Debt Ceiling Panic?

The discussion continues to swirl concerning the debt ceiling, and we have received calls from many of our clients. For those clients who may have skimmed the most recent quarterly report, we are reprinting the comments from the Fixed Income portion that covers this matter more fully. We continue to believe the issue is first and foremost a political one, but we monitor events closely. The stock and bond markets continue to be subdued, and while the politicos will milk this for all its worth, we will actually be looking for buying opportunities during and hiccups. Please call us at any time to discuss your particular situation.

The fixed income markets have had much more than just inflation to worry about during the second quarter. The Greek debt crisis, jobless growth problems, and the extended housing slump are all worthy topics, but the topic we are starting to get more and more calls about is the impending debt ceiling for the US government. Our crystal ball isn’t any better than anyone else’s on this matter, but we are less concerned than the popular press would have you think. Let us explain why.

The first limit on the federal debt was imposed by the US Congress in 1917 via the Second Liberty Bond Act. Prior to that act, the US Congress acted specifically to approve (or not) of each individual borrowing by the US Treasury. The advent of World War I required greater flexibility in financing options, and so the concept of letting the Treasury decide how to finance the United States without having to go back to legislators was born. Over the ensuing years, the debt ceiling has been raised to accommodate the effects of inflation and various deficit spending programs, such as World War II. In fact, since 1917 the debt ceiling has been increased well over 100 times and stands today at $14.3 trillion.

With only $25 million of room left on the nation’s credit card, discussions have turned to the implications of hitting the ceiling in August, as predicted by the Secretary of the Treasury. The popular press has focused on the possibility of the US defaulting on its debt, and the calamity they claim will follow in the markets. However, the US Congress is still an elected one, and the financial markets are a hard master. Very few in Congress have forgotten the 777 point drop in the Dow Jones Industrial Average on the day Congress failed to pass the Troubled Asset Relief Program in September 2008, and fewer, still, wish to be on the watch should the US default on its debt obligations. Nonetheless, the political opportunity represented by the debate leading up to the ceiling limit is just too good to pass up, so Congress will milk it for all it’s worth.

As investment managers, we take a more sanguine view and step back to see what the markets are telling us. According to the press, we are fewer than 30 days away from default on the world’s “risk-free” benchmark, and, yet, the current rate for the 10 year US Treasury is a paltry 3.1%. That doesn’t seem like a rate I’d want on the debt from a defaulting borrower for 10 years. Greece, on the other hand, pays its lenders 16%, and they have the entire European Union running to their rescue.

Ecolab & Clorox

This week, we have some merger and acquisition news to pontificate on with regard to our portfolios.  In the Blue Chip Growth portfolio, our long-time holding Ecolab (ECL) announced it had reached an agreement to acquire Nalco Holding Company (NLC) for $8.1 billion in cash (30% of deal) and stock (70% of deal), including the assumption of Nalco’s $2.7 billion in debt.  Ecolab sold off after the announcement (not an unusual response to most large acquisitions) and some pundits thought Ecolab was overpaying for a business, Nalco, with inferior business economics.  Nalco, by our analysis, has a return on tangible invested capital (ROIC) of about 30%, consistent with Ecolab’s business.  Nalco earned about $626 million in adjusted operating earnings in 2010.  Ecolab is paying about 13 times operating earnings or about a 20% premium to where the composite S&P 500 is trading.  Ecolab, itself, is trading around 13 times operating earnings.  While it will be tough for Ecolab to squeeze much more out of Nalco’s 30% ROIC, Ecolab is picking up a good business with its, already, pricey stock.  So, in the end, we think the market’s reaction is more about the value of Ecolab than the quality, or price, of the business it is buying.

In the Equity Income portfolio, Carl Icahn first proposed acquiring Clorox (CLX) for $76.50 per share and then upped his unsolicited takeover price to $80.00 per share about a week later.  We carry a fair value estimate of about $80 per share currently for a minority position.  While we would hate to see a good company like Clorox go from the Equity Income portfolio (good companies trading at reasonable price are difficult to find), we do welcome Icahn pointing out that Clorox was undervalued by the market.  A price of $80 would represent a 13x multiple of enterprise value (stock capitalization plus debt) to adjusted operating earnings.  We think the Board of Directors should reject $80, but be open to accepting an offer between $95 and $100 per share, or a 20% control premium on top of our estimated value.