Thursday, December 08, 2011

Thoughts on the Evolution of Warren Buffett's Investment Style

Readers of this blog know, I am a big fan of Warren Buffett - hard not to be if you aspire to investing excellence.

Over at "Can Turtles Fly" there is an excellent post on Buffett's investment choices.  The author breaks his investments into three phases, each of declining productivity, as assets under management and more expensive (and more efficient?) markets increasingly limited his investment choices.

I think the author mostly has it right, and it is definitely worth a read.

Tuesday, November 22, 2011

China vs. India vs. US - more details

I focus a great deal on demographics and the interplay between macro regions on this blog.  There is a reason for this: I believe that apart from individual firm analysis, the most important structural questions an investor has to ask himself are about the future nature of markets - particularly financial markets.  Moreover, I believe that the investing climate in which we are operating is and will remain, driven by macro questions as governments rewrite social contracts that have mostly been stable since the 1940s.

Changing demographics influences work, output, production, consumption and ultimately the propensity to save, invest and to assume risk - these are the key factors for the investment environment.  Within that environment, of course, we also have to pick firms with good economics, but these factors will help to understand the ever-uncertain future prospects of a firm.

I also write about demographics and about global growth becuase I believe that much of the information in the public sphere is written with particular agendas in mind - and that most of that is not aimed at investors.  Most people are China bulls - either because they think it good that the US lose its preeminence or because they are horrified at the prospect and want to issue cautionary tales to Americans to avoid a declinist destiny.  Mostly the arguments are political, or are driven by investment banks who want to have an easy job of selling securities to gullible investors.

I am decidedly on the side of the China bears - and mostly because of demographics.  There seems to be increasing evidence that my forecast makes sense.

Awhile back I made a prediction about China, India and the US. I argued that China will become the worlds largest economy before 2030, and based this on some simple calculations from the Economist. I further argued that China would only hold this position for a short time before it was eclipsed by India, which has grown slower, and started later, but is recently accelerating and which also has better demographics (and a better education system) than China.

But perhaps my most surprising prediction was that by 2050 China would rank third, because it would again be passed by the United States.  Now, I have some more evidence that this may indeed happen.

An economic think tank that focuses on demography and economics has concluded that China's growth rate, which has already slipped from double digits to high single digits (with the usual investment banks and bulls arguing that slowing growth is an indication of economic health.  Funny, I never hear them saying this about the US).  According to John Mauldin, this think tank Global Demographics, has further argued that growth will slip to the high sevens, about the level India is experiencing now (though India's economy is much smaller than China's) and after 2016 will likely fall to the 5% range - and to the 3% range after 2021.  (Higher √≠nflation means that China's economy will still grow larger than the US in nominal terms).

But this means that the US will have a chance (if it can restore historical growth rates) to essentially keep pace with China.  Likely the US will grow at slightly less than 3% because its own demographic profile will be less favorable than that over the past nine decades, but China will not keep outstripping US growth significantly, and the long-term favorable demographics of the US, coupled with its strong R&D and productivity gains mean that the US will be poised to surpass China by 2050.  India will be a bigger challenge for the US.

Of course, such dramatic slowing of economic growth will no doubt lead to significant political unrest, as Chinese, having grown accustomed to a world in which everyone is much better off each year than the year before (at least among the urban middle class) will find the economy's inability to keep up with their expectations a sore point - and one which will undermine the legitimacy of the CCP.

It also means that beyond 2021, investors will have to look to other regions for economic leadership.  Of course, China will be a very large economy and growing solidly, but so will the US - except that the US will not have the political risks associated with China.  Expect asset prices and investor appetites to wane.

Monday, October 10, 2011

HELE Earnings FY2012 Q2

Helen of Troy delivered an underwhelming quarter, to say the least.  Revenue was well below analysts forecast of $288mn, and net income for the quarter was essentially flat, and due to higher shares outstanding, EPS actually fell.  This was also below analyst estimates, which had expected a rather substantial increase in EPS.  Worse, the company had the worst conference call I have ever heard; after a delay (for "technical reasons"), it seemed as if management was completely unprepared or distracted - they could not even read their prepared remarks correctly, indicating that they had not prepared adequately.  All of this was a reason why the stock tanked when earnings were released last Thursday.  Since hitting a peak of $36 in June after the Q1 earnings report, the stock is down about $11, or nearly 30%.

The poor earnings were due to weakness in the traditional Helen of Troy businesses.  The personal care segment, which includes most of the styling products for which HELE is known, actually experienced sales declines, in part because in-store promotions, which were used to increase (uh, maintain) volume, were taken as a reduction in sales.  According to the company, the increased marketing expense was $4.1mn (although an unspecified portion of this was also credited as SG&A and not as a reduction in net sales).

Management has suggested that consumers are really curtailing their consumption of these products, and that any improvement will be "heavily dependent on improvements in employment, housing markets and consumers' personal finances" (10-Q, pg30).  Let us hope they are wrong, since we are likely a good 3-5 years away from any meaningful improvement in any of the three macro factors the company has cited.

It should also be noted that the company sources many of these products from China, and, low and behold, the costs of manufacturing in China and importing to the US are rising.  Wage inflation, which has been running around double digit levels is piled on top of a rising currency, leading to margin contraction on top of sales declines.  The rising cost of labor and the currency are both secular trends that are set to continue for the foreseeable furture.

Operating income in the segment declined by $3.59mn in the quarter, primarily due to the increased advertising expense noted above.  While the company attempted to argue that this was mostly a timing issue (advertising programs occuring in the 2nd quarter of FY2012 occurred instead in the 3rd and 4th Quarter of FY2011), this only reinforces the difficulty of the operating environment, since sales declined even though significant incremental promotional expense was incurred.  The $4.1mn, incidentally, is about 13cents on EPS, which would have been enough to lift EPS from $0.74 to $0.87, about what analysts were looking for.

Six month results were better, with an increase in operating profit of $2.68mn.  There is a catch, however.  The company has started to allocate some corporate overheads to the new operating segment (Healthcare/Home Environment)  These costs were previously borne by the Personal Care and Housewares segment.   For the six months, the reallocation was $3.01mn.  The company does not clarify how these costs had prevoiusly been allocated to the PC and HW segments, but it seems likely that they were shared 2/3 to PC and 1/3 to Housewares.  If I am correct, then Personal Care received a $2mn operating income boost, which basically leaves operating income flat for the first half of the year.  Note that in Q2, operating results declined, even after receiving a $1mn benefit from reallocation of SG&A.

Taken as a whole, we have a segment that looks set for quite a bit of future weakness.  On the conference call, the CEO remarked that "most people have a hair dryer, we need to convince them to purchase a new one even though their existing one still works" a sure sign that saturation is occurring.  One wonders if the company does not have rethink its product and category managment and consider offering more discount items to compete effectively in the discount segment.  The company notes that people are trading down.  The company may be in a tough position, strategically, in that it licenses brand names and produces merchandise for which it believes it can charge a brand premium greater than the cost of the license.  In many cases, this license fee is likely to be a fixed cost (at least in part), meaning that increasing sales of unbranded or value branded products may compete with the branded products for which the company already has a fixed expense. 

It is difficult to determine the extent to which competitors are experiencing the same challenges in the segment, as most competitors are either private companies or are simply to large to break out sales in this area.  The closest analog, Spectrum Brands, had strong sales growth in the category, but that was for the period ended in July, a selling period most closely aligned with the HELE's first quarter, in which sales growth was solid.

As this segment has traditionally represented 2/3 of the company's sales, and after the Kaz acquisition still accounts for 40%, it has the potential to be a drag on earnings for some time.

The story is somewhat happier with the OXO brand (Housewares segment), with strong sales growth in both the quarter and the first half of FY2012.  Managmeent was quick to caution that double digit sales growth is likely to moderate such that for the full FY2012 revenue growth is likely to be in the high single digits.  Based on FY2011 sales of $216mn, this would imply a full year revenue increase of $11mn - $20mn.  Since revenue growth in the first six months of FY2012 is already $13mn, we have to expect relatively flat sales in the back half of the year.  Sales this year have been helped by strong volume growth from OXO Tot (baby goods), but also happily, expanded shelf space and small growth in geograpic distribution.  It is not clear to what extent this is due to increased leverage as a result of the Kaz acquisition, it may be entirely due to the expansion of the product range.  The company's ability to continue to growth this segment will be based on the ability to continue to deliver new product introductions and to increase the geographic reach of distribution.  The company has a good track record here, and Kaz ought to help with finding new channel partners and geographies.

One cautionary trend to monitor is the fact that the OXO brand is coming under some price pressure.  OXO has generally been able to position itself as a premium product and maintain strong pricing, but the second quarter saw significant promotional efforts around stock-outs.  Coupled with higher costs (the China effect, again), the higher discounting led to a decline in operating income in the 2nd quarter, which pretty much cancelled out the gains in the first quarter.  Again, this margin contraction occurred despite allocating (my estimates) $500k and $1mn from Housewares to Healthcare.  Had these allocations not been made, the declines would have been much lareger.

Nevertheless, there are some signs of optimism.  First, the Kaz acquisition is performing better than I had expected.  Sales increased for the first half, though sales were lower in Q2, apparently due to supply shortages, which may lead to higher sales in Q3 adn Q4.  Operating income was $7mn in Q2 (up from a small loss in Q1).  The six month result of $7mn is after taking on $3mn in SG&A from the other two segments.  According to the company, this is due to sourcing and synergy savings, as well as improved category managment.  Better yet, management has indicated that due to strong seasonality at Kaz, the Q2 and the first half are not indicative of full year results, and it expects to outperform the $7mn operating in each of the last two quarters of the year.  This should lift operating profit above $20mn for the year, which is what I estimate is the segment's actual capital cost.  After interest charges of about $8mn for the acquisition, Kaz may add $16-$18mn operating, or $0.50 EPS after tax.

Moreover, the company claims to have identified an additional $10mn in synergy costs, which, if it is all incremental, would represent another 30cents (before tax).

The company has also improved working capital ratios, reducing the number of days receivable and increasing inventory turnover, which should help to free up some more cash to reduce borrowings.  The company was also able to sell its entire stock of Auction Rate Securities, which converts $20mn in nearly non-interest bearing "investments" into $19mn in cash, which is avail√°ble to reduce borrwings.  And speaking of reduced borrowings, the company paid a $50mn note with cash on hand and increased borrowing under its revolving credit facility.  Strong cashflows in 2H resulting from an inventory sell down and strong oeprating results should enable the company to make a major reduction in the $105mn in revolving debt.

I am still annoyed that management used its view of Q2 to sell options dear.  I am also concerned about the planned compensation for Gerald Rubin, as adjusted EBITDA excuses bad behavior in the form of overly generous Goodwill.  However, I can easily see the company earning $3.40 in FY2012 and $3.70 in FY2013, and my own estimates of value based on DCF peg the value of the stock between $35, assuming very negative assumptions (no gross margin expansion and very slow revenue growth) or as high as $54, if growth is a bit stronger and margins can be returned over time to the 45% enjoyed by the legacy HELE.

All of which is to say that the stock still looks cheap.  A buyback would be in order.

Monday, October 03, 2011

HELE Earnings Preview, Part II

In part one of the analysis, we reviewed the Kaz acquisition and set some targets for the financial performance of that business unit.

HELE has also been in the news for some other recent decisions by management - insider stock option conversion and a new proposed compensation plan for the founder and CEO, Gerald Rubin.

Mr Rubin, it may surpise, does not have a very large stake in the company.  According to the most recent filings, he owned about 2.4mn shares, less than 10% of the total.  At current market prices, his stake is worth about $60mn. This is not a bad thing, except that it means his annual compensation, which can run to above $10mn matters a great deal in comparison to changes in the market capitalization of the firm.

What is particularly interesting is that he, and a few other senior executives, chose to exercise their options back in early July, when the stock was trading at an all-time high of near $36.  The stock has subsequently declined by over $10 per share, partly on market fears, but also perhaps because there is a perception that insiders, six months into their largest acquisition, believe the company may struggle going forward.  This is particularly true when one considers the fact that Mr Rubin cashed in all of his outstanding options, 1.325mn shares worth - two years before expiration!

How do I arrive at this conclusion?  By checking the latest 10-Q which notes on page 22 that there were 2mn options outstanding and exercisable as of May 31, 2011, with an average life of 2.11 years.  Mr Rubin's 1.375mn represent over 65% of the 2mn total shares, enough that his expiration cannot diverge significantly from the overall average.

Given the opportunities the Kaz acquisition presents, not to mention the ongoing and rising cash flows from the legacy business, one would assume that Mr Rubin would want to hold out for future appreciation with at least some of his options.  Why not leave some skin in the game, unless you believed the stock price had peaked?

Incidentally, Mr Rubin submitted most of these shares in settlement for taxes and the purchase price of the stock.  The company retired the tendered shares, so net share issuance only rose by about 300k - or 1%.

In fairness to Mr Rubin, the exercise may have been related to the intent to change the management contract.  Mr Rubin had been barred from participating in options under the existing stock programs, becuase of his high number of outstanding options.  Cashing them in may have been part of an arrangement between himself and the board to obtain a new incentive agreement.  I say this, because in early September, the Board announced a new agreement with Mr Rubin, one which has not been ratified by shareholders.  In this agreement, Mr Rubin will no longer participate with a share of Net Income, but rather based on "Adjusted EBITDA".  What this does is separate Mr Rubin's pay from the effects of asset impairments, such as writedowns in estimates of the value of intangible assets and goodwill.  (It applies to writedowns of other physical assets as well, but over 50% of HELE assets are of the intangible variety).

From my perspective, what this does is insulate management from the impacts of it's own decisions.  Mr Rubin has led the company for four decades.  He has made the decisions to purchase these assets - subtantially all of the intangible assets are the result of a strategy Mr Rubin has pursued.  It makes no sense to release him from the consquences should history show him to have overpaid.

These two decisions, more than anything else, indicate that Mr Rubin believes the company's prospects are less rosy than they appeared in the months after the acquisition.

Incidentally, I encourage you to vote AGAINST this proposal, as I shall.

In purchasing Kaz, HELE decided to grow the top line fast, and enter new categories.  The company has incredible cost management and has consistently managed to grow the business.  Indeed, the OXO brand alone might be worth more than the market cap of HELE.  But the acquisition is risky and it looks as though management is looking for ways to insulate itself from the consequences of those decisions.

Thursday will be most interesting.

Sunday, October 02, 2011

HELE Earnings Preview, Part 1 - the Kaz Impact

HELE will be releasing its earnings report for the fiscal 2nd quarter this Thursday.

This quarter is particularly important, because of the unfolding informatin about the Kaz acquisition, and investors will want to know how well the economics of the deal are working out.  If recent moves in the stock price reflect sentiment about the business and not just reaction to market gyration, then investors are concerned about the performance of this deal.

There are several other factors that could be weighing on the share price.  Earnings per share will likely be under pressure because of significant (and early) options excercise (at what turned out to be the recent top around $35 per share).  Management also has renegotiated a new contract, and it appears very lucrative.  More on this later

I am among those who are curious to see how managment is handling the sudden and massive growth of the business.  My own view is that the company will likely earn a fair return on the investment, but that it will be less successful than some of the smaller, more bolt-on, acquisitions (such as Pert and Infusium23) that the company has done in the more recent past.  More deals are likely to be avaible in the not-to-distant future as macroeconomic fears weigh on business valuations.  The jury is still out on whether this deal was wise - HELE may have overpaid.

The Kaz acquisition was designed to be transformative, with $270mn flowing to Kaz shareholders in an all-cash deal. (The combined company has a market cap of $775mn). This was a high sum to pay for a firm that was not making money prior to the acquisition, so we have to believe that HELE management will be better able to sweat the assets, to break up the assets and sell the pieces at higher prices than they paid, or that other synergies such as increased pricing power with suppliers and consumers will contribute to greater earnings across the company.

The deal recorded $154mn of Goodwill, indicating that HELE mangement believes there is much value to be unlocked beyond the value of the brands themselves.  Investors have to be wary, since management has a history of having to take write-offs against intangible asset values acquired at optimistic valuations. 

Nevertheless, the Kaz acquisition offers HELE many opporunities: first and foremost significantly increasing revenue - while organic growth of 5.9% was strong for a firm that makes consumer staples, the acqusition increased revenue by an additional 63.9% over the prior year quarter - if Kaz can be made anything like as profitable as the traditional HELE, earnings per share (which remain undiluted in the deal) will soar, and the stock price with it.

Moreover, Kaz helps the company to expand it's geographic footprint and it's overseas sales - so Kaz can also help to grow sales of HELE products and enhance the value of the traditional business.

Unfortunately, Kaz is a much less profitable company.  Management has not clarified the extent to which this reflects weakness of its brands compared to competitors, or whether it competes in lower-margin categories.  That HELE management has stated its aim to increase profitability in Kaz to levels consistent with the legacy business suggests that it is the former.  In the meantime, Kaz weighs on the gross margins at HELE.

In my mind, to be considered successful, the deal must achieve all of the following:
  • Produce operating cashflows in excess of both the direct financing costs
  • Demonstrate an ability to delever the firm on its own (i.e. to generate enough cash to repay the debt assumed to acquire it without resorting to cashflows from HELE)
  • Produce a satisfactory return on company cash employed in the deal - $77.5mn.  This is money that had been avaible to invest in other HELE product lines, make smaller acquisitions (with less imapact on the balance sheet)
If the company achieves all three of these objectives, it will have been a good deal in which HELE shareholders will have acquired a substantial business with little investment.  This would make Kaz essentially a good "financial" deal - in which affordable financing allowed a new revenue stream to be purchased for less than its financing costs in return for the company having to sit on the deal-making sidelines for 12-24 months while the core business piles up more free cash for the next round of acquisitions. 
To be a truly fantastic deal -
  • Kaz should begin generating substantial operating earnings within the next 12 months
  • Kaz should show ongoing incremental margin expansion as a result of the increased market power of the combined entity
  • Kaz should be able to do so while shouldering costs formerly assumed by the legacy busienss (i.e. improving profitability in the legacy business through efficiencies
  • Grow it's own revenue at a faster pace than the legacy business
  • Support improved margins in the legacy business.
How is it doing against these objectives?

According to the filing, revenue of $95mn represented an increase of 7.2% compared with the (pro forma) prior year period, so we are seeing nice revenue growth.

In the 53 weeks ended April 30, 2010 (the last full year of operations prior to the acquisition), Kaz earned an operating profit of $4.4mn on revenue of $440mn, so a 1% return on sales.  This return was consumed by $5mn in interest payments, so that Kaz made a loss.  Gross margins were 32% in contrast to HELE's 45%.  In the six months prior to acquisition, margins were even lower, (though they were improved over the comparable period in the prior year).  Opearting income was essentially zero, as increased gross profit was consumed by much higher SG&A expense.

In the latest HELE report, gross margins have appeared to increase to around 32.2%.  While revenue is broken out by segment, cost of sales and gross margins are not.  I have calculated this number by taking sales in the legacy businesses and applying the historical 45% gross margin to derive a cost of sales for the legacy business.  The remainder must apply to Kaz, and the difference must be the amount of gross profit earned by Kaz.  This number is similar to the previous year, and is in any case, imprecise, due to the method I had to use to determine it.  I would like to see an increase above 33% in the current quarter, indicating manaagement is getting better control of product lines.

Operating income was a slight loss, however, management is careful to note that the quarter is a seasonally weak one for Kaz, which averages $110mn in revenue per quarter.  Moreover, management noted that some overhead costs have been allocated to Kaz, such that Kaz is now covering $1.5mn of costs from the legacy HELE business, implying that operating income could have been as high as $1.4mn were Kaz a stand alone business - well more than 1% of sales.  We can only hope this trend will continue and that operating margins in this quarter will be above 2%.

Unfortunately, this is still not enough to cover the interest costs associated with the acquisition, so that it cannot be said to be self-financing, at least not yet.  The company needs to earn about $7mn operating just to cover the interest costs.  Based on the metrics above, it must earn another $8mn to cover the cost of equity capital injected by HELE, and finally, we would like to watch this thing delever, so let's say we need a $20mn operating profit - which means that the unit has to earn 5% on sales

Finally, management may come to regret the amount of commitment they have to Kaz because nine months into this exercise, the markets seem shaky, and it appears there may be some real opportunity to pick up quality assets on the cheap.  On a positive note, the core business seems to be generating cash quite rapidly, which means that in six more months, the company's coffers should have it in position to do another modest deal.


Part II - Management concerns next.

Buffett rationalizes repurchases

In this interview with Andrew Ross Sorkin, Warren Buffett explains his logic for repurchases.  His logic supports my thesis from an earlier post that Buffett is really making a statement about how to do buybacks - not as an annual and ongoing "return of cash" (as another Strategic Investor favorite, CL, does) but rather as a choice among investment alternatives.  Buffett wants to buy large companies with good prospects at low prices: BRK qualifies and so long as the price remains attractive relative to intrinsic value, he is a buyer.



A similar approach was explained by Lee Raymond, the man who made ExxonMobil.  Having done many deals building the world's largest non-goverment run energy company, people asked him why he suddenly stopped doing deals.  Mostly, the critics argued that the acquisition of Mobil had been too difficult for XOM.  Raymond countered that there were no deals worth doing: he noted that "we looked around and the cheapest oil we could find was our own, so we bought back stock".  You can read more of the interview here.

Buffett, I think is saying the same.  Sure there are opportunities, and from time to time a business that meets his criteria will become avaiable.  In the meantime, there is a business that meets his criteria which he can purchase as common stock - and unlike other stocks he buys, he has an opportunity to use the treasury shares in private market transactions when the stock more closely reflects intrinsic value, to acquire firms.



Friday, September 30, 2011

Economics Humor

If you read this blog, you like finance and economics, which means that you will find this funny, even if you have seen it before.

http://www.standupeconomist.com/videos-public/

Wednesday, September 28, 2011

Thinking about Buffett's decision to repurchase

Well, the recent announcement by Berkshire Hathaway that it would initiate an open-ended buyback at prices up to 1.1x book value has raised quite some stir in the investment community, about BRK stock, the company's future, equity prices in general and the future direction of the stock markets.

Opinions range from the idea that this is a shrewd PR move to boost the stock price, by essentially setting a price floor at 10% of a (rising) book value, to the opposite idea, that the action will set a ceiling on the price, since if Buffett is unwilling to purchase the stock above 1.1x book, why should any other investor?

The International Business Times has a very thoughtful quote from Thomas Russo, of the asset management firm Gardner, Russo and Gardner - arguing that the buyback is part of planning for life after Warren, because with Buffett "cash had such a high value", but that under another manager, the value of the "cash option" will be lower.  This is almost certainly right, as Buffett regularly gets to make investments on "only for Warren" terms - e.g. his investments in Goldman Sachs and Bank of America, which both were willing to pay up to get his imprimatur and prevent a confidence crisis that could have caused a (liquidation-forcing) run.  With lowered expectations for cash deployment, it is time to begin returning cash to shareholders.

Finally, there are a host of arguments about what the buyback means for equity valuation and market direction, typically these span the gamut of arguing that the buyback is a bearish signal, and that it is a bullish signal.

Taking the arguments, I think the last one can be dismissed out of hand - the author makes some tortured arguments about the relatively low premium of the S&P500 to book value, to argue that if Buffett is wiling to purchase at 1.1x book, then why not the whole market at 2+ times.  Indeed the author acknowledges that only 20% of companies actually trade at or below the price at which Buffett is willing to buy BRK.  Unsaid is that many of them carry far more risk, a company that certainly meets the first three Buffett criteria for a business - good trustworthy management, simple understandable businesses, possessing wide moats with reasonable growth prospects.  These, he obviously now feels he is getting a reasonable price.  Given the arguments of the Bullish writer, it appears that BRK is now trading at quite a discount to the market (this is my own view, which is why, prior to this announcement, I have considered purchasing "B" shares).

The bearish argument makes more sense, as it rightly argues that were valuations cheap, Buffett would take the opportunity to deploy cash scooping up assets at a discount.  The fact is, large cap value stocks - the kind that produce stable cashflows, strong returns on equity and allow for higher leverage are among the least expensive, as measured by PE (and adjusted PE, since most of these firms did not sustain huge losses in 2008/2009).  The fact is, a buyback is indicative of the lack of attractive investments relative to the cash generation of the company.  (Buffett and Munger have repeatedly argued that buybacks and dividends are symbols of failure - an indication of an inabilty to put the cashflows of BRK businesses to work making yet more money).

The argument about the relative valuation of cash is particualrly an interesting one.  In Buffett's hands, liquidity is incredibly powerful.  My only argument against this is to point out that Buffett is hardly out of the picture, so presumably, there has been no loss of the value of the cash - only that BRK is now generating too much.  This is not a new situation, actually.  Over time, Buffett has migrated from purchasing businesses that produced huge amounts of float (cash to invest) such as Blue Chip stamps and his insurance businesses to purchasing businesses that needed little increase in capital to grow the business (See's Candies - Buffett's favorite investment, I think), to purchasing large capital intensive businesses, such as Burlington Northern and Lubrizol.  This is no accident.  Buffett's traditional businesses produce so much cash, he can no longer acquire enough businesses, so he has instead looked to businesses that require large capital injections, but which can then earn acceptable rates of return on that capital.  Buffett is essentially providing internal financing to these large industrial companies so that they can avoid the difficulty of raising funds on the open markets in difficult times.  But even these cannot absorb all of the cash Berkshire now generates.

As to the value of BRK stock, well, Buffett has always maintained that the intrinsic value is high above book value, (but that change in book value is a good proxy for the change in intrinsic value).  There is good reason to believe that the stock's intrinsic value is well above the price at which Buffett is willing to purchase.  As we know, Buffett is a student of Ben Graham, and is particularly influenced by the idea that investing requires a margin of safety, and to always purchase when you are assured that there is one.  We also know that Buffett never breaks discipline.  Nevertheless, there is a chance that by trying to set a floor, Buffett may limit the upside to the stock price.  But if intrinsic value is truly greater than 1.1x book, there would still be significant money to be made purchasing above Buffett's price, but below intrinsic value, so the likelihood is that ultimately, the price will rise well above that Buffett is offering.

My own view is the Buffett has made yet another shrewd calculation in offering to buy back stock.  He is, in fact, taking advantage of Mr. Market's preference for growth, which has companies like Salesfore.com trading at triple digit multiples (or nearly), while allowing companies like Microsoft to trade in single digit multiples.  Moreover, BRK may be suffering from a discount related to the expected change in leadership - management changes are risky for investors, since new mangement may not act in shareholder friendly ways (or even with good business sense).  Finally, BRK is more than anything else an insurance company, and financial firms are also quite out of Mr. Market's favor, so Buffett will be happy to take shares off his hands.   Buffett gets a diversified conglomerate trading at a significant discount to both the market and his own estimate of intrinsic value, and will be able to put the money to work in large sums (provided the stock doesn't rise above his bid).  Ultimately, I am not even sure that he will actually repurchase any shares, as the market will likely keep the stock at a premium to his bid.

Please note that there are arguements to be made that the performance of Buffett's businesses is deteriorating, and that perhaps the stock should not trade at such a premium to book.  But this article is too long already to debate that issue.

Returing to the rationale for the buyback, I believe the decision to repurchase shares is serving Buffett - and his shareholders - in three other ways.

First - it is allowing Buffett to make a statement about how management returns cash to shareholders.  Buffett has actually named his price for shares, which is highly unusual.  Most managements declare a willingness to repurchase a certain number of shares, or a certain dollar value of shares, but do not specify at what price they are buyers or at what price they are sellers.

Most company managers use buybacks as a means of deploying excess cash - that means, however, that they are usually buying when business is good (and stock prices are high), because that is when the business is generating surplus cash, and are hoarding cash and not buying when stock prices are low.  Thus firms set a record for buyback in 2007 at the market top, but were at a multi-decade low in spring of 2009, when stocks were at their nadir.  Buffett has instead argued that buybacks should be based on valuation - management should initiate buybacks ONLY WHEN the stock trades at a discount to intrinsic value, otherwise, they should just return excess cash to shareholders (via dividends).

Moreover, Buffett is telling his shareholders that he thinks he is getting a very good price.  Buffett has effectively said, "At 1.1x book, I think I'm getting a good deal.  Now, if you still want to sell, then ok, but just be aware, I think I'm getting the better end of this trade".  Buffett in his interview with Becky Quick earlier this year, explained that when buying back stock, you have to recognize that you are ultimately trading with your shareholders, and that the agents of shareholders, management has a duty to advise shareholders of the economics of the deal prior to making it (which is why BRK has never repurchased shares).  Once you tell someone, "hey, just so you know you're getting screwed," they usually decide not to deal.

Second - I believe Buffett is trying to counteract the effect of the rapid expansion of BRK float resulting from long term, octogenarian, holders finally liquidating positions that have not traded in decades.  While this should not really have a signficant impact on the stock price (which should reflect intrinsic value), the fact is that markets also respond to short term differences in supply and demand, and that at the moment, supply is being increased rapidly as the Gates foundation liquidates the shares Buffett is donating to them.  This is potentially weighing on the price (even though this is an extended process), and Buffett has an opportunity to mop up some of the excess supply (at a nice gain).

Third, and most important, is what BRK did not do: issue a dividend.  Overlooked by every commentator I have read, is the fact that buying back the shares doesn't limit Buffett's ability to acquire other businesses - it may change the currency, however.  Repurchased shares become treasury shares and are then available for acquisitions.  Indeed, if the stock returns to intrinsic value (or even a premium), Buffett may be able to use the currency of treasury shares to acquire a company for less than if he had paid all cash (there are some tax advantages that often mean a stock deal can be had at a discount).  Thus, the money allocated to treasury purchases is not really "gone" (though of course, reissuance of treasury shares increases shares outstanding, with implications for book value and for EPS). 

Had Buffett instead issued a dividend, the money would truly be no longer available and a new deal would have to be done by issuing new stock.  Of course, if the stock continues to trade a discount to intrinsic value (it could fall further, even), then treasury stock is not an attractive currency, so in that sense, there is risk in comparison to keeping the cash.

All in all, I believe that Buffett is deploying BRK cash quite wisely in making this purchase.  I would that more CEOs would focus on valuation when repurchasing stock.

Wednesday, July 20, 2011

Tech Earnings

Well, Lenovo is entering the tablet space, and at least one product will have an MSFT operating system.
 Granted this space is getting crowded, fast, but it looks like MSFT will at least play.  I am still looking to see how the Skype acquisition fits into the overall picture, but it does mean that MSFT will handle many of the calls going over competitive handsets .... including the iPhone.

I do see where expectations are for an earnings miss from Intel, based on margin compression as they work to bring new chips into market.  It seems that the bigger issue will be the outlook for the PC market, which Intel has estimated to grow double digits.  This seems unlikely given the strength of tablet sales and slowness in hiring, so actually, Q2 earnings will probably not be the determining factor in the price movement, but rather INTC ability to sustain any sort of top line growth.  This was the same discussion in Q1, however, which turned out to be pretty good and let to a dividend increase.

Speaking of CSCO

I see that CSCO is trying to remind everyone of how much bigger the internet is getting, and at what speed.
Not sure I believe that 20 households will generate enough traffic to exceed the entire internet of 2008, but still, I admit, we are getting more interconnected by the day.

It is a cool graphic (scroll down) after you click.

What AAPL Earnings Imply for Tech

Yesterday was a big day on the stock markets.  The Dow, not a great indicator, was up by 202, on the strength of earnings from IBM and Coca-Cola.  (The Dow is price weighted, so stocks with the highest prices have the most impact.  IBM trades at $185, by far the most important Dow component).

IBM's big upside earning surprise helped tech rally sharply, with the Nasdaq up over 2% on the day.  Among those that saw big rallies were INTC and MSFT, which report today and tomorrow, up 3.5% ahead of earnings.  AAPL was also up about 3.5% at the close.

And then AAPL reported.  It was, at least from the headline number, a monster quarter, and the stock was quickly up another 17 points (4.5%) on top of the strong gain booked at the close.

While IBM led to a huge surge in other tech stocks, which encouraged optimism on IBM's good results, all other tech stocks dropped in after-hours trading (INTC did recover to book a very small gain). 

Now, admittedly, stocks that have good days tend to have weaker performance in after-hours as savvy traders try to book some profits before markets open, so some downward movement might be expected - but against continued strong performance of tech companies, I would expect that strong results in the tech sector would bolster expectations for MSFT and INTC.  I believe they will report above average (or "consensus" - a most [intentionally] misused term in earnings jargon).

Apple's success, in other words, did not provide further enthusiasm for stocks of PCs and laptops.  No, they saw Apple's sales of tablets and concluded that the PC is dying faster than anyone thinks.  I guess this is what everyone believes - that Apple will kill the PC and with it the great franchises in tech.

I should point out that expectations are for INTC to report the same $0.51 per share it reported last year (on a similar number of shares outstanding) and for MSFT to report $0.58 per share - an increase of 7 cents, or nearly 14%.  I have to ask how it can be that a stock projected to grow earnings 14% per year with mountains of cash and a tremendous franchise can continue to trade at 10x earnings.  What am I missing?

I can accept that INTC and MSFT's franchises may be less valuable going forward than they were in the past.  And yet, at MSFT sales and profits continue to rise.  MSFT continues to produce the most valuable productivity software in the universe.  It may be a laggard in online games (though Xbox is competitive) - but is entertainment really where the big market for tech spending is going to be, or is it just a small market segement currently experiencing rapid growth (and therefore loved by the people who kibbitz markets - investment banks and the like?).

Ditto Intel.  They still produce the best chips.  Sure, Apple wants to use its own stuff, and it's market share has grown to the point where that may be feasible, so everyone is afraid that Intel's share will drop (which in a high operating leverage environment could hurt profitability).  But how many times have we watched AMD go through near death experiences when there is a downturn and it cannot match Intel's cost structure?  The fact is, Intel has the know how to build chips for phones, and competitors to Apple have an incentive to work with Intel to avoid ARM and the Apple ecosystem, for fear of feeding the beast.  Plus, Intel has the strength to buy it's way into the market, if need be.

The market sees these companies as dead or dying dinosaurs; I always remember that dead dinosaurs are a major source of the energy that powers the world.

In any case, I am looking for earnings beats by MSFT and INTC.  Even CSCO may surprise, excluding the costs of restructuring - which in any case may have been booked after the quarter.  I am almost starting to think that CSCO could finally revive itself, were it not for the billion shares in phantom equity sitting off balance sheet in the notes.

Tuesday, July 12, 2011

Why Facebook is Worth Much Less than $100 per User

One of the perils of being a very part-time (read: occasional) blogger is that you have lots of ideas that you don't have time to write about.  One of my long-held views about "social networking" and Facebook in particular is that it is a fad, and will have much less long term impact than people believe.

I have always believed that as soon as it went mainstream, it's attractiveness to the people who sustain such networks - the young - would evaporate.  Youth are the core of any such network, because it is they who adopt new technologies and who invest lots of effort in these kinds of elaborate displays of self-identification and expression, and that once the adults started to invade the party, the cool kids would find somewhere else to decamp.

It turns out that someone in Forbes has written an article that encapsulates my views on the whole exercise: that Facebook's early success was it's exclusivity for youth.  When it was launched, it was a platform for communicating with other youth, shielded from the prying (spying) eyes of mom and dad.  Now at over 600 million users, the growth is in the older age segments - grandparents looking to keep track of the grandkids, maternity leave moms - desperate for communication beyond gurgling noises - posting the endless photos of their kids and people long out of school trying to stay in touch or to reconnect with their classmates.

In short, Facebook is losing it's cool - and with it, it's teen users.

This doesn't mean that it cannot make money, or that it cannot remain a good business, provided it can maintain it's position as the leader in sharing for the older set (who, after all, have larger wallets).  The problem is, it is hard to maintain leadership at the forefront of technology if your users are late-adopters.  Even if you push them into using new features, you lose that core group of innovative users who see unexpected, but important ways of using feature sets and who ultimately become the arbiters of what features become dominant.

If it loses it's edge in technology, it has little choice but to become a fast-follower.  This might be a better position, in some sense, but it means that Facebook may also lose the talent war.  It also risks having someone else do to it what it did to myspace.

For investors, what it means is that one has to apply a very substantial discount rate (at least 25%) to the earnings of the business (if it has any), because one must assume a much less than infinite duration of revenue.  Even if revenue can grow by 50% per year for the next five years, and earnings presumably faster, the present value of those earnings is less than 30% of its nominal value.

Ironically, by the time Facebook reaches IPO it may already be in decline.  At this point in it's lifecycle, MySapce began experiencing a terminal revenue decline.  Admittedly, becoming acquired by a big corporation did not help, but it seems ironic that the most enduring legacy of the site is Lily Allen, which only goes to suggest that Zynga might be the big winner in all this (and of course, the investment banks).

But what do I know, I am just a part-time blogger who doesn't get it anyway.  While I like technology and can develop MS Access databases and for the record, I do have a Facebook account, I am not a big gadget collector.  I have been called a Luddite by friends who are more technophilic).  It is why I like to invest in companies that sell toothpaste and hair dryers.

Thursday, June 09, 2011

A good take on MSFT

Insider Monkey has the complete transcript of David Einhorn at the Ira Sohn conference, in which he picks MSFT as a long, and explains the overhang in the stock.

Like Einhorn, I believe that MSFT is just ridiculously cheap.  Given the fact that many cloud businesses are trading at 10x revenues (with few or no discernable profits), MSFT, which trades at 10x earnings, is a bargain.

Einhorn's view - that the big risk is not that earnings will suddenly evaporate when the iPad kills the laptop (this is Street fancy compounded by the need to make aggressive predictions if you want to appear reguarly on CNBC), but rather that Steve Ballmer and the management team will reinvest those earnings poorly is exactly right.  Unfortunately, we have received another sad example of this with the insane valuation MSFT paid for Skype.


Of course, people don't own tech for value - they own it for momentum and huge operating leverage - and without big growth prospects, MSFT cannot attract growth investors, and as a tech company - particularly one with huge amounts of outstanding shares, it cannot attract value investors, or at least not enough value investors to help the share price.  But this means that the best investment MSFT can likely make is in its own future cashflows from Windows - by repurchasing shares.

Sure, you can argue that they already do this - and they have made a significant reduction in shares outstanding.  Moroever, they have finally reached the end of the stock options issued to employees, so equity conversion will no longer be a drag on net repurchases.  But there is no reason they cannot continue or even consider accelerating repurchases.

Plus, if they were to dump the online search business, which has been a perennial loser, they could convert a $2.5B drag on earnings ($0.28 per share before tax) into a one time gain - potentially as equity in a complementary business.  Personally, I like Einhorn's suggestion that MSFT sell Bing to Facebook for equity in Facebook, but I digress. With the savings, they could raise the dividend again to become that much more attractive to value investors and the rising tide of Baby Boomer retirees, who need to figure out how to invest their 401(k)s for the next several decades.  This would be almost a "free" dividend hike, since it would not reduce after-dividend cash flows - meaning that R&D could continue apace, and MSFT would hold out the attraction of being able to raise a solid dividend at a rate faster than inflation, a retirees' dream: a rising standard of living in retirement!  As a very liquid stock, this could create a large bulk of "permanent" capital held by long term investors.


But, Ballmer is well on his way to being the largest individual shareholder, as Gates continues to whittle down his direct holdings, so the likelihood that he will be ousted is small.  Even so, I believe that MSFT can be a $34 stock at virtually any moment.  In the meantime, I can collect my dividend and wait, while the company continues to by $34 dollar bills at $24, giving me an immediate 30% return on repurchases.  I also reinvest my dividends.

[UPDATE]: I think I also want to look at this insurance company Einhorn mentions.  The numbers are simply amazing.

Saturday, May 14, 2011

Great Colgate Palmolive Analysis

After reporting a solid first quarter and indicating that it has instituted pricing actions that will enable it to continue to gain market share and hold margins, CL stock has rallied substantially and now trades near all-time highs.  Which begs the question - has the stock topped out?

Management has raised the dividend to $0.58 per quarter, or $2.32 over the next year and has continued a frantic pace of stock buybacks while managing to pay cash for Unilever's Sanex business.  This will provide CL with an even stronger European market position.

This breakdown estimates the value of CL stock at $95 based on historical valuation.

I think it is about right based on my own internal DCF models. My own view is that the company is likely to earn near $5 per share this year.  It will depend on how the 2nd half goes (though lower commodity costs should help margins) and of course, how much stock the company is able to buy back.




There is no doubt that the company will be able to continue to grow earnings and take advantage of its market position to maintain margins (the company vows to improve them).


The stock remains a core holding for me, with the expectation that it will provide a nice dividend income sufficient to function as a small pension in retirement.  Nothing is more satisfying than watching the growth in each quarterly dividend payment and knowing that even as I am accumulating shares, the number of diluted shares outstanding continues to contract sharply, ensuring that each share represents a growing share of the future earnings of an incredible business.

Why CSCO is so cheap: John Chambers Risk

By any realistic measure, Cisco Systems stock is cheap.

Yes, the company reported a bad quarter and has announced plans to restructure, which will entail more asset write downs, separation costs, and other drains on the company while it seeks to right the ship.

But, at $17, the stock is trading at 12x trailing earnings and (while I put little faith in such a number) less than the average of analysts estimates for 10x forward earnings.  Such a set of metrics don't tell the actual story, though, because CSCO is sitting on a cash pile of $7 per share.  Net of debt, a $4.50 cash pile.  Subtract this from the price and the company is trading at 10x trailing earnings, and an even lower forward multiple.  (I suspect that analysts estimates will be wildly optimistic as CSCO is likely to take some very large restructuring charges going forward).

There are estimates that suggest that the pieces of CSCO are worth $24-28 share.  [Cannot find link at the moment - sorry].  I haven't done a detailed "sum of the parts" analysis on CSCO , but suffice it to say that a company with the demonstrated earnings power of CSCO should trade at a higher multiple, unless you have reason to question the quality of earnings going forward.

Turns out, there is a great reason to value CSCO at a discount to the value of its components: management sucks.  This is why, even though the stock is cheap, I will not purchase it.

Evaluating management is arguably the most important decision an equity investor makes.  Warren Buffett's first question for any business is about the quality of management.  Jack Welch argues that "people are the whole game" of business.  Why?  Because management all processes, policies, customer solutions - in short, everything that comprises a business, both internally as an institution, and externally as a competitor in the marketplace to solve customers' problems, springs from the human mind.  No business, no matter how good, is likely to continue to be successful if it is run by bad people, because bad people hire bad people, institute bad process and misuse or abuse the assets investors have entrusted to them.  This sounds alot like CSCO.

Henry Blodgett, has written an article describing his view on what has gone wrong at CSCO: he cites poor choices in management structure and lack of focus. I find his critique persuasive.  (Apparently, the company has 53 management committees, which sounds more like Congress than a corporation). 

In a CNBC interview, Chambers himself acknowledged that the company had become to unfocused, but notice how he continues to lobby for the copmany, talking always of what CSCO was "doing well" - and the revenue growth that various pieces of the business were experiencing.

Blodgett points out that revenue growth, a Chambers obession, is not really the measure of a business. It is the earnings power of that business into the future that counts.
I actually think Blodgett oversimplifies this, because the real measure of a business and of management is rather returns on capital employed (ROCE, RONA and ROIC). A CEO who is doing his job is earning high returns on the capital investors entrust to him, so that the stock can obtain a high multiple of book value.  This necessarily entails having strong earnings. CSCO actually does a decent job of earning high returns on capital employed - return on book is 17%, but adjusted for capital employed, returns are closer to 40%, which would justify a price to book significantly higher than the 2x at which the company presently trades. 

Blodgett's oversimplification is a problem, because it still focuses on growth in earnings, which is one way to raise a multiple, but using capital carefully is better - CL, hardly a fast growth stock, has a price 10x book value because of the efficiency of its balance sheet.

In contrast, CSCO management has not proven able to reinvest that money wisely, and has engaged in many shareholder unfriendly activities.  Chamber's relentless belief that CSCO can grow 15% per year has encouraged him to seek (and sadly to find) a host of business opportunities that promised to provide that top-line growth.  Unfortunately, these businesses may have had revenue, but did not have anything like CSCO's core economics and therefore actually undermined ROCE.  He would have been better off returning the money to shareholders. 

But even when the company does "return" money to shareholders, it does so in a shareholder unfriendly way.  Yes, the company has repurchased billions of shares of stock, and reduced shares outstanding by over 1.5bn.  But it has long resisted paying a dividend (it has finally relented on this point).  Worse yet, what it has taken away with one hand (shares from the marketplace), it has given away with the other (options to management), which has left the company with over 1bn shares in phantom equity awaiting conversion.
Companies that repurchase stock can easily overpay, as their intentions are public record and the volumes they seek to purchase are often a significant amount of the float.  They must therefore take care to ensure that they don't distort pricing and force the shareholders, through their ownership of the company, to earn poor returns on the cash used to repurchase.  As a result, companies usually make major repurchases over long periods to ensure that they don't compete with themselves for shares. Shareholder friendly management keeps annual share-based payments to 1% of outstanding shares or less to enable them to be net repurchasers while buying only 2-3% of the shares outstanding.  Under Chambers, CSCO has regularly made awards of 3% of the stock.

Moreover, companies that issue large amounts of stock often repurchase to offset dilution from option exercises.  This means, however, that the company is repurchasing at the moment option holders are exercising.  Since option holders have a choice of whent to exercise, they usually pick moments at which the stock is trading at high valuation, which means the company repurchases at exactly the wrong time.
Until CSCO gets more shareholder friendly, by focusing on generating high returns and funnelling that money to investors, I believe that the stock will struggle.  This cannot happen so long as John Chambers is CEO.  He has to go for shareholders in CSCO to regain investor's confidence.

Wednesday, May 11, 2011

The Reason MSFT is an unloved business: Management

So, in some earlier posts I explained why I like MSFT - the company continues to earn near monopoly profits in its core segments, which, despite all of the hype to the contrary, are not going away any time soon.

Actually, my favorite comparison is IBM, which has continued to make money in mainframes even as "everyone" was switching to distributed computing.

Unfortunately, MSFT is not happy to mint money with its signature franchises.  It is looking to grow, like most companies, and is determined to be a player in mobile communications and mobile computing, as well as online services.  This is not a bad idea, necessarily, though, one has to concede, it is not as good a business as the ones it already has.  Still, it is a viable use for some of the company's cash, which it spews in copious amounts.

The problem is, management doesn't seem to have a clear plan for all of the acquisitions it is making.  Worse, it doesn't seem terribly concerned about the valuation at which it is buying companies.  Skype is clearly not worth $8.5bn.  I mean, this was a company MSFT could have had for a third of its current valuation just 18 months ago.  My own view is that MSFT management, paranoid about competition from Facebook and Google, is rushing to purchase firms that appear to be interesting to either of the other two.  Not, therefore, because of the strategic value to MSFT, but just as a blocking manoeuvre.

Such unstrategic, reactive, decisions mean that MSFT is focusing on outbidding competitors for assets, usually a good way to ruin a good business by overpaying for shit you don't want.  Moreover, it is hard to see why MSFT should worry much about Google acquiring things: most of GOOG acquisitions have been disasterous.  Despite billions on assets like youtube, GOOG has only ever made money at one thing: search.

I say to MSFT, let Google overpay for assets.  Focus on a core strategy and invest in your core business.  Or return the cash to shareholders to invest in better businesses elsewhere.

Incidentally, Jim Cramer had an interesting idea for MSFT - that they could have built Skype's functionality into MSN Messenger for less than they paid, and could have instead purchased a company with real revenues and good subscription revenues - i.e. buy Netflix.

 

Friday, April 29, 2011

MSFT, INTC and thoughts on MSFT and AAPL

So, MSFT has disappointed and INTC has surprised. I own both stocks and purchased both before their respective earnings reports.

Of the two, I believe MSFT is the better value, though not by a wide margin. I will most likely purchase more if the weakness continues. The market does not agree with me, pushing INTC above some resistance points and on way to at least $24, though based on the fundamentals, it could be much much more. I believe the stock to be worth at least $30 per share, given the earnings power of the company. Fortunately, like MSFT, you are paid well to wait for Mr. Market to realize this.

MSFT is a company whose valuation baffles me. It is clear that tech stock buyers, who are fad-chasers as a rule, don't see the story in MSFT products. As a result, they are ignoring solid fundamentals. Value investors, who should be favoring the earnings stream they can purchase, are generally reluctant IT purchasers, and have shunned the stock. It is true that IT firms have short product cycles and require constant CapEx to maintain their market position, but MSFT has no issues making capital expenditures, in fact, they have the luxury problem of not having enough attractive investments for their cashflows.

Look carefully at the financial statements released with their recent earning report. They are on track to earn $26bn this fiscal year, slightly above my own DCF model (which valued the stock at $35). They are doing this with assets of $100bn - which is a return on assets of 25%. I will repeat that their ROA is 25%. This is an incredible multiple. Most firms would be ecstatic to earn this on equity.

The story is actually better than that. $50bn, half the balance sheet, is cash and short term investments - and cannot be said to be capital employed. So their actual ROCE is closer to 50%. Amazing.

Moroever, those earnings are growing, even if they will be slower growing in the future. (My DCF assumes a growth rate of 6% with a final perpetual growth rate of 2%).

This enables MSFT to comfortably raise their dividend at double digit rates for the foreseable future, while repurchasing gobs of stock. At current rates, MSFT reduces common stock about 250mm shares per year (after accounting for new issuance and for stock options, which mercifully are all about expired). They could be far more aggressive with the repurchases, actually, and so long as the stock is cheap, there is no reason not to do so.

I contrast the earnings power with AAPL, which everyone loves. This is a stock which also has about $90bn in assets, and which earns $20bn - or 22% on assets. So far, quite similar results. AAPL has "only" $30bn in cash and equivalents, however, which means that it employs $60bn in the business. Thus its ROCE is a "mere" 33% - an awesome number, to be sure, but well below that of MSFT. AAPL is growing earnings faster, but it is also retaining all of those earnings, presumably for bigger and better things, but possibly only to earn a low return. Hard to argue that they aren't investing well, given the popularity of their products, but successful IT companies have a history of making questionable acquisitions - look at eBay and Skype, Google and YouTube and the like.

To my thinking, MSFT deserves a higher price on book value than AAPL, since it earns more on assets and capital employed and has greater opportunity to return cash to shareholders.

Obviously, for others, the risk of the stock losing ground in PCs, and having it's Windows architechture undermined scares alot of people. But the fact is that in a connected world, systems have greater power than ever. Even AAPL, which loves to have a totally controlled architecture, has had to adopt MSFT software because of the importance of MS Office. Meanwhile MSFT is gaining ground in several other businesses, including gaming and, crucially, online search.

All in all, I think people who count MSFT out are really very, very premature. They remind me of the marketing professor Theodore Levitt, who asked in 1960 "What business are you in" and famously "demonstrated" how the buggy-whip makers died out because they failed to see that the automobile would make buggy-whips obsolete. He went on - in 1960! - to explain that Exxon (Standard Oil of New Jersey) would be out of business in 10 years because the electric car was about to make motor oil obsolete! Imagine taking his advice in 1960 and selling your Exxon stock, which had a single digit PE. You gave up a fortune because you made a possible and uncertain future the enemy of the present facts. (Note that Levitt actually never proved that the buggy-whip companies actually failed to adjust, he just observed that no one made them anymore. Never trust a marketer to do research).

This is not to say that it cannot happen. Eastman Kodak and Xerox were also large companies with long histories of good earnings that were ultimately unable to move to new technologies. But MSFT is not simply reinvesting in it's core business. It is also moving forward with mobile and online services. (In contrast to EK which clung to film when digital cameras came out, arguing for higher quality).

Personally, I think MSFT will struggle with mobile, but it has the resources to play. And the company learns, much faster and much better than people give it credit for. It knows how to spot promising technologies - it saved AAPL, don't forget, and did so along with archrival Larry Ellison.

Unlike AAPL, which requires new product introductions in new categories to sustain its revenue and growth, MSFT has a core cash cow it can use to fund a variety of alternatives and acquisitions. Of course, AAPL also has awesome cashflows and strong reserves, a failed product launch is not going to kill the company. But, and this is crucial - a failed product launch from AAPL would have much greater impact than one for MSFT. MSFT has stumbled multiple times (Windows Vista, anyone?). AAPL is the "cool kid". When he makes a misstep, people look elsewhere. Investors expectations of MSFT are low, clearly and that gives them a big advantage: they are far more likely to exceed them and reward investors.

Wednesday, March 23, 2011

Can you have a Double Dip without a Recovery?

CNBC's Real Estate Correspondent refers to the recent Housing numbers as a "Double Dip".  My question is, where was the recovery, from which this is a dip?  The small amount of activity driven by the New Buyer Tax Credit?  That was simply a forestalling of the fact that prices needed to fall.

Personally, I have seen lots of bullish information for house prices.  The fact is that housing starts are a historic lows - which means that new supply is well below the rate of household formation, and that unoccupied housing stock is being absorbed.  In the video, Gary Shilling talks about the surge of people who have returned to live with their parents, which he sees as bad, since it creates a temporary decrease in the number of occupied units, but this is the equivalent of "sideline demand" which can be tapped in a year or two, either as buyers, for those that can repair credit and save and be in a position to reenter the market, or as renters.



Finally, the best sign for a bull market it simply lower prices.  If, as many doomsayers suggest, we are experiencing massive debasement of the US dollar and are likely to get inflation, then rents, which constitute some 30% of CPI, will also be rising.  This will have the effect of making real estate attractive as an investment or, in the case of owner occupiers, as a hedge against higher future rents.  Against this, are likely to be higher mortgage costs, of course, but on the other hand, these are still tax deductable, and if tax rates rise to address government deficits (which I think likely), this is again a positive for housing.

All this leaves me asking the question, though: why does the media insist on seeing lower housing prices as bad?  Lower prices for consumable goods are positive - cheaper housing is a POSITIVE outcome, it means people can afford more house, just as lower prices for electronics, computers, or the proverbial hamburger mean higher living standards, so do lower housing prices.

Wednesday, March 16, 2011

More good news for US Housing Market

Latest report on US housing shows that housing starts are at the 2nd lowest they have been in 50 years of data.

This is good news for housing, I argue, since prices cannot stop falling until inventory and demand equalize.
Fewer new homes being built means that with ongoing household formation of around 800k-1000k per year, there should be absorbtion of 400-600k homes per year.  That will bring supply and demand more into alignment.

The news folks, of course, suggest that this is terrible news for housing, but they also though the news in 2006 was good for housing, when clearly it was bearish.

I think we will finally hit a bottom in Q1 of 2012.  We might scrape it for a while, as housing starts and household formation may coincide and keep prices from rising, but lower prices are actually a good thing, since it means that housing is becoming more affordable.  We can only hope that prices stay muted for an extended period.

Saturday, March 12, 2011

Invitation to other Finance and Econ Bloggers

If you wish to link exchange with a long established blog, please contact me.

Good Advice

If I have a weakness, it is procrastination.

This is in part because I am something of a perfectionist - I like to believe that I can produce the Platonic Form of whatever it is I am doing.  This has cost me in the past, in investing, and in other things.

This article from CNBC talks about habits of economically successful people.  I strive every day to be more like this, though I find the going hard.

Of course, deciding NOT to do something, for the right reasons, is also a good thing.

Friday, March 11, 2011

Things that don't make sense

So, much talk of the market being overvalued has me wondering - might it not simply be a few insanely priced stocks?

How does a company with returns of 5% on Equity trade at 13x that equity?  I mean, seriously?  The P/E is a .com bubble era 268.  I hear the siren call of the investment banker saying - "it's not like one of those companies - it has earnings!"

I found it so odd, I had to dig - turns out, of course, that Salesforce.com has been increasing revenue smartly, and generally, net income has also trended in the right direction.

But with such low ROE, I figured that revenue growth of that level still doesn't justify such a price.  After all, even AAPL, which has ROE of 35% and growth rates better than CRM, only trades at 6x equity.

So then I figured, well, let's look at operating margins.  Software companies often have high operating leverage, so maybe "investors" can expect that profits will grow much faster than revenues.

Top 10 Audit Red Flags

It's Tax season again, so I figured that you might find this information on IRS audit flags helpful.

It is a good site for people with small businesses of their own.

Why this market is stalling out

So, many stories this week have highlighted that we are at the 2 year mark of an incredible bull run for US equities.  Mind you, at time of this writing, the Dow recrossed the 12,000 mark, which it lost yesterday, leaving it up about 3 percent from the Jan 2000 high of 11722, which, to my mind, still marks the top of the bull market.

For eleven years now, we have essentially gone nowhere - except to get some dividends.

Of course, if you traded in this market, or kept buying through the 2000-2002 crash, and then sold in 2007 or 2008, you did pretty well (provided you weren't heavily invested in Qualcomm or Nortel in 1999).

But where do we go from here?  Indications on several stocks are saying - earnings are strong, the bull should continue.  Other people, like Charles Nenner, believe things are heading back down from here.  I have believed in a double dip in equity prices, because lots of fundamental research I have read suggest that bull markets begin when valuations, as measured by P/Es, are below 10.  We are definately not there today, which means that we have another leg to go before we can build another bull market.  It is possible that this won't be as sharp as the 2008-2009 crash.  It might not be as deep, either, since P/E can fall if prices decline modestly and earnings increase.  This would be much like the late 1970s, when, earnings growth was rapid (becuase of inflation) but multiples contracted (because investors demanded a short payback period on investments to compensate them for inflation).

Facebook's Founders Selling Shares

While checking out the Forbes Billionaires list, I saw a link to an article about the Facebook's founders reducing their shares.  What is that old Wall Street truism about insider buying and selling as the best leading indicator of a firm's share price?

That the owners' shares would decline is sensible enough - they have been accepting small investments in the firm - at successively higher valuations.  But the article seems to imply that the owners have also been doing private transactions for their shares - i.e. that the stock sales are not through new issuance but through the founders looking to raise cash.

Forbes Billionaires

Forbes has released its annual survey of the World's Billionaires.  Again, I fell short.  C'est la vie.  I remember when I was a kid in the 1980s, that this list was actually shorter than the Forbes 400 list.  Now, it has grown to over 1200 people worldwide.

The list might be longer, but Forbes excludes people, like Sovereigns, whose wealth can be hard to distinguish from that of the Crown.  Were some of these included - like the Thai King, Bhumipol Aduljedej (Puh-mi-pon A-dul-ya-dayd), the Saudi Royals (apart from Prince Taleed), Kuwaiti Royals, and the Sultan of Brunei, the list could increase by some 50-100 people more.

One thing is for sure, the last 12 months have been very good to the world's billionaires - with surging equity and commodity markets, these folks tended to see their assets rise sharply, in some cases, extraordinarily.

At #1 Carlos Slim proves that even in Mexico, a country some suggest is on its way to becoming a failed narco-state (I am not so pessimistic), it is possible to make good money with the telephone service.  Mexico needs a Judge Green to force deregulation.  Bill Gates is again America's richest, in spite of his continuous donations to his foundation and other charities.  That may be because Buffett is doing the same (giving money to Bill Gates' foundation), it certainly is not due to a huge rally in MSFT.

Friday, March 04, 2011

Ford's Big Write Up

Ford has just announced a likely major write-up to it's balance sheet, according to Automotive News. It is reversing an impairment charge against its deferred tax-assets that could see its profit increase by several billion dollars - possibly as much as $13 billion.

Deferred tax assets are a financial accounting phenomenon that arise from the fact that sometimes companies pay taxes on a different schedule from that which is used in their public financial statements. This can happen when for instance, financial depreciation and tax depreciation differ. It also happens when a company experiences a big loss for which it earns a tax-loss carryforward. This is a real benefit, because it means that future earnings will be tax free (on a cash basis). The company can book the difference as an asset, which can then be applied against income tax provisions.

The problem is, tax loss carry forwards are a wasting asset - they have to be used up within 20 years. If a company has really large loss carryforwards (GM at one point had $39bn), and uncertain profitability, it may have to impair those assets, which, like any writeoff count as a loss.

Ford, however, is now making some good money and even after losing $31.5bn is now looking to earn enough going forward to actually claim the benefit. Thus, it is looking at reversing much of it $15.7bn valuation allowance. This is an incredibly positive sign for the company and a very strong statement about management's future expectations for profitability.

Such a large write up would raise retained earnings above a deficit level and eliminate the overall shareholder's deficit as well. While this would not reduce the nominal value of the debt, it would improve Ford's debt/equity ratio, and improve its crediworthiness and potentially enable the firm to cut borrowing costs through refinancing. (The cash outlay for taxes that it does not pay also provide Ford with extra resources to reduce the nominal value of outstanding debt.

About 10 years ago, I predicted that Ford and General Motors would be bankrupt (I believed that Daimler would hold on to Chrysler and would scrape by). I was of course, wrong.

Not entirely wrong, but I was wrong. Ford, which I believed would crater first, dragging GM with it, has instead managed to survive without a bankruptcy (though also without most of its brands, which included Volvo, Mazda, Aston Martin, Jaguar, Land Rover and Mercury).

It turns out that I was really wrong about my central premise: that Ford, with a two-tiered equity structure, had a weaker capital structure and would therefore reach illiquidity first. It's share of the car market was declining precipitously, in absolute terms about as fast as GM, but GM's share of the market was larger, so relative to size, Ford was imploding. Moreover, I assumed that the only shot the companies had to avoid bankruptcy was a major equity raise, which with Ford's special B class shares, seemed unlikely.

It turns out, Ford had just enough assets against which it could secure financing to avoid that capital raise (lucky for Ford, underwriting standards and interest rates were incredibly favorable to heavily indebted, risky credits). GM, likely the firm with poorer management (though both firms had questionable managements), collapsed instead.

My second error was to believe that the bankruptcy of one would pull down the other, since they competed heavily for the same customers, and the cost advantages of the bankrupt firm would allow it to purchase market share at the expense of the other. This has also turned out not to be true. In part, this is because of the structure of the bankruptcy, which has maintained labor cost parity between the firms. In part, it is because angry consumers are rewarding Ford for avoiding a direct government bailout (the preservation of the supplier network was a major, if indirect, help to Ford. Production disruptions, which were highly probable, would have cratered the firm's cash and brought on bankruptcy and possibly liquidation).

Ford's shares, which hovered near $1 for quite some time, are now at $15. Many questions remain - can Ford revive Lincoln? What happens to Ford's franchise in light trucks if gas prices rise above $5. Can it straighten out its overseas arms, which are large, but need operational reforms?

I wish Alan Mullaly and his team well.

Employment Report Looking Positive

So, the Bureau of Labor Statistics released its monthly reports of employment and both were positive. As expected, payrolls increased by about 200k in February, along with substantial upward revisions to January and December, indicating that corporate payrolls are expanding.

December 2010 was originally reported at 103k, then revised upward to 121k in the Feb report was revised again to 152k. Jan 2011 was also revised up from a disappointing 36k to 63k, I expect a number closer to 100k come April.

It suggests that the unemployment rate, (from the household survey, a different measure), which continues to decline is not just a statistical quirk, but is indicative of real job market experience.

The unemployment rate, which has dropped from 9.8 percent in November is not only dropping because more people are working, however. It is also due to the fact that the participation rate (the percentage of adults who are part of the labor force) is declining. I expect this trend to continue, as large numbers of Boomers retire and leave the workforce permanently. This phenomenon has implications for economic growth and taxes, many of which are not necessarily positive, but the good news for job seekers is that fewer adults are trying to hold a job, which should mean more opportunity for those who have jobs and are looking for them.

It may mean that the job creation rate necessary for absorbtion is lower than anticipated. It is estimated that the US has to generate between 125k and 150k jobs per month to accomodate new net labor force entrants, which the economy is now doing. However, this number has not changed since the 2000-2002 recession, whereas the net new market entrants may in fact be much lower going forward.

CNBC is suggesting that unemployment will now stay below 10%, and I believe this is correct. Unemployment will likely continue to drift lower, slowly perhaps, but another 0.5% to 1.0% by the end of the year is conceivable, with further improvement in 2012.

What will impede rapid decline will be the large number of discouraged workers who are no part of the labor force returning to the job market as they perceive better employment prospects.

Nevertheless, the numbers were quite encouragining - private sector employment was up over 220k, while state and local government cut employment. Counting the upward revisions in the earlier months, private sector employment expanded by nearly 300k. This will have positive impact for government budgets as well, as taxes increase and costs decline.

The stock market, after an initial positive response, turned around and was down on the news. Though this follows a big surge on Thursday, when rumors of a +250k number were circulating.

The markets may have also woken up two other facts: first, that productivity gains, which have been astonishing (and helpful of corporate profits) are likely going to moderate - after all, new hiring is what happens when the existing labor force cannot meet the demands for output, and second, that it is only a matter of time before the Fed begins to withdraw its exceptional monetary support.

I am hopeful that awareness of these two facts will drive the market lower and provide attractive long term valuations.

Thursday, March 03, 2011

A Swiss Bank Account for the Rest of Us


Having diffiuclty meeting those private client investment minimums after selling out in early 2009?

Perhaps your UBS account is being audited by the IRS ....

Well fortunately, you can still have a " Swiss Bank " account - though it might not be quite as secure as a vault deep under Zurich. The good news is, you won't have to worry about your banker recieving margin calls on structured finance vehicles, and the zero percent interest you receive won't be materially different from what you get from your "regular" bank.

One piece of advice though, fill it with Swiss francs, not dollars or euros .....

MSFT - did I undershoot growth potential?

Barrons has an article that forecasts PC growth over the next several years at 10%. They are quoting this article. This has big implications for MSFT revenue growth.

I estimated a 4% volume growth in pricing MSFT at $34, does this 10% mean that I was too conservative? Not necessarily, but it is an interesting question.

Microsoft has two different sales targets - pre-installed software and upgrades for computers already in use. The first will generally track computer sales overall - thus if sales increase by 10% we can expect that MSFT products will rise with it.

More difficult to assess is the upgrade market. Slower growth in sales mean more parity between scrappage rates (which are high in a product as disposable as an old computer) and sales rates and thus a more stable installed base. At the same time, the increasing age of the installed base means that opportunities for upgrading within the installed base may increase, suggesting a continued rise in sales.

Unfortunately MSFT does not break this out entirely. The $5bn of revenue - and $3bn in operating profit - from the Windows and Windows Live divisions is likely to increase at near 10% a year, as 75% of revenue comes from pre-loaded software on new PCs. (There was a spike in 2009, reflecting the launch of Windows 7, which increased sales to the installed base significantly as people with Vista or XP upgraded).

MS Office, however, is only broken out into business licenses, (which are usually bulk) and individual licenses. These also grew nicely in 2010, but in no small part because of the introduction of Office 2010. We can expect some decline in sales there into 2012, but overall sales should remain brisk.

MSFT's third major revenue trunk - the Xbox360 is seeing massive growth, primarily from the Kinect, which enables users to be their own controllers. Sales will not continue to grow 55% per year, but a higher installed base should lead to more licensing sales of software going forward.

So, 4% growth may be a bit conservative, but then again, my 2% price increase could be a bit aggressive. Ultimately, I think it means that MSFT is likely to be able to maintain a solid growth rate over the medium term (my estimates for long term growth are around 2%).

Call it some margin of safety, and one more and more gets the sense that MSFT is truly undervalued. Not enough of a growth stock to have an I-Banking / financial media story, and requiring too much CAPX for most hard value investors.

Please tell me why I am wrong.

Wednesday, March 02, 2011

Refresh and Some Other Changes

So, I have decided to refresh the look of the site.

I am experimenting with a few different formats, though I still believe the three column approach is best.

Have also updated my blogroll - a long period of inactivity had allowed some links to get out of date, these have been removed. I will resume reviewing sites in the blogosphere and adding to my list of sites.

Finally, I notice that my Google Page Rank has dropped to zero.

I suppose I deserve this, somehow. I still have some good inbound links, but due to some inactivity, I think several larger sites dropped me.

On the other hand, maybe I am being punished for having criticized AdSense?

For the time being I have decided to remove all advertising and refocus on delivering quality content.

If you want to link exchange, please let me know.