5 Tales of Luck, or Lack Thereof

Christine Benz: Hi, I am Christine Benz for Morningstar.com and welcome to the Friday Five. Spring is in the air. St. Patrick's Day is around the corner, and Morningstar markets editor Jeremy Glaser is here to share five tales of luck or maybe a lack of luck.

Jeremy, what you have today?

Jeremy Glaser: Well, Christine, today, we are going to talk about Cisco, Citigroup, dividends, retail sales, and finally, Ireland.

Benz: So Jeremy, Cisco this week announced a big acquisition. You think that this could go either way. Shareholders could get lucky, but they might be unlucky?

Glaser: Yeah. I think it certainly could. Cisco is spending $4 billion to buy video software maker NDS. This is not a deal that is crazy or that doesn't make sense. I think it certainly does make sense for Cisco. The firm has a set-top box business, with Scientific Atlanta. This kind of software really fits into that business and kind of fits into Cisco's idea that video is going to become more and more important. The firm wants to be there and make sure that it creates that infrastructure to deliver that video to consumers. But for some of the other comments that Cisco made around the acquisition, CEO John Chambers talked a little about how Cisco wants to do more acquisitions and wants to do bigger deals. The firm is going to become more acquisitive. I think this could cause shareholders to wonder if the luck is going to start running out for Cisco.

A few years ago, Cisco really got into trouble by doing a lot of these acquisitions that didn't make sense. These included things like the Flip video cameras and a lot of even the consumer routers. These items just weren't core to their business and weren't areas where the firm had good competitive advantages. Cisco has really been spending the interim period kind of getting rid of some of those businesses, becoming more shareholder-friendly, and doing things that would really make people trust management to be better capital allocators. And if Cisco goes out on another acquisition spree and just tries to spend that money because it can, I think that consumers could find themselves somewhat unlucky. I think certainly it's key to make sure that when these acquisitions are announced, that they actually are a core part of Cisco's business, are really bolt-on acquisitions, and aren't just there for growth at any price.

Benz: Another company that has been more working hard to earn or rebuild investor trust is Citigroup. This week, this firm is maybe not feeling quite so lucky in terms of its results on a recent Federal Reserve stress test?

Glaser: Absolutely. I think Citi probably was not terribly pleased with these results and was not pleased with what they're going to see as a case of bad luck. What happened here is that the Federal Reserve is now doing a yearly stress test, where it says in the case of really another severe recession--one that was even worse than what we saw in 2008--what would capital ratios look like at these largest financial institutions that they consider to be very important to the operation of the U.S. economy. And the Fed also looks to make sure that these banks hold enough capital. The banks also then submit capital plans in which they say, "We want to pay out this large a dividend. We want to do the share buybacks. We are going to issue shares, or whatever it might be."

The Fed then says to the banks, "If you execute this plan, and you have this big downturn, what would your capital look like?"

Citi with its plan that was somewhat aggressive--to start returning capital to shareholders--failed by just a hair. Citi needed to have a 5% capital ratio; it had 4.9% under the Fed test. The bank was basically told that it will have to go back, resubmit its plan, and find ways to keep its capital levels up.

I think this is not a case where the Fed was saying that Citi was in big, big trouble and needs to go out and raise a ton of capital. But it definitely was a rebuke to management which had really hoped to rebuild investor confidence, like you were saying, by paying out these bigger dividends, by showing that the bank really intends to have good returns for investors over time and that Citi is really out of woods in terms of kind of getting past the crisis and getting past a lot of those bad loans that were on its books for a long time. Certainly, this was not a stroke of luck for Citi to fail by just that small amount, and the bank will have to go back and redo that capital plan. I think certainly, it's just going to make it that much more difficult to convince investors that Citi is really back.

Benz: But some other bank investors got pretty lucky this week. The stress tests were good news for other firms that had wanted to increase dividends and share buybacks.

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Glaser: Absolutely. That's the flip side of this. The other banks that did submit their plans that were approved were able to increase their dividends and somewhat quite aggressively. I talked to Morningstar's Josh Peters about this earlier this week, and he identified that Wells Fargo, BB&T and U.S. Bancorp were just some of his favorite dividend banks. They really came out with pretty big increases. Even a company like BB&T, which didn't cut its dividend as much in the downturn as some of its peers, even got double-digit increases in the payout ratio. I think it shows that these financial firms realize that dividends are really important to investors who are interested in those stocks. Not only do investors want price appreciation over time, but they want that current income that they are demanding to get that money paid out to them in cash so they can either use it to fund expenses, they can use this as income, they can use it to reinvest, or they can use it for whatever reason they see fit.

I think certainly that's a change from when companies felt that they couldn't pay the dividends and they really needed to keep all that capital. The fact that these banks are feeling confident enough to pay back a lot, to really increase the dividend even more than investors were expecting and more than they probably really had to in some respects, I think it's a good sign that these banks really feel strong. They feel that the recovery is here. It's a good sign for dividend investors who have been starved for yields and gives them more options and places that they can get a bigger payout.

Benz: Absolutely. There is a lot of appetite out there for some current income as we all know from hearing from subscribers. Now, retailers are another set of companies that experienced some good luck recently?

Glaser: Retail sales looked tremendous in February. Even excluding gasoline sales, which obviously saw a big increase--those gas prices go up and people pay more even though it's not because they are using a lot more gas--really across the board, the retail categories looked really good. People are out there spending on all sorts of things from apparel even to building materials. Really the only thing that wasn't doing well was furniture, which I guess somewhat makes sense because as people aren't buying as many new homes or moving into new homes, there is less of a need to buy that new furniture. But really retail sales looked pretty good. Now some of this was the luck of pretty good weather. This is something I know Bob Johnson has talked about a few times, that when you have better weather people might move up some of their construction projects and they might be more likely to go out and go shopping, and less likely to be holed up in their homes and not go out because it's just so snowy outside. So the good weather I think certainly helps, but other factors are that consumers are feeling better, the job situation is better for a lot of folks now, and people really are out there spending money.

Benz: When you look at the data, is it consumers across the spectrum, not just at the high end? Is it a broad spectrum of consumers?

Glaser: Yes, I think certainly when you see all categories doing well, it definitely points to the fact that consumers--high-end as well as middle- and lower-income--are really out there spending. I think restaurants was another area that did very well. People are going out to eat, and a lot of that's happening at more casual dining restaurants. I think certainly we're seeing pretty good consumer strength across the spectrum.

Benz: It's good to know. One last thing you want to talk about: the luck of the Irish. Certainly, European economies have been under some stress during the past few years. You note that the picture for Ireland might be brighter than some of the other countries that have had financial and economic difficulties?

Glaser: It certainly would be hard to have a St. Patrick's Day Friday Five without talking about Ireland. I think what's notable is that we haven't been talking about Ireland. Ireland has received a bailout like other countries such as Portugal and obviously Greece. But in a lot of ways you don't hear about the country with the same fear as a lot of the other countries that either might need bailouts in the future or are kind of teetering about on the edge and people are watching where their credit spreads are going on a day-to-day basis. I think a lot that is that the Irish economy really is a lot more resilient than some of the other economies that we talk about like Greece, Spain, and Portugal. Ireland has a lot of multinational companies based there, and it has a very competitive regulatory environment. One of the big reasons that Ireland got in trouble was that it had a few really big banks that made some really bad loans. Ireland nationalized a lot of those debts, and those are the debts that are really becoming very challenging for the country right now.

I think the fact that the economy is strong enough, the idea is that the bailout has given Ireland the time the country really needs to have that growth that's going to come and help reduce that debt burden to something more reasonable. So, Ireland certainly is not out of the woods yet. In a broad crisis I think country could easily kind of fall back into the problem pile. But for the moment it really looks like Ireland is following the path that it needs to kind of get its economy back on more stable footing, and I think that's something that's certainly positive for Ireland.

Benz: Well, Jeremy, thanks for sharing your insights and happy St. Patrick's Day to you.

Glaser: Thanks Christine. You, too.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.