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.
Wednesday, July 20, 2011
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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