Wal-Mart's Mexican scandal: Who got hurt?...

Wal-Mart's Mexican scandal: Who got hurt?... Will anyone remember this in 20 years?... Netflix's business deteriorates... Are you in love with Apple?... For-profit education getting crushed...

 Wal-Mart is down another 3% or so today, after falling nearly 5% yesterday. The drop in share price comes after the New York Times published a more than 7,000-word article over the weekend that accused Wal-Mart of $24 million in bribes to Mexican officials. The alleged payoffs helped facilitate the retailer's growth in Mexico. (Wal-Mart de Mexico is the largest private employer in that country.)

Wal-Mart could face billions of dollars in fines. Most disturbing to shareholders, the highest echelons of Wal-Mart's management are alleged to have known details about the scandal as early as 2005... and covered it up instead of reporting it. Even Wal-Mart Chairman S. Robson Walton – son of founder Sam Walton – is alleged to have received an anonymous e-mail about bribes to Mexican officials.

 I (Dan Ferris) have thought about this a lot the past two days, since I have Wal-Mart in both my Extreme Value and 12% Letter newsletters. It's perhaps the most well-known of my "World Dominator" stock picks.

I have a lot to say about this, but here's what I'm wondering this morning...

Who got hurt?

Let's say Wal-Mart is guilty of all the accusations... that it spent $24 million bribing Mexican officials to expedite the process of permitting new land for Wal-Mart to build new stores. Who was hurt by that?

The Mexican economy unquestionably benefits from a strong and growing Wal-Mart. The company employs more than 200,000 people in its nearly 2,100 Mexican retail and wholesale locations.

What taxpayers on either side of the border were hurt? Again, the alleged bribes focused on speeding up the permitting and zoning process... bureaucratic constructs of dubious value.

And would-be competitors? In practical terms, anybody with a prayer of competing with Wal-Mart can afford to pay bribes, too. I cannot imagine major Mexican retailers Sears de Mexico and Sanborns (not to mention a slew of smaller competitors) aren't doing exactly the same thing. A reader brings this up in the mailbag (below)... but corruption is notoriously rampant in Mexico. Wal-Mart executives couldn't be the only ones putting cash in those open hands.

A rapidly growing Wal-Mart is great for the company and its shareholders... great for the Mexican economy... and great for the officials who took the bribes since they'd never make that much money otherwise.

I'm not saying bribery is a victimless crime... I'm just having trouble finding the victim.

 I imagine we'll get a lot of nasty mail telling me how awful and immoral I am. But I'm just asking a simple question... the kind of question you ask if you're truly paying attention in life. In practical terms... who was harmed by the alleged bribes?

Much of what is illegal is harmful to no one except the government in its attempts to force you to behave a certain way. Most "public corruption" is an offshoot of stifling regulation. If people didn't feel the need to work around government meddling in areas where it offers no value... this "problem" would vanish. Aren't licenses and permits mostly legal means of extorting cash for the public coffers? What if we simply allowed the company that paid the most to develop the land? Wouldn't that be more civilized, since property tends to be traded fairly and lawfully... unless it's stolen by governments and given out in exchange for favors?

 One final thought about Wal-Mart. I read a report recently by GMO, the money management firm co-founded by prolific market commentator Jeremy Grantham. The report noted that two-thirds of all corporate value lies 20 years or more in the future. In other words, businesses are valued based on future earnings. Most of that value lies 20 years out.

Will anyone remember the Mexican bribery scandal in 20 years? I don't know... but I doubt it. Even if the fines destroy an entire year of Wal-Mart's operating income (more than $26 billion last year)... the damage to the company's valuation would evaporate after two decades. If the company paid out a dividend of that size, the stock would soar... yet that would have about the same effect on the business' earnings power as a fine the same size.

I imagine the headlines will get worse and a big Wal-Mart executive or two will have to step down. But I doubt this will hurt Wal-Mart's business much. It'll remain a World Dominating, relentlessly growing retail network of more than 10,000 locations worldwide.

 "Why are you so confident?" was the first question an analyst asked Netflix CEO Reed Hastings on the company's earnings conference call yesterday... Netflix, as you may know, rents videos to its customers via the mail... It also offers a "streaming" service that lets customers watch movies on their computers over the Internet. Hastings said his company would add 7 million customers to its U.S. video-streaming service this year (the same growth rate it had in 2010, when business was booming).

Wall Street didn't buy it. Shares of Netflix fell 15% today to $86... They're down nearly 70% from their all-time high of $298.73 in July 2011.

 Before we get into the company's earnings, I want to discuss why the switch from physically mailing DVDs to its customers (Netflix's initial business model) to streaming its content will erode the company's margins. I wrote in the December 2010 issue of Extreme Value...

Since then, gross margins have thinned considerably, to 28.3% last quarter. Its operating margin is now negative. Competition will squeeze margins, too... Netflix has to compete with cable companies like Verizon and Comcast that offer video-on-demand services and web-based streaming services like Amazon and Hulu... Redbox (the giant, red video-rental boxes you see in grocery stores) is preparing to launch a video-streaming service, too.

 Netflix ended the second quarter with between 23.6 million-24.2 million domestic online subscribers, up from 23.4 million the previous quarter... Those 200,000 to 800,000 new second-quarter users are less than the 1.74 million new users it signed up in the first quarter. Hastings cited "seasonal" turnover for the slowdown... I can't seem to remember the seasons changing my desire to watch TV.

The company announced a $4.58 million loss for the quarter, better than analysts expected. And it increased revenue to $870 million from $718.5 million (also better than expectations). But the stock is still getting punished... The market thinks Netflix's growth story is over.

 Computer and consumer electronics sensation Apple announces earnings tomorrow... The stock is already turning over...

It's easy to understand why investors fall in love with Apple. All its products are stylish and sleek-looking. It single-handedly revamped the phone, film, computer, and music industries. It's a major force... a cultural icon.

But it would make sense for investors' ardor to cool a little. Apple has been one of the best-performing stocks of the last 10 years, rising from a split-adjusted $6.36 per share in April 2003 to its recent all-time high of $644 a share – a 101-bagger.

In addition to an iconic company with iconic products and an iconic founder... Apple is also a market bellwether. It makes up more than 4% of the S&P 500. Without Apple, the market's 8.8% rise year to date would be a mere 7.5% gain, according to the Financial Times this morning. The Times noted perhaps ominously, "There are times when the popular notion of equity investing revolves around one company. Right now, that stock is Apple." Does anyone not own Apple?

 Apple really is a great business. It gushes money. It's got $97.6 billion of cash on the balance sheet, accounting for almost one-fifth of the market cap. That means the business itself is trading for a mere 12 times trailing earnings per share. That is not the sort of multiple you normally see on a company that has grown at an astronomical pace for more than a decade.

And on top of all that, management is starting to think more about shareholder value. Apple's top brass finally decided to initiate a dividend and begin repurchasing shares. The quarterly cash dividend of $2.65 per share starts in the fourth quarter (which begins on July 1, 2012). The share repurchases are slated to begin in the next fiscal year, which starts on September 30, 2012.

Yes, it's very, very hard not to fall in love with Apple...

 But at some point, won't the rest of the world figure out how to make cool, sleek-looking hardware devices that perform just like Apple's iPod, iPhone, and iPad? Can you build a truly competition-resistant brand based on hardware? Apple looks a lot more like Dell than Microsoft or Intel to me.

 Longtime Digest readers know our thoughts on the for-profit education sector... In short, these colleges are riddled with fraud and deliver little value. And they depend on government grants (through student loans) for revenue.

Last month, attorneys general from more than 20 states joined to further investigate these companies, like Apollo Group, ITT Educational, and DeVry. And last week shares of Apollo Group – the largest company in the sector – fell 1.7% in a trading session after the Securities and Exchange Commission said it was investigating insider trading at the company.

We summed up our thoughts on the sector in the May 27, 2010 Digest (after seeing a presentation by hedge-fund manager Steve Eisman, who was shorting the sector):

 So these companies charge a lot for tuition, saddle their students with debt, deliver little value, questionably recruit students, and they're being investigated for fraud by the same entity that provides it with nearly all of its revenue (the U.S. government)... How do you think they've performed over the years?

 DeVry, one of the industry bellwethers, is down nearly 1% today before its earnings announcement. We'll update you on the announcement tomorrow... Shares are at their lowest point since 2007. Education Management Corporation, a $1.5 billion for-profit educator, is also at a 52-week low.

 New 52-week highs (as of 4/23/12): Calpine (CPN).

 So once again, we ask: How have we offended you lately, dear reader? (Today, we've got a hunch.) Send your e-mail to feedback@stansberryresearch.com.

 "It's simply incredible to read about the Wal-Mart bribery story. What a pile of garbage. Anyone who has ever lived, worked or run a business in Mexico knows this is a way of life. At the local, municipal level, officials regularly charge a fee (mordida) for building permits. That's a fact!. 'Sin pagos no hay permisos.' Which translates into 'no payments, no permits.' It's the same as using a turnpike or toll road in the U.S.

"Now representatives Cummings and Waxman are going to stick their noses in. It just makes me sick. It is astonishing that the U.S. government enforces the FCPA when for decades Washington D.C. has, and continues to use, food, money, weapons etc. to bribe and prop up foreign governments for their support. Talk about hypocrisy! When are Americans going to wake up?

"In addition, the New York Times published this investigative expose. The newspaper is 8.09% owned by Inmobiliaria Carso, a wholly owned investment vehicle of Grupo Carso of Mexico. Grupo Carso also owns Grupo Sanborns and Sears de Mexico, two large retailing operations that are in fierce competition with Walmex. Connecting the dots may be an interesting exercise. Mexican business tactics may have arrived on the U.S. business scene." – Paid-up subscriber Steve

Ferris comment: Kudos to you for making the connection between the Times story and Wal-Mart's Mexican competition. If Wal-Mart is doing it, so are Sears and Grupo Sanborns. I wonder who would be the winner in a Mexico without bribery? It'd be stupid to bet against Wal-Mart. And I agree with you that the U.S. government prosecuting bribery and extortion is particularly rich.

I feel the same way about India. Everyone seems to think pervasive low-level corruption there is a problem, but it just seems to be the way everyone keeps the mountains of red tape and bureaucracy from destroying their lives. Without massive bureaucracies, there's less incentive to go around paying people off. By making it too difficult to live, work, and do business... governments create the circumstances under which corruption may thrive. Mexico could easily reduce its crime rate by decriminalizing drugs and getting government out of the way. It's funny how this is never, ever seriously considered.

 "Your honesty about your results as an investment team is admirable as is your courage to speak your truth about the markets, the end of America, our government, whatever.

"I have been with you many years and I know the punishment you took from the SEC when they tried to shut you up and wanted to shut you down because you did not conform. The cost to you in money and stress would have silenced most people. Your courage and fortitude to continue is an inspiration to all of us in America to not be intimidated by big government and crony capitalism.

"You offer the best investment advisory service I have ever found and you and your colleagues have helped me become wealthy over many years.

"No matter how many negative comments you get from subscribers please continue to share the truth as you see it. I find your perceptions invaluable but I am sure they scare people who do not like to face painful realities and offend some who do not like people who see things differently from their own point of view. All of us would like others to agree with us, but we would suffer from the stultification that comes when everyone agrees or conforms to the same point of view.

"We are now so polarized in our country that it is difficult to listen to the other side's viewpoint. America has been through this before. I know it was this way during the Revolution and during the Civil War.

"We are now in the third Great Awakening choosing between freedom and Constitutional, limited government versus material equality imposed by big government through taxation and redistribution.

"True equality cannot be imposed because it is a feeling within people that can neither be legislated nor enforced. We are created equal, we are not born equal, and no two people can ever be made equal.

"Equality is based on how you feel about yourself and how you see your neighbor and this is up to each of us to determine. Having wealth, political power, rich parents, or more education does not make anyone superior; and not having these things does not make anyone inferior. Steve Jobs is a good example as is Martin Luther King.

"What is great about America is the right to free speech, religious tolerance unseen in most of the world, and the acceptance of the fact that we each have the right to speak our truth.

"God bless you and your colleagues. Keep up your exceptional work." – Paid-up subscriber Doug Welpton

Ferris comment: I won't speak for anyone else at S&A, but the courage and fortitude, as far as I could tell, came from Porter. He bore the brunt of all of it. As I understand the suit, it was aimed squarely at his work (and definitely undeservedly so, in my opinion).

 "The problem isn't your B of A recommendation, it's the fact that any amateur IRA consultant for Fidelity would recommend B of A or Citigroup or Wells or what have you. Why should someone pay a premium for such novice advice? 'Uh, banks are cheap, so buy banks... ' Ah no sh*t, buddy. Same thing as saying that mining stocks are cheap or any other sector that is trading cheaply right now. This isn't exactly a pillar of insight, now is it? Recommending whatever is currently cheap puts you guys on par with the Power Lunch clowns on CNBC. Also, you're just copying that other clown Dick Bove, who recommended B of A at 18, right before it began the long, painful slide back down to sub-5." – Paid-up subscriber Charles Peabody

Ferris comment: Our job isn't to tell novel stories. It's to be right. Stock prices change about 19 times more in either direction than the U.S. GDP. That creates opportunity in everything from the tiniest microcap all the way up to Bank of America.

Goldsmith comment: You clearly didn't read the recommendation... Good luck with Fidelity.

Regards,

Dan Ferris and Sean Goldsmith

Medford, Oregon and New York, New York

April 24, 2012