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.