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Paying Up and Paying Out

Jason Stipp
Jeremy Glaser

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

We saw a lot of parties paying out and paying up this week. Here to offer the details is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: Jason, glad to be here.

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

Glaser: We're going to talk about Netflix, Apple, auto sales, dividends and finally Deutsche Bank.

Stipp: So Netflix was paying up for some Disney content. What does that deal mean for the somewhat troubled online-video operator?

Glaser: Netflix is going to spend a considerable amount of money. They didn't release the exact financial terms, but our analyst Michael Corty thinks it's around $300 million in order to license Disney theatrical movies for use on Netflix. These will show up on Netflix starting 2016 right after the DVD window. So basically they'll be in the theater, then on DVD, and then when traditionally they would go to, let's say, HBO or Showtime or Starz, instead those movies are going to come to Netflix.

The market seemed pretty excited about this deal. Netflix shares rallied pretty heavily on the news that they had inked this deal, but we're a little bit less excited. If I had $300 million lying around, I too could be streaming Disney movies. The reason they were able to get this deal done is they were going to pay the most. They outbid any other rivals who might want to carry this content. I think the fact that Disney did it now for a 2016 timeframe means that they just thought it was an offer that was just too good to refuse that they were getting from the video-streaming company.

So I think it's probably not the case that Netflix got a big steal on this. They just are hoping they're going to be able to increase their subscriber count enough to make investments in content like this really worth it. We just think in the long term, this isn't a game that Netflix is going to be able to win, or one that they are going to be able to turn into a true, sustainable business model. There are just too many other competitors out there. The content holders just hold too many of the cards for them to really turn it around.

We still view [Netflix] shares as fairly overvalued. There's been some talk that maybe there will be a buyout. We just don't see that as something that's going to come anytime soon. Certainly it's possible, but buying the shares and just hoping for someone else to come up and pay more isn't a great investment strategy.

Stipp: We learned this week that Apple is going to be moving some manufacturing back here to the U.S. and paying up a bit to do that. This is just one piece of news, though, for the giant company. They've had a bumpy few days here.

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Glaser: We got a lot of little tidbits this week from Apple--nothing earth-shattering, nothing really game-changing, but certainly the market was very focused on the stock.

On Wednesday [Apple stock] had the biggest decline that it's had in four years. And this is a stock that is just not used to big declines, and now we've seen a pretty big decline from its peaks. I think a lot of this is just due to growth worries. The idea that people had expected that maybe Apple would be able to move more iPhones in emerging markets, that it would be a bigger player in China, but instead we're seeing a lot of competition. Home-grown Chinese handset makers, Android devices, even Nokia and Windows Phone are starting to make some inroads, making some deals with some of the Chinese carriers to get their products out there. [These factors] are going to make it somewhat of an uphill battle for Apple to really take a huge amount of market share.

Certainly, the top of the market, that premium market, is one that they can really win, but the mass market in emerging areas is one that's potentially vast and one that Apple hasn't made a big push for yet. I think that's what a lot of the weakness, a lot of the concerns were about [this week].

We also saw, as you mentioned, they are going to spend $100 million to bring some manufacturing back to the U.S. This is not going to be a huge deal for the company, probably just a trial to see how it works, see if those costs really do make sense to make stuff back in the U.S. It's not something that moves the valuation around.

The [fact that] the iPhone is coming to T-Mobile, something that I think a lot of analysts had expected for a while, will provide some incremental growth, again, not a huge trajectory.

Apple shares look modestly undervalued right now. Certainly they're going to see a lot more growth in their core products in the years to come. There's still a lot of runway there, but I think as this week shows, it's not a complete destiny. They still have to work for it, they still have to fend off those competitive threats, and I think those are threats that the market is going to be very focused on.

Stipp: Data this week also showed auto sales are gearing up, so consumers are paying out for new vehicles. What's behind that?

Glaser: Auto sales looked pretty good. We had a 15% increase in auto sales levels in November of this year from November of 2011. Now, some of that increase is coming from Hurricane Sandy, people whose cars were flooded, were ruined in some way were out there. They were buying new cars; they had to replace their vehicle right away. That probably brought forward some demand, some artificial demand, if you will, from the natural disaster.

But overall auto sales are looking pretty good and have been improving for some time. This is a story we've been talking about for a while, because it has lot of implications for the broader economy. The auto sector employs a lot of people. As those new cars roll off the line, it looks good for GDP, it looks good for employment, and it means that they are adding a shift, it means that they were opening a new factory or not closing a factory that may have been at risk earlier.

So I think that's certainly good news for the economy, and for investors it's nice that we think--and Dave Whiston, our auto analyst, thinks--that both General Motors and Ford are 5-star stocks right now. There’s still opportunity, there’s still room for auto sales to grow even more, and I think this could be compelling recovery for some time.

Stipp: We've seen companies lining up to pay special dividends ahead of the potential for higher tax rates next year, but what does this mean for investors?

Glaser: What started off as just a little trend has really seemed to gain a lot of momentum as companies rush to beat the potential of those changes in 2013. You see it ranging from really big moves like Las Vegas Sands paying out almost 6% of the current share price as a special dividend, to much smaller moves like just taking January's payment and moving it into December.

Certainly for current shareholders this is pretty nice for them. If the company isn't leveraging their financial future to do it, it lets you get in at those lower tax rates. Since you just don't know what it's going to look like in the future, this kind of reduces some of that uncertainty.

But what it does for potential shareholders, and what it means for the future, is a lot murkier. Our dividend guru Josh Peters looked at this issue recently. He says what's really important is finding a dividend stock that's going to have a consistent payout over time, one that you can count on, and one that has the ability to grow, and that doesn't necessarily rely on tax rates. It relies on the board of directors and on the management team thinking that the dividend is really important and continuing to allocate resources there.

So, for investors who are interested in yield, who are interested in that total return investing picture, focusing on those core fundamental dividends I think is going to be more important than trying to chase special dividends, or worrying about the tax treatment over the long term. So short term, this probably is the right move for a lot of companies. But long term, it probably isn't going to make a big difference for dividend investors.

Stipp: Lastly, allegations this week suggest that Deutsche Bank may have hidden losses during the financial crisis. Will there be some kind of a payout for the bank coming up here?

Glaser: This has been a fascinating one. Chances are Deutsche Bank will not have any big payouts or any big problems related to these exact allegations, but they do raise some troubling questions.

Some whistleblowers have alleged that the bank hid about $12 billion in losses at the height of the financial crisis related to their derivatives book. Essentially they said they had to mark these things to market, and they just did not have a realistic view of how much these contracts were actually worth. And I think this raises a couple of interesting questions and a couple of interesting points.

The first is, it shows that these big global financial institutions really are black boxes. You can look through all of the filings, you can have a lot of faith in management, but you don't really know exactly what's on the books and if it's valued fairly. It just makes it that much more difficult to be an investor in a lot of these banks and raises a lot of potential uncertainties to people getting involved.

Then I think looking at Deutsche Bank today, these derivatives contracts are no longer on their books. They've closed all these positions. Because the world didn't collapse in 2008-2009, those worst-case scenarios that they would have had to value them at the height of the crisis didn't come to pass, and the bank was able to make it through, but we don't know what's on the books right now.

Our analyst Erin Davis thinks that their capital cushion is a little bit light at the moment. She expects there is a 25% chance the bank would have to go out and seek additional capital--a dilutive capital raise--something that would not be good for current shareholders. So given that we see that there were these potential problems back during the financial crisis, that their capital cushion doesn't look that strong compared to some of their European peers that might have to raise capital, it certainly doesn't seem like a really strong bet for investors right now.

Stipp: Jeremy, it always pays very special dividends to hear your insights on The Friday Five. Thanks for joining me.

Glaser: Thanks, Jason.

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