trade also got a letter from one of its big investors. I assume it wasn't just asking how their summer is going. What did that letter say and what do you think is going to happen there?

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Glaser: Citadel also, like Icahn, is really looking to get more out of their investment in E*Trade. Certainly I think they've been a little bit disappointed at the speed at which E*Trade has recovered from the financial crisis. If you may recall, E*Trade got into a lot of trouble in the mortgage business and had a very toxic balance sheet for a long time, and I think a lot of people had hoped that they would have had most of those issues behind them and cleaned up most of it by now, but they really haven't.

I think Citadel wants E*Trade to really improve their corporate governance. Here at Morningstar we give it an F rating in their corporate governance, and Citadel seems pretty unhappy with it. So to get better corporate governance, to get really some of those issues cleaned up, and to really potentially sell the company to someone who is going to be able to use the core assets and get the core earnings power out of it.

Shares were up pretty substantially on this news, 17%-18% rise in the shares, just on this letter. So I think that investors broadly think that management isn't really capable of doing that, but that in the right hands, E*Trade could be a lot more valuable. So I think they are also going to have to make a decision soon, to see what the future of E*Trade is going to be.

Stipp: Morningstar analyst Joe Beaulieu had one word for Apple's quarter this week. What was that word?

Glaser: He called it a "monster" quarter...

Stipp: ...and monsters have a way of forcing the hand of their competitors, right? So what's going on with Apple and their peer group?

Glaser: Yeah, it definitely does. Apple had another just incredible quarter. Analysts keep increasing their expectations to levels that sounded crazy just a few months before, and then Apple has a way of exceeding those expectations.

Really to say they are firing on all cylinders at the moment is somewhat of an understatement with the exception of the iPod business, which is declining slightly. Everything else is really posting pretty incredible growth.

And I think that this presents a bit of a conundrum for some of their major competitors across all sorts of different business lines, but particularly in mobile. For Android and Windows Phone 7, they've been doing pretty well, particularly Android in the mid-range market and in getting some penetration in the high-end market, but I think it's only a matter of time before Apple introduces phones that are at a lower price point, before they really are available across all carriers and even more geographies than they are now. If that ecosystem continues to grow and grow and grow, and people get used to it and maybe become a little bit hesitant to switch, it could be difficult for those other companies to really get entrenched in the mobile market.

And I think as that moat for Apple continues to widen, and they continue to put up these big results, the impetus is really going to be on their competitors to come up with some outstanding products that can take some of the oxygen out of the room, and get people excited about it. It's not clear that can happen right now, but certainly the more quarterly results like this, the faster [Apple's rivals] are going to have to work on those new products.

Stipp: A move by American Airlines this week put some heat on Boeing. What's the story there? What's the flight plan?

Glaser: We had talked about this earlier, a few weeks ago, that Boeing was really going to be in a bind in deciding how to replace their very popular narrow body 737 aircraft, and American Airlines somewhat surprisingly decided to place a very large order for aircraft, over 400 aircraft, that would help modernize their fleet and get rid of some of their older Douglas airplanes that aren't as fuel efficient as more modern airplanes.

And for a company like American that flies all Boeing aircraft, surprisingly they were looking at both Airbus and Boeing. They decided to split the order between the two of them. So, with Airbus they are buying their narrow-body A320 and A320neo, which has a new engine; it's a reconfigured one, a little bit a more fuel efficient. And they committed to buying some 737s but were very vague about exactly what kind of 737 they were going to be buying. They mentioned that there could be some re-engined option, it could be some of the existing models, or it could be some new yet-to-be-determined model that Boeing needs to decide what to build.

I think this just shows that Boeing can't sit around forever twiddling their thumbs deciding if they are going to put new engines on the 737, if they are going to build a whole new narrow-body aircraft, exactly how they are going to tackle that strategic choice. They've been putting it off for a while as they try to get some of their other long-delayed programs like the 787 out of the hangar, but they don't have that benefit of time anymore. Their customers need those aircraft. They want those new ones. They need the fuel efficiency, and they are going to look elsewhere if [Boeing is] not able to provide it. So, I think the board of directors at Boeing right now is probably glad they got some of that order, but they are going to need to make that decision, I think, very soon

Stipp: In Washington it's crunch time. Politicians are going to have to force their hand soon. The clock is ticking. What's the story on the debt ceiling?

Glaser: The question now is, what is going to force the hand of the Republicans and Democrats to get together and really finally pass some kind of deal in order to lift the debt ceiling? At this point, most of the major players have basically conceded that the debt ceiling needs to be raised one way or the other. The idea that default won't be that bad or that it's not going to be that big of a deal certainly is held by some ... of the freshmen Republicans in the House of Representatives. But for the most part, most of the people at the bargaining table really think we need to raise it, but the question is, how?

There is talk of a grand bargain where we're going to cut spending, maybe raise revenue, reform entitlements, and that will go along with the debt ceiling. There is talk of a short-term patch that will just kind of get us over this hump so that we can have more time to debate some of these very major changes.

But I don't think there is a lot of pressure right now to get that done until right into the last moment. I think for a lot of political reasons if you wait until the very end, it's easier to go back to your constituencies and say, "We did everything we could. We tried to get as much as we can." If you agree too early, people will say you could have pushed a little bit harder.

So, we'll have to see what forces their hand. I think the real question, though, is will the market freak out before we reach that date in August where Secretary Geithner said we're going to have to stop paying our bills. Will we lose confidence even before that, next week or the week after. And I think if that were to happen, the hand could be forced a little bit closer, but certainly I think it's something we're going to, again, be talking about until it actually happens. It could go up right to the wire.

Stipp: All right, Jeremy. Nobody forced me to be here. I always enjoy sitting with you and getting your insights. Thanks for joining me today.

Glaser: You're welcome, Jason.

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