States Move Closer To The Edge

May 17, 2010  |  

By Charles Payne, CEO & Principal Analyst

For a long time I’ve felt that California would be the first state to receive a federal bailout, but now I’m sure it will be the President’s home state of Illinois. On Friday, Midwest Bank & Trust in Elmwood Park, a suburb of Chicago, failed. The bank had $2.3 billion in assets but couldn’t stay in business since taking a mighty hit from $82.0 million in losses from its holdings of preferred shares in Fannie Mae and Freddie Mac.

Closing the bank will cost the FDIC $216.4 million. (There were three other failures which cost the FDIC $31.3 million, $25.0 million, and $29.0 million) Eleven banks have failed in Illinois this year, reflecting a state that has veered into complete disarray. Since the beginning of 2009, 21 Chicago area banks have failed. By the way, Midwest Bank received $85.0 million in TARP funds but over the past year failed in attempts to raise $200.0 million from private equity firms.

First Merit of Ohio is buying the assets and actually paying a 0.4% premium, while the FDIC got a “value instrument” that will allow it to participate in future upside.

Illinois lawmakers took recess without passing a budget because they can’t decide if they should make real cuts in spending or craft a budget that would require massive tax hikes. In the meantime, suppliers aren’t being paid. One of the wildest stories is a supplier refusing to sell bullets to the state’s Department of Corrections unless it got paid in advance.

Legislators have received eviction notices, and one used campaign funds to turn on the phone to his office that was disconnected because the state hadn’t paid the bill. The state was already a laughing stock after the hi-jinxes of former Governor Rod Blagojevich and a sad sack after losing the Olympics to Brazil, despite the personal involvement of President Obama. Inaction is only making matters worse as many workers, programs, and departments got through each day in a haze of confusion.

The state’s debt is now $140.0 billion, of which $130.0 billion are public sector retirement programs. The state’s public pension obligation is only 54% fulfilled, the worst in the nation. The amount of debt the state owes amounts to $25,000 per household. Governor Quinn has been pushing for a 33% tax hike just for education. Economists say personal income tax would have to climb to 8.2% from the current 3.0% for the state to catch up. Such a hike for an individual making $50,000 means taxes of $4,100 instead of $1,500. There is a push now for politicians to actually cut spending before hiking taxes, but there is push back from powerful municipal unions and the tax and spend crowd which always thinks hiking taxes is the way to go. The pool of so-called rich people is thinning out so spending cuts are the only way to go. It’s the right way to go.

This is the reality facing Arnold Schwarzenegger, who would like to cut a welfare to work program, Cal Works, among other actions to close the state’s massive deficit. April tax revenue was $3.0 billion less than expected. There will be something akin to the ghost in the machine that is saving Greece, a massive government bailout at some point very soon. In the meantime, Arnold is asking state workers to make sacrifices not unlike those facing government workers in Spain and Greece:

* 5% Pay Cut
* 5% Payroll Cap
* 5% Increase in Employee Pension Contributions

Spending is budgeted at $83.4 billion, the lowest in six years. California has dodged several bullets in recent years but behavior hasn’t changed, there hasn’t been political will and now there is no choice. Austerity measures can be forced upon individuals but more often than not the spendthrift only swallows such actions as a result of personal bankruptcy. Greece is bankrupt, Spain in many ways is even worse off and so, too, is California and Illinois. Bailing them out in my mind would be a mistake because there is no doubt destructive behavior would be enabled. For southern European nations it’s too late to turn a new leaf if the goal is to save the Euro and the EU. I think the same could be said for U.S. states in deep trouble. Moreover, it’s just not going to happen, a change in entitlement behavior. On the topic of bailouts, Arne Duncan, Labor Secretary, says $26.0 billion is needed to save 300,000 teacher jobs.

The stimulus plan supposedly saved those jobs already. Of the $920.0 billion (and counting), $100.0 billion was marked for education spending. Apparently it wasn’t enough or was misused. Unfortunately, the spending has been touted as a success already so this news of a need for more money is something of a punch in the gut. It should also serve as a warning. Once these spending programs begin they almost always become permanent. The nation can’t afford anymore stimulus spending. The first became a tool for expanding unions and doling out political favors. Along with TARP, which is now a piggybank for the White House, taxpayer money isn’t benefitting taxpayers.

There isn’t much economic data out this week so the action will be paced by developments in Europe and Washington. Last week movement on financial regulatory reform stunned the market a few times. Then there is the return of Cap and Trade, which would decimate the competitiveness of American business and increase energy prices for all households.

On the topic of energy, BP has announced some success with its latest attempt to stem the flow of oil from the Gulf disaster. There is still much work to do but in the meantime, there are eight formal investigations into the spill, with another coming from an independent commission established by the White House. It’s going to be pile on time, and I bet none of the probes will be conclusive. Politicians are going to flog this one for years to come.

On that same note, Greece is now looking into the role of Wall Street banks for that nation effectively going into bankruptcy. Citing favored buzz words like “fraud” and “transparency”, Greek Prime Minister George Papandreou says he has investigations underway.

The Market

It looks like the market is going to open gingerly but that is something of a moral victory as many overseas markets were hammered and nobody would have thought twice for a triple-digit point Dow decline at the start of trading. There are three mergers/takeovers, and positive earnings from Lowes (LOW; see color below) but the market is looking elsewhere for direction. The key could be the euro which hit a four-year low, if it finds a bottom then begins to rebound our equities market could follow. There is no doubt that anxiety begets anxiety so the longer questions go unanswered the more vulnerable the market becomes.

Is Lowe’s Low Balling it with Respect to Guidance?
By: Brian Sozzi, Research Analyst

Today, home improvement retailer Lowe’s kicked off what is the pinnacle of the reporting season for the nation’s top retailers. To summarize, the 1Q10 earnings season for retailers has been chock full of sales and earnings beats but very cautious comments by executives, which have overshadowed the positive start to the year. Lowe’s can now be included in the camp of serving up mixed guidance.

1Q10 sales and EPS surpassed consensus forecasts, supported by the first positive comp for the business since the August quarter of 2006 (+3.3%). Favorable two-year comp comparisons, government stimulus efforts (appliances and “green” upgrades), new build activity, and willingness by homeowners who rode out the eye of the housing downturn storm to spend on items other than paint and plants drove the 1Q10 comp improvement. Sales totaled $12.39 billion, $150.0 million higher than consensus, while EPS upside was $0.03. EPS was above management’s guidance of $0.27-$0.29 (we had modeled for net sales of $12.3 billion and EPS of $0.31). However, the quality of the report may have spooked investors in the early going.

Gross margin fell below consensus by 31 bps coming at 35.17%, and was down 29 bps y/y. The Company materially took its inventory higher in the quarter (+9.83% y/y) to likely plan for future renewed demand and there are expenses associated with this move (think freight etc.; a year ago tight inventory management was the name of the game). Furthermore, the Company likely invested in price to bring in traffic to discretionary merchandise departments; Home Depot (HD) for example lowered prices on plants this spring. The Company was able to make up for the gross margin disappointment through disciplined expense management and $420.0 million in share repurchases (23.0 million shares). The Company’s guidance was not particularly robust for 2Q10 or FY10; 2Q10 EBIT margin expansion is pegged at 40 bps y/y and 60 bps for FY10, despite comparisons to double-digit percentage EBIT profit declines (2Q10/3Q10) and what apparently is a challenging 4Q10 comparison for EBIT (+10.41%).

We are holding off on a new idea this morning.

Charles Payne is the CEO and Principal Analyst of Wall Street Strategies . This post was republished, with permission, from his company’s column, WStreet Market Commentary.

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