This may come as a surprise, but I have only owned 2 financial stocks in my entire career: Raymond James Financial (RJF), and Annaly Capital (NLY). Mostly, I view financial stocks as highly levered black boxes. You cannot analyze a million loans that Citibank has made. Or the billions of mortgages on Bank of America's books that they got from Countrywide. It's simply impossible. In essence these are organizations built to leverage shareholders for the benefit of the employees. Work for them, don't ever own their stocks. That still remains true.
Coincidentally I just got the annual report from Raymond James yesterday, and at the same time got a nice dividend deposited in my account from Annaly Capital. Figured I would talk some about each, and why in almost 20 years of investing, I have never succumbed to owning anything else in the financial world. Although I do confess to being handed some Merrill Stock in my short time there as a bonus, it was yanked when I left. MER stock has since declined over 75% in a decade. My apologies to my hardworking friends there, they deserve better.
As for Raymond James, I have owned RJF stock non-stop since 1993. I worked at Raymond James back then, it being my first job out of college. Raymond James is regional investment bank, with a decent brokerage network, capital markets business, and asset management division.
It's a stock that is underfollowed, considered quite boring by the sellside, and tends to operate quietly but profitably in its own niches. Since they are an investment bank located outside of NY, generally they are considered second tier. Don't be fooled though. Top management, including the founder's son Tom James and his partner Bo Godbold, are Harvard Business School grads. Southern, but no dummies. They hire top talent there, the place is littered with HBS people. Today RJF trades around $36 a share, up from an adjusted price of $2 a share (split and dividend adjusted). I can't complain about an 18 bagger in 16 years. Even GS is only up 2.5x since it IPO'd 12 years ago.
Today I am not really advocating buying the stock. Honestly I would wait til it gets back to $30 a share. But given that only a handful of financial stocks in the entire country survived the 2008 meltdown, it's one to keep on your radar screen. I consider it a Buffet type play: management is almost boringly capable and conservative. They focus on generating high ROE type business such as advisory work, brokerage, and fee-based money management. And, best of all they eschew risky proprietary trading and leverage, the combination of which all but blew up Wall Street in 2008.
Throwing out just a few numbers, RJF has a book value of $19 a share, trades at $36 a share today and will do around $2.50 a share in EPS in 2011. That's a 14.4x multiple (or 7% FCF yield), and a big premium to the Goldman Sachs and Morgan Stanley's of the world. GS and MS trade around 8-10x 2011 earnings. Since RJF though only generates 30% of its pre-tax income from banking activities, and the rest from its fee-based businesses, its far less risky than almost any other bank out there. It's more like a T Rowe Price than a JP Morgan.
To illustrate how conservatively run the company is, take a look at Book Value per share and ROEs over the past 5 years. It even grew in 2008 throughout the crisis:
Book / Share
2006 $12.83
2007 $15.07
2008 $16.18
2009 $17.11
2010 $19.03
ROEs
2006 15.7%
2007 15.6%
2008 13.0%
2009 7.9%
2010 10.6%
As far as risk to the balance sheet, the biggest item is the $6BB of loans that the bank has made. The loans that are non-performing, or NPL's (in default, or over 90 days past due) adds up to $182mm. That's about 1.3% of the total. Further, they have already built up $147mm in loan reserves. Note that the loan allowance was $88mm in 2008, on a book of $7BB in total loans. So, compare that to today, $182mm on $6BB of loans. So you have some pretty conservative provisioning, and a potential improvement in earnings of up to $100mm should loan defaults continue to fall, and loan charge-offs normalize over time.
Considering that total net income was $228mm in 2010, its a big potential boost. On the flip side, if we get another recession, and NPLs rise, say another $75mm, that is only a 58c hit to the company's $19 book value per share. I am pretty sure that such a hit would be far higher to almost any big bank out there.
So, long term this is a decent play. We'll look for a dip to add. The trading mantra for this name is probably: buy it at 1.5x book, and sell it at 2.0x. That puts a buy price of $27 a share, and a sell price of $38 a share. Typical of this market, most names are fully valued.
So, on to Annaly Capital. I have followed and owned this stock off and on for years. I must have traded it at least a dozen times, within my old fund and within my personal account. It's probably the best performing financial stock in the past decade. Its stock chart isn't impressive, but in combination with the huge dividends it consistently pays out, it's been phenomenal. Since Jan 1, 2005, NLY has generated a total return of 66% through yesterday. Thats 6 years, call it up 10% a year on average. By comparison the financial index (XLF) is down from $30 a share, to $17 today. Disaster, down 43% in the same time period. All the massively levered banks were contributors to the declines: MS, MER, JPM, C, AIG et al et al.
So to back up, Annaly is a mortgage REIT. The name alone sounds scary given what happened to the real estate markets in 2008. But generally, management here buys Agency bonds: that is pools of Fannie Mae and Freddie Mac guaranteed mortgage bonds. They are implicity guaranteed by the US government. In fact, since the govt owns 80% of Fannie and Freddie now, they are all but explicity guaranteed by the government too.
So, Annaly essentially buys packages of your mortgages, called Agency MBS. They then borrow to buy more, leveraging themselves 6-7x. That is, on equity of about $10BB, they own $76BB of Agency bonds, borrowing the other $66BB. Most of their MBSs are fixed rate, plain vanilla 15- or 30-year mortgage paper. Only 16% of their portfolio of bonds is not fixed but rather in floating rate mortgages. Either way, defaults by homeowners has no impact on the payments of Agency bonds, Fannie or Freddie pay the interest no matter what.
Today, Agency bonds yield 4.1%, and it costs the company 1.95% to REPO them, or borrow money using them as collateral. So NLY's business model is very simple:
Interest Income: 4.1%
Interest Costs: 1.95%
Spread: 2.1%
Then they lever that spread above by 7x, meaning they make:
Spread 2.1%
X Leverage 7x
Total Return 14.4%.
Then they make the full interest income on bonds that they own outright. That is 4.1% above. So,
Levered Spread: 14.4%
Return on Bonds: 4.1%
Net Return: 18.5%
So ROE's track pretty closely to this number (although a little lower given OH and G&A costs). The problem with the stock is guessing which way mortgage yields (their assets), and REPO rates (their costs) will go.
Ok, so that gets to why Bill Gross recommended NLY. Basically, if REPO rates stay low, then borrowing costs stay low for Annaly. That is a good thing. REPO rates are ultimately driven by 2 things: market liquidity and the Fed Funds rate. This is all essentially Fed managed. With QE2 going on, liquidity is good. And the Federal Funds Rate right now is 0.25%. After yesterdays Federal Reserve meeting, low rates seem assured for some time.
So, clearly key is that the Fed doesn't raise rates. And the only thing that would make Bernanke lift rates is if we see inflation building. I am not a deflationist, ultimatey we'll get scary inflation. But not for at least 2-4 years. After all, it took Paul Volcker 3 years to quell inflation in the 1970s. And that was with massive Fed Funds hikes. It will take at least as long to get it going again. Unemployment is high, overcapacity is still a problem, and wage growth is pretty tame. Not to mention that the govt is manipulating the CPI data to show less inflation than there is. (another topic altogether!) So, on the whole, that means I can own NLY at today's price: $17.90 and be pretty comfortable its not going anywhere.
Another reason the Fed is virtually guaranteed to keep rates low is the state of our fiscal deficits. They HAVE to keep borrowing costs low. In effect the govt is financing our deficits by offering cheap money to banks. Who then turn around and buy Agencies and Treasuries. How do you think we are selling $1.4 Trillion in new treasuries every year to finance our deficits? Its not because foreigners (or anyone) for that matter actually thinks they are a good buy. Its because it's free money for the banks, who get Fed Repo financing, and turn around and buy long dated treasuries. (the classic carry trade, also helping to recapitalize the banks, the hidden subsidy).
Finally, lets discuss Annaly's dividends. At $0.64 a share, its current yield is 14.3%. Solid. It happens on occasion that the company raises equity capital, and they just did a deal earlier this month. Typically the stock gets beat up on dilution concerns (valid). So, with their fund raising out of the way for at least 4-6 months, perhaps longer, and with Fed Funds staying low for the next 2 years, I think this stock will be fine. Perhaps buy it on a dip if possible. Just don't look for any real price appreciation, all you will get is lots of cash back in the form of dividends. I'll take 14% a year though and be happy. And besides, what's better than cash?
Thursday, January 27, 2011
Tuesday, January 25, 2011
Selling Johnson & Johnson, JNJ
I follow Warren Buffett's purchases avidly. JNJ, Johnson & Johnson, was a name he bought last year around $60 a share. I was happy to have paid about the same. Today its around $61.25.
Johnson & Johnson endured signficant bad press in 2010 with multiple recalls of a variety of products across the spectrum: Motrin, Tylenal, Arthritis drugs, Benedryl, Rolaids, Hip devices, and on and on and on. The recalls were relentless, and drove the stock down from $70 a share in 2009, to under $50 at one point. Dozens of products were recalled due to manufacturing deficiencies, as they outsource manufacturing and dealt with continued unexplained problems. This bad press seemed temporary though, and very solvable. Combined with the impact of the Healthcare Reform Act, this meant to me that the HC overhang would wear off, and that recalls would end in 2011.
So, not surprisingly, earnings for 2010 (reported today) were weak. EPS was $4.76 a share, (actually not terrible) up from $4.40 the year before on about flat sales of $61BB. The biggest problem was that sales fell 5.5% in Q4 vs Q4 2009, quite a surprise. In Q3, sales year over year were only down 0.7%, with some negative currency impacts. But generally this company has never experienced this kind of negative sales growth, ever. The CEO said, "we will continue to see near term pressure on the business for 2011." Ouch.
But overall, the problem on top of the sales declines is that guidance for 2011 was also very weak. While the Street is forecast about $5.00 in EPS in 2011, the company is guiding to $4.80, just about flat with what they did in 2010. Not terribly impressive.
One problem with giant cap companies like JNJ (with a market cap of $170BB), is that largely they are un-analyzable. They have so many segments, its almost impossible to guage where they are going. Drugs like Remicade and Prezista were strong, but then sales of Topamax and Risperdal are succombing to generic competition and falling 35% and 50% year over year.
But the tone from management on the call was heavy. "Disappointed" and "we are refocusing" and "looking for positive movement" are discouraging. Sales for 2011 are only forecast by management to be up 2-3%. They also reported that regarding the product recalls, its not even over. They anticipate that "80% of recalls are behind us." More bad press to come, more recalls.
Also surprisingly, total consumer sales were down 15%, which is comprised of down 6% internationally and down 30% in the US. Pharmaceutical sales we know are suffering as generic competition ramps up and product pipelines dry up, so I wasnt surprised that sales fell 5.5% there. But then sales of almost every category of consumer products were also falling: skin care, baby care, womens health, wound care. Very discouraging.
Finally, medical device sales were also barely flat. There just is very little to like here, and I suspect this stock will continue to languish in the $60 range, give or take $5 bucks.
It is no secret why Buffet invests. He buys companies with decent FCF yields & Returns on Equity (ROEs), with a "moat" around the business, and businesses you can understand. He would rather pay a fair price for a good company, than a good price for a fair company. On a FCF basis, the stock is reasonably cheap, with $5 in FCF per share last year. That implies an 8.2% FCF yield, and the company pays out much of this cash in the form of dividends. The div yield is 3.5%. Its why I bought it originally.
However, I now question the moat here, especially given their sales declines. Generics and non-branded OTC drug competition are clearly having a big impact. With high unemployment in the US, its cheaper to purchase non-branded over-the-counter medicines then pay full price for the branded. Everyone knows that it's all the same stuff inside. The HC reform act is also impacting sales, hurting topline by 4-5% last year. Doesnt seem that that is ending either. This could easily slip further next year, becoming a drug company like Merck or Pfizer, desperately making large acquisitions with FCF to try to buy topline growth. (they tend to make smaller acquisitions with FCF today).
So, JNJ to me is like owning a bond. I had originally pegged this one at a slight growth type multiple of 14-15x, getting me to a value $70-75 a share, with a $2.16 dividend on top. But with growth drying up, I suspect this could trade between 10 and 12x, which puts it around $50 a share on the downside, with real upside today perhaps in the mid to high 60s best case. Up $6-7 bucks, down $10 bucks. I'll pass.
Regarding what to buy, I could be wrong, but to me it looks like the market is selling JNJ and buying TEVA. TEVA is a pharmaceutical company that focuses on generics. I think its cheap, havent bought it yet, but 10x forward earnings compared to 12x for JNJ, its immediately compelling. To boot, TEVA is sporting 20-25% growth rates as the drug patent cliff continues to hit the branded research focused firms out there. JNJ will perhaps eake out 3% sales growth in 2011.
Johnson & Johnson endured signficant bad press in 2010 with multiple recalls of a variety of products across the spectrum: Motrin, Tylenal, Arthritis drugs, Benedryl, Rolaids, Hip devices, and on and on and on. The recalls were relentless, and drove the stock down from $70 a share in 2009, to under $50 at one point. Dozens of products were recalled due to manufacturing deficiencies, as they outsource manufacturing and dealt with continued unexplained problems. This bad press seemed temporary though, and very solvable. Combined with the impact of the Healthcare Reform Act, this meant to me that the HC overhang would wear off, and that recalls would end in 2011.
So, not surprisingly, earnings for 2010 (reported today) were weak. EPS was $4.76 a share, (actually not terrible) up from $4.40 the year before on about flat sales of $61BB. The biggest problem was that sales fell 5.5% in Q4 vs Q4 2009, quite a surprise. In Q3, sales year over year were only down 0.7%, with some negative currency impacts. But generally this company has never experienced this kind of negative sales growth, ever. The CEO said, "we will continue to see near term pressure on the business for 2011." Ouch.
But overall, the problem on top of the sales declines is that guidance for 2011 was also very weak. While the Street is forecast about $5.00 in EPS in 2011, the company is guiding to $4.80, just about flat with what they did in 2010. Not terribly impressive.
One problem with giant cap companies like JNJ (with a market cap of $170BB), is that largely they are un-analyzable. They have so many segments, its almost impossible to guage where they are going. Drugs like Remicade and Prezista were strong, but then sales of Topamax and Risperdal are succombing to generic competition and falling 35% and 50% year over year.
But the tone from management on the call was heavy. "Disappointed" and "we are refocusing" and "looking for positive movement" are discouraging. Sales for 2011 are only forecast by management to be up 2-3%. They also reported that regarding the product recalls, its not even over. They anticipate that "80% of recalls are behind us." More bad press to come, more recalls.
Also surprisingly, total consumer sales were down 15%, which is comprised of down 6% internationally and down 30% in the US. Pharmaceutical sales we know are suffering as generic competition ramps up and product pipelines dry up, so I wasnt surprised that sales fell 5.5% there. But then sales of almost every category of consumer products were also falling: skin care, baby care, womens health, wound care. Very discouraging.
Finally, medical device sales were also barely flat. There just is very little to like here, and I suspect this stock will continue to languish in the $60 range, give or take $5 bucks.
It is no secret why Buffet invests. He buys companies with decent FCF yields & Returns on Equity (ROEs), with a "moat" around the business, and businesses you can understand. He would rather pay a fair price for a good company, than a good price for a fair company. On a FCF basis, the stock is reasonably cheap, with $5 in FCF per share last year. That implies an 8.2% FCF yield, and the company pays out much of this cash in the form of dividends. The div yield is 3.5%. Its why I bought it originally.
However, I now question the moat here, especially given their sales declines. Generics and non-branded OTC drug competition are clearly having a big impact. With high unemployment in the US, its cheaper to purchase non-branded over-the-counter medicines then pay full price for the branded. Everyone knows that it's all the same stuff inside. The HC reform act is also impacting sales, hurting topline by 4-5% last year. Doesnt seem that that is ending either. This could easily slip further next year, becoming a drug company like Merck or Pfizer, desperately making large acquisitions with FCF to try to buy topline growth. (they tend to make smaller acquisitions with FCF today).
So, JNJ to me is like owning a bond. I had originally pegged this one at a slight growth type multiple of 14-15x, getting me to a value $70-75 a share, with a $2.16 dividend on top. But with growth drying up, I suspect this could trade between 10 and 12x, which puts it around $50 a share on the downside, with real upside today perhaps in the mid to high 60s best case. Up $6-7 bucks, down $10 bucks. I'll pass.
Regarding what to buy, I could be wrong, but to me it looks like the market is selling JNJ and buying TEVA. TEVA is a pharmaceutical company that focuses on generics. I think its cheap, havent bought it yet, but 10x forward earnings compared to 12x for JNJ, its immediately compelling. To boot, TEVA is sporting 20-25% growth rates as the drug patent cliff continues to hit the branded research focused firms out there. JNJ will perhaps eake out 3% sales growth in 2011.
Wednesday, January 19, 2011
Some Thoughts on Apple Stock AAPL
If you read this blog, then you have probably seen me allude to the fact that everyone should own Apple in their PA. There has been a bit of news on the stock in the past 2 days, and I thought it would be helpful to revisit the name.
First of all, on Monday Apple announced that CEO Steve Jobs is taking a leave of absence for unspecified medical reasons. Further, there was no mention of how long he would be gone. Steve Jobs, who founded Apple in 1976, is considered by many to be the best product development manager ever. CEO of the decade, you name it, he single-handedly poured his life into designing their computers, the iPod, the iPhone, etc etc. He could be considered the most important CEO to any company out there. Without Jobs, there is great risk that product development languishes. And the world of mobile computing is notoriously cut throat. Motorola was the king of mobile phones in the early to mid 1990s, and eventually lost out to better designs. That stock has only gone down in the past 15 years since it peaked.
So, the question is, has AAPL peaked? The stock has rocketed from $75 / share 5 years ago, to $345 today. Jobs' job may be on the line, and competitors like the new Microsoft phone and Android are actually pretty decent. Can Apple continue to grow?
The good news is, the company reported earnings yesterday. I don't think it was a coincidence that they reported good quarterly earnings the day after Jobs took his medical leave. They are managing the newsflow. This is also the 3rd time in 5 years that Steve Jobs has taken a medical leave. None of those episodes were explained either. I find it a little irresponsible of the company not to better explain the management situation, but Apple respects his privacy more than the shareholders' right to know. Enough said.
The first indicent, it turned out Jobs had a pancreatic tumor, and he recovered and was pronounced cancer free. The second time, he told the world after the fact that he had a liver transplant. That was 2 years ago, and he took 6 months off. His COO, Tim Cook, handled the day to day management of the company. Tim Cook is considered an apt manager though, and I have read more and more that Wall Street is comfortable with Cook running the company during Jobs' absence.
So, the question is now, is the stock cheap? Does it discount the risk to losing Jobs? Well, AAPL reported December earnings yesterday after the market closed, and by almost any metric, they were phenomenal. Sales were up 71%. EPS was up 72%. Sales of iPhones were up 88%. iPads generated 4.6BB in sales in the quarter on 7.3mm units sold. They had zero iPads a year ago so you can't measure growth. And so on.
So, in the calender year 2010, Apple generated $76BB in total sales, vs only $46BB the year before. iPhones and iPads and applications and iTune downloads continue to grow at very high growth rates. I asked myself though if growth has peaked. It cannot accelerate, although in the last 5 quarters, EPS growth has been 50%, 89%, 78%, 70%, 72%. Strong. And revenue growth amazingly appears to be accelerating, growing in the last 5 quarters: 32%, 49%, 61%, 67% and 71%. Wow.
So, what is the market saying about Apple. Well based on its Q4 earnings, the company first of all has $59BB in cash. That's $64/share. So I am going to subtract that from the share price and calculate what the business generates in earnings. At 346/share, less $64 leaves me buying the business at $282 per share. And on a TTM basis, they did $18.10 in EPS (excluding interest income which was nil). That means I am paying 15.6x earnings. Compared to the S&P, the market essentially trades at a 15.2x P/E ratio. That is a very negligible premium compared to the market. Furthermore, GS calculates that AAPL has traded on average at 23x earnings over the past decade, much higher than today. I dont quite get it honestly. Perhaps it's just a case of the stock not keeping up with earnings in a volatile world.
Clearly it's also that the law of large numbers has to hamper growth here. But if S&P earnings are expected to grow by 9% in 2011, shouldn't Apple still trade at a much better multiple? Why does it languish at a market multiple when the numbers suggest that AAPL will grow EPS by 40-50% in 2011?
Finally, I did some math to figure out if there really is growth left. Based on guidance for the next quarter, annual revenue through March 2011 will be $85BB. Thats pretty much in the bag. Now everyone knows that finally the iPhone is coming to Verizon. That date is February 10th. Based on some surveys I saw online, an astonishing 26% of Verizon users expect the switch to an iPhone. Count me in that category. We plan to be dialing on an iPhone on the 10th. Further, there are 93mm Verizon wireless subscribers. That means you have a potential of 24mm unit sales of iPhones over the next say 2 years as contracts roll off. Now you could argue that Verizon sales will cannabilize AT&T sales, but really of the 9omm total iPhones sold worldwide, about 15-20mm are US AT&T models, I estimate. 80% of iPhone sales are international.
I have read that VZ expects to sell between 7-13mm iPhones in the first year. I think 10mm is a reasonable number. At $625 a pop, that is 6.25BB more in revenue in 2011 just from the VZ iPhone. We didnt count the AT&T users who plan to switch to Verizon because the network there is notoriously bad. So, if Apple has $85BB in sales pretty much in the bag, and you throw in another 6.25BB from the VZ iPhone, and add a full year of the iPad (add another $3BB), then that gets you to $94BB of annual sales. Translating that to EPS gets me in the $22-23 per share range. That is awfully close to where the street is forecasting EPS for 2011 too.
And then there is China. They only did $3BB of their sales to China last year. The US generated $20BB in sales last year on a $14 Trillion economy. China's economy was $5 Trillion, so it seems there is much room for further growth. This is heavily generalized but, in fact, in December the quarterly numbers show that revenue was up 175% in Asia Pacific compared to the year before. Its just starting to take off there.
Finally their quarterly numbers were hampered by production backlogs. They cannot make enough iPhones and iPads. It appears that the iPad shortages have been resolved, and they now plan to add 15 more countries this month to their existing list of 46 countries where the iPad is available. More sales growth.
I almost hate to agree with the sellside on a valuation. But I think this stock is worth 15-17x its 2011 EPS number. Figure that they'll build another $12 per share in cash, that means you will have 76/share in pure cash, and a business doing between 22-24 in EPS. You are in essence paying $269/share for a business that will do $22 per share in earnings. That is 12x forward earnings! Note that RIMM trades at 10x 2011 earnings, and given that 40% of Apple iPhones are sold to enterprises, that could seriously dampen Blackberry sales.
I am not surprised that GS and JPM just raised their forecast for the stock. They peg value at $450/share, which to me is not crazy. 375/22 in EPS implies that the stock can get to a 17x multiple by year end, still below its historical average. That is 30% upside.
As a final gut check, I always focus on cash earnings. Here I took CF from operations, and subtracted capex. That is REAL cash flow, unmanipulated for the most part. (D&A, depreciation and amortization is the biggest driver of manipulated earnings along with "non-recurring items"). Anyway, here is what I get per year in cash vs GAAP earnings:
Cash EPS GAAP EPS
2008: $9.20 $6.78
2009: $9.94 $9.08
2010: $17.25 $15.15
As you can see, Cash EPS is higher every year. I haven't done the forensic accounting to figure out why, but I note that they deferred a lot of revenue (ie the cash comes in, but not booked until as late as possible). The balance sheet shows almost $4BB of deferred revenue as of the end of September. Probably also some inventory management going on. Doesn't really matter. But this also brings up the point of returns on equity (ROEs). ROEs were around 29% last year, but the company's ROA, if you take out the cash would be an astronomical 58%. And in fact if you used CASH earnings, the number goes even higher. Very impressive. You cannot find a better, cleaner company from a balance sheet and reported earnings perspective.
Now, the negatives to the stock should also be pointed out. I have no idea what they do for growth beyond 2011. Steve Jobs may not come back this time, let's hope he does. But if his health has finally caught up with him, then there is real product development risk. The established base of devices is high, but then always subject to declining market share and cyclicality. Near term the quarter benefitted from a lower tax rate of 25% from 29%. That could go back the other way again impacting earnings.
And finally, sentiment is very high for Apple. I assume you have heard of a short squeeze before, but there is also such a thing as a long squeeze. That is, NOBODY is short apple stock. The short ratio is 0.6%, or about 6.8mm shares short out of 915mm publicly traded. That number is also down from almost 20mm shares short last February. You need a good short base to generate some buy orders when the stock falls. If not, you need to find new buyers of the stock to support it. Long holders keep pushing it down with no support. Feels like its happening now actually. If the short interest ever gets back to 20mm shares again, then probably that would mark a bottom.
So, do you buy here? I don't really know. I already own it, I'll probably look to buy more if it falls 5% from here, which is around $320-325 a share. One study showed that tech companies that get new CEOs, fall on average 10% in the 12 months following the change in management. If Jobs has to fully resign, then history suggests this stock falls to $300 a share. Could be worse though given his importance to the company. If it works and he comes back to work in a few months, then I think $450 is a reasonable upside in 9-12 months.
First of all, on Monday Apple announced that CEO Steve Jobs is taking a leave of absence for unspecified medical reasons. Further, there was no mention of how long he would be gone. Steve Jobs, who founded Apple in 1976, is considered by many to be the best product development manager ever. CEO of the decade, you name it, he single-handedly poured his life into designing their computers, the iPod, the iPhone, etc etc. He could be considered the most important CEO to any company out there. Without Jobs, there is great risk that product development languishes. And the world of mobile computing is notoriously cut throat. Motorola was the king of mobile phones in the early to mid 1990s, and eventually lost out to better designs. That stock has only gone down in the past 15 years since it peaked.
So, the question is, has AAPL peaked? The stock has rocketed from $75 / share 5 years ago, to $345 today. Jobs' job may be on the line, and competitors like the new Microsoft phone and Android are actually pretty decent. Can Apple continue to grow?
The good news is, the company reported earnings yesterday. I don't think it was a coincidence that they reported good quarterly earnings the day after Jobs took his medical leave. They are managing the newsflow. This is also the 3rd time in 5 years that Steve Jobs has taken a medical leave. None of those episodes were explained either. I find it a little irresponsible of the company not to better explain the management situation, but Apple respects his privacy more than the shareholders' right to know. Enough said.
The first indicent, it turned out Jobs had a pancreatic tumor, and he recovered and was pronounced cancer free. The second time, he told the world after the fact that he had a liver transplant. That was 2 years ago, and he took 6 months off. His COO, Tim Cook, handled the day to day management of the company. Tim Cook is considered an apt manager though, and I have read more and more that Wall Street is comfortable with Cook running the company during Jobs' absence.
So, the question is now, is the stock cheap? Does it discount the risk to losing Jobs? Well, AAPL reported December earnings yesterday after the market closed, and by almost any metric, they were phenomenal. Sales were up 71%. EPS was up 72%. Sales of iPhones were up 88%. iPads generated 4.6BB in sales in the quarter on 7.3mm units sold. They had zero iPads a year ago so you can't measure growth. And so on.
So, in the calender year 2010, Apple generated $76BB in total sales, vs only $46BB the year before. iPhones and iPads and applications and iTune downloads continue to grow at very high growth rates. I asked myself though if growth has peaked. It cannot accelerate, although in the last 5 quarters, EPS growth has been 50%, 89%, 78%, 70%, 72%. Strong. And revenue growth amazingly appears to be accelerating, growing in the last 5 quarters: 32%, 49%, 61%, 67% and 71%. Wow.
So, what is the market saying about Apple. Well based on its Q4 earnings, the company first of all has $59BB in cash. That's $64/share. So I am going to subtract that from the share price and calculate what the business generates in earnings. At 346/share, less $64 leaves me buying the business at $282 per share. And on a TTM basis, they did $18.10 in EPS (excluding interest income which was nil). That means I am paying 15.6x earnings. Compared to the S&P, the market essentially trades at a 15.2x P/E ratio. That is a very negligible premium compared to the market. Furthermore, GS calculates that AAPL has traded on average at 23x earnings over the past decade, much higher than today. I dont quite get it honestly. Perhaps it's just a case of the stock not keeping up with earnings in a volatile world.
Clearly it's also that the law of large numbers has to hamper growth here. But if S&P earnings are expected to grow by 9% in 2011, shouldn't Apple still trade at a much better multiple? Why does it languish at a market multiple when the numbers suggest that AAPL will grow EPS by 40-50% in 2011?
Finally, I did some math to figure out if there really is growth left. Based on guidance for the next quarter, annual revenue through March 2011 will be $85BB. Thats pretty much in the bag. Now everyone knows that finally the iPhone is coming to Verizon. That date is February 10th. Based on some surveys I saw online, an astonishing 26% of Verizon users expect the switch to an iPhone. Count me in that category. We plan to be dialing on an iPhone on the 10th. Further, there are 93mm Verizon wireless subscribers. That means you have a potential of 24mm unit sales of iPhones over the next say 2 years as contracts roll off. Now you could argue that Verizon sales will cannabilize AT&T sales, but really of the 9omm total iPhones sold worldwide, about 15-20mm are US AT&T models, I estimate. 80% of iPhone sales are international.
I have read that VZ expects to sell between 7-13mm iPhones in the first year. I think 10mm is a reasonable number. At $625 a pop, that is 6.25BB more in revenue in 2011 just from the VZ iPhone. We didnt count the AT&T users who plan to switch to Verizon because the network there is notoriously bad. So, if Apple has $85BB in sales pretty much in the bag, and you throw in another 6.25BB from the VZ iPhone, and add a full year of the iPad (add another $3BB), then that gets you to $94BB of annual sales. Translating that to EPS gets me in the $22-23 per share range. That is awfully close to where the street is forecasting EPS for 2011 too.
And then there is China. They only did $3BB of their sales to China last year. The US generated $20BB in sales last year on a $14 Trillion economy. China's economy was $5 Trillion, so it seems there is much room for further growth. This is heavily generalized but, in fact, in December the quarterly numbers show that revenue was up 175% in Asia Pacific compared to the year before. Its just starting to take off there.
Finally their quarterly numbers were hampered by production backlogs. They cannot make enough iPhones and iPads. It appears that the iPad shortages have been resolved, and they now plan to add 15 more countries this month to their existing list of 46 countries where the iPad is available. More sales growth.
I almost hate to agree with the sellside on a valuation. But I think this stock is worth 15-17x its 2011 EPS number. Figure that they'll build another $12 per share in cash, that means you will have 76/share in pure cash, and a business doing between 22-24 in EPS. You are in essence paying $269/share for a business that will do $22 per share in earnings. That is 12x forward earnings! Note that RIMM trades at 10x 2011 earnings, and given that 40% of Apple iPhones are sold to enterprises, that could seriously dampen Blackberry sales.
I am not surprised that GS and JPM just raised their forecast for the stock. They peg value at $450/share, which to me is not crazy. 375/22 in EPS implies that the stock can get to a 17x multiple by year end, still below its historical average. That is 30% upside.
As a final gut check, I always focus on cash earnings. Here I took CF from operations, and subtracted capex. That is REAL cash flow, unmanipulated for the most part. (D&A, depreciation and amortization is the biggest driver of manipulated earnings along with "non-recurring items"). Anyway, here is what I get per year in cash vs GAAP earnings:
Cash EPS GAAP EPS
2008: $9.20 $6.78
2009: $9.94 $9.08
2010: $17.25 $15.15
As you can see, Cash EPS is higher every year. I haven't done the forensic accounting to figure out why, but I note that they deferred a lot of revenue (ie the cash comes in, but not booked until as late as possible). The balance sheet shows almost $4BB of deferred revenue as of the end of September. Probably also some inventory management going on. Doesn't really matter. But this also brings up the point of returns on equity (ROEs). ROEs were around 29% last year, but the company's ROA, if you take out the cash would be an astronomical 58%. And in fact if you used CASH earnings, the number goes even higher. Very impressive. You cannot find a better, cleaner company from a balance sheet and reported earnings perspective.
Now, the negatives to the stock should also be pointed out. I have no idea what they do for growth beyond 2011. Steve Jobs may not come back this time, let's hope he does. But if his health has finally caught up with him, then there is real product development risk. The established base of devices is high, but then always subject to declining market share and cyclicality. Near term the quarter benefitted from a lower tax rate of 25% from 29%. That could go back the other way again impacting earnings.
And finally, sentiment is very high for Apple. I assume you have heard of a short squeeze before, but there is also such a thing as a long squeeze. That is, NOBODY is short apple stock. The short ratio is 0.6%, or about 6.8mm shares short out of 915mm publicly traded. That number is also down from almost 20mm shares short last February. You need a good short base to generate some buy orders when the stock falls. If not, you need to find new buyers of the stock to support it. Long holders keep pushing it down with no support. Feels like its happening now actually. If the short interest ever gets back to 20mm shares again, then probably that would mark a bottom.
So, do you buy here? I don't really know. I already own it, I'll probably look to buy more if it falls 5% from here, which is around $320-325 a share. One study showed that tech companies that get new CEOs, fall on average 10% in the 12 months following the change in management. If Jobs has to fully resign, then history suggests this stock falls to $300 a share. Could be worse though given his importance to the company. If it works and he comes back to work in a few months, then I think $450 is a reasonable upside in 9-12 months.
Friday, January 14, 2011
What the "New Normal" Really Means for the Economy and Your Portfolio
Buying: FXA see below.
Ok, you must have heard the phrase the "New Normal." Coined by Pimco's uber-smart chief Muhamed El-Arian in 2009, the term essentially refers to the fact that the US economy will persistently have sluggish growth & high unemployment, and wealth will continue to migrate from industrialized economies to more emerging countries.
My question is, what does this mean for how to allocate assets over the next 5 years. Because right now, the dollar seems stable, the US economy appears to be humming along, and emerging market stocks last year lost out to the S&P 500. That is a first in a long time, and even this month EEM (a good emerging market ETF) is barely up 0.3%, vs the S&P is up 2.0%. So should we buy US stocks and avoid EM markets now? What will the US economy really look like compared to EM markets in the next few years?
Generally speaking, I think its worth backing up and looking at WHY we are in the "New Normal." And also asking the question, is the New Normal OVER for the US?
To put it bluntly, no, its not over. It's been delayed, the proverbial can has been kicked down the road again, so to speak. We have a leverage problem that will take years to solve. The analogy I will make is that economies are no different than a household. Think of the US economy as your house, Japan as another house etc. That is, your household generates a certain amount of income. Then, you spend that income. Hopefully you spend a little less than you make. That's how you get rich. By saving. Your accumulated savings builds up, and eventually (hopefully) you start making money off your money. The American dream. Retire with lots of capital to have fun with.
Now, imagine the US economy is your household. The US economy generates a certain amount of income. That is, the US generates business income in the form of profits, and consumers generate income in the form of wages (and profits too, say from stocks or businesses or loans). (Governments generally get a piece of everyone else's income). Then our economy (household) spends money. That spending number is GDP. Think about that. Nobody really looks at income in our country, we only look at GDP. Sure we call GDP income, but it's not. Economists and politicians strive to grow GDP, not strive to grow NET WORTH or income, which means they just want everyone to spend money, even if anyone and everyone has to borrow that money to spend it.
If you remember your economics, GDP is:
Consumer Spending, plus
Govt Spending, plus
Corporate Spending, less
Net imports.
SPENDING money isn't the same as generating wealth, and really why the US may be one of the poorest countries in the world. Essentially, the problem we have in this country, among others, is that politically its very painful to see GDP decline. People lose there jobs, demand falls, worker's wages decline. Not good. Especially around election time.
So for the past 30 years, Consumers and our Government have been steadily borrowing more money so that they can spend more and grow GDP. Spending has nothing to do with generating wealth however. I find it ASTONISHING when I read things like this: "The economy is suffering because people aren't spending as much as they used to." Or, "the government is encouraging banks to lend more." HOLY CRAP, that is most riduculous thing I have ever seen. Saving money is NOT BAD for our economy, it is the only way to truly generate wealth. This is true of consumers, businesses, governments, and entire economies.
Since we have ignored savings for decades, our infrastructure is declining and educational system are also seeing far too little investment. We aren't competitive in the world in manufacturing, and its not a surprise that we have lost 3mm manufacturing jobs since the year 2000, and China has gained 6mm manufacturing jobs.
So the quandry we have now is that our debt growth has actually fueled GDP growth for about as long as we can remember. Somewhere around the early 1980s we decided that peace time government deficits were ok. The problem is that politicians have entirely ignored that our country's income has been lagging spending grossly. And, just like your house, at some point you cannot borrow any more money, the well runs dry and you have to repay your debts. That is where we are today. GDP will not only revert back to income levels, but likely has to revert to below income levels to begin de-leveraging.
Now, Keynes would have you believe that when the economy hits a rough patch, government spending can make up for slowing business and consumer spending. That is partly true...you lose your job you can make up for lost wages by borrowing a little money. However, what our economic leaders of this country (lead by Bernanke and Tim Geithner and the entire Republican party) believe is that Keynesian economics always works. They take Keynesian economics to the extreme, that you can always turn on the government spending spigot and keep our economy growing forever. Ridiculous, I encourage anyone serious about this subject to do a little work on the Austrian School of Economics, which is what our economic leaders will eventually learn, the hard way.
So, to put some numbers and historical perspective on that, Total US Debt (corporate plus consumer plus government debt), is now at 350% of GDP. In 1980, that number was 150% of GDP. In 1929, that number was 300% of GDP. Take a look at this chart courtesy of Morgan Stanley to see why we will face a New Normal for at least a decade.
http://paul.kedrosky.com/archives/2009/03/us_total_credit.html
(on chart GSE debt is basically mortgage debt backed by the US govt, more govt debt).
That brings up one other side point. The Great Depression wasn't caused by bad monetary policy, as Bernanke would have you believe. It was caused by the after-effects of a decade of de-leveraging. I don't understand how its not abundantly clear that everyone and their brother margined stocks in the late 20's, then got stuck paying back the bill for a decade. The same is going on now, but its mortgage debt turned governement debt that we'll be repaying for a long time. (there is also the problem that we have been shifting mortgage debt to our govt's balance sheet, via bailouts and subsidies on home purchases and guarantees of mortgage debt, much of which will default).
So, why is GDP looking like its going to grow 2.5 to 3% this year? Well, while consumers were net borrowers for years up until the bust of 2008/2009, savings rates have stabilized now, at around the 5% level. However, government borrowing continues to rise to offset consumer saving to keep the debt train going. Tax rates are actually falling in 2011 in the face of more govt spending. I was amazed that our newly appointed Republican House, elected because of American's disgust with large deficits, immediately CUT taxes and basically got on board with even larger deficits. Somewhat a slap in the face in my opinion.
All of this makes me worry what will happen to the US economy come 2012 or 2013, when we are forced to make government spending cuts. GDP will get hurt, government workers will be cut. For a preview, see today what is happening at the state and local level. The muni market is again selling off, dramatically this week. Workers are losing jobs, taxes are going up (Illinois just raised state taxes by 50% or something crazy). Ugly.
So, as we are already seeing, US unemployment isn't really improving. Sure GDP is growing a little, but that isn't necessarily a good thing. It's just huge government spending. We aren't saving anything, we are getting poorer as a country. If you think this is fine, we'll talk in 10 years and compare China's wealth and clout in the world vs ours. China has 15% government Debt to GDP, however Consumers save 50% of GDP, and they have net trade surpluses of another 4% of GDP. Their economy is saving MASSIVELY. Who do you think will be richer in 10 or 20 years? Who owns much of our debt that we have to repay? Foreigners, to the tune of 50%.
As for Japan, much has been made of their declining population, coupled with huge government deficits and pension obligations as their population ages. However, their consumer savings rate is 15% of GDP, and their governments hold large quantities of cash/money market funds, especially at the local level. So while gross government debt is the biggest in the world at over 200% Debt to GDP, their total societal or economic debt is probably around 100-150% I estimate, far less than the US at 350%. And China has net wealth (not debt) of at least 30-50% of GDP.
So what does that tell me about allocating personal savings? Clearly owning non-dollar assets is key. The dollar can only fall in the face of a weak economy, government deficits and debt monetization. Second, it's imperative to find non-dollar assets that will benefit from global growth. Right now the problem with EM stocks is that PE ratios are pretty high, 15-25x, a fair amount higher than the historical valuations in the 10-14x range. That said, growth is higher, but then again, political risk and currency risk are also higher. Brazil was up 83% in 2009 but then only 7% last year. I don't really know enough to want to get long these equities now, they are more expensive, there has been a lot of popular media attention on owning EM stocks. Its tough to add here. Perhaps when they pull back.
That said, I think Jeremy Grantham, one of the smarted investors in the world, makes the most sense. He likes big cap US equities with international exposure. Furthermore, many blue chip companies are trading at near all time valuation lows. (the S&P is flat in the last 10 years, but not because earnings are flat). Now, while the US economy will bumble and stumble for a long time, I think that stocks with low valuations and high international sales offers a good way to get exposure to EM and foreign markets, without paying high multiples. Here are a few I like, and already discussed in prior emails:
IBM, CSCO, HPQ, JNJ, KFT, AAPL (yes 57% of Apple's sales last year were international).
I know these name seem boring, but when you can buy them at 7-10% FCF yields, and benefit from a falling dollar, which is clearly inevitable, then there is much to like. I also think Newmont Mining, NEM is interesting here, its gotten beaten up with the dollar rallying. I see that Gold prices are up 50% in the last 2 years, and this stock is flat. It trades at 12x earnings, a 7.5% FCF yield, and is a good hedge to the dollar falling. While I think gold is a bubble to some extent, the bubble is not over. Consider Argentina in 2001 after the peso devaluation. Gold skyrocketed from $265 to $1120 an ounce, in ONE year. (Aug 1, 2001 to Aug 1, 2002 to be exact).
Oil stocks are another necessity to your portfolio. While oil is priced in dollars, and seems crazy at 90 a barrel, its still well below the 2007 highs of $140 a barrel. There is only a fixed amout of oil in the world, with new reserves clearly declining every decade since the 1970s. If you don't believe in peak oil, send me an email and i'll send you a chart of new oil discoveries by decade for the last 100 years. We peaked 40 years ago. Either way, dollar declines benefit oil prices in addition to simple demand growth for the commodity.
Oil plays to consider are COP, PBR, and XOM. My next task to figure out which one.
Finally, own some non-dollar hedged EM bond funds and currencies. I am today adding a small amount FXA per one of my smart hedge fund buddies. Its an Australian dollar ETF, and actually yields 3.2% given higher rates in Australia. Australia is a $1 Trillion economy, GDP grew 3.3% last year, unemployment is 5.4%, Debt to GDP is 17%, very low. The negatives are a 6-7% current account (trade) deficit, and high real estate prices. The Australian dollar tends to be somewhat correlated to the US stock market, so if it falls as I expect a pullback soon, add more then. But LT its one of the best currencies in the world.
As for EM bonds, I like PLBDX. Also consider TPINX. I have almost 20% of my PA in PLBDX, and it was up 12% last year. Its down 3.2% in the last 3 months, mainly on a bounce in the US Dollar, but I think PLBDX will rally as the dollar starts to decline again.
I also will mention WGRNX, another international stock value fund. Up 20% last year, its down a little in January, again as the dollar has rallied. Its my biggest position and is 68% long non-USD companies.
Net net that gets me well over 60% of my exposure is to foreign currencies, gold or non-dollar denominated assets. Note that that includes the international components of my big cap US stocks and mutual funds. But on the whole its a level of exposure that I think is a necessity.
Ok, you must have heard the phrase the "New Normal." Coined by Pimco's uber-smart chief Muhamed El-Arian in 2009, the term essentially refers to the fact that the US economy will persistently have sluggish growth & high unemployment, and wealth will continue to migrate from industrialized economies to more emerging countries.
My question is, what does this mean for how to allocate assets over the next 5 years. Because right now, the dollar seems stable, the US economy appears to be humming along, and emerging market stocks last year lost out to the S&P 500. That is a first in a long time, and even this month EEM (a good emerging market ETF) is barely up 0.3%, vs the S&P is up 2.0%. So should we buy US stocks and avoid EM markets now? What will the US economy really look like compared to EM markets in the next few years?
Generally speaking, I think its worth backing up and looking at WHY we are in the "New Normal." And also asking the question, is the New Normal OVER for the US?
To put it bluntly, no, its not over. It's been delayed, the proverbial can has been kicked down the road again, so to speak. We have a leverage problem that will take years to solve. The analogy I will make is that economies are no different than a household. Think of the US economy as your house, Japan as another house etc. That is, your household generates a certain amount of income. Then, you spend that income. Hopefully you spend a little less than you make. That's how you get rich. By saving. Your accumulated savings builds up, and eventually (hopefully) you start making money off your money. The American dream. Retire with lots of capital to have fun with.
Now, imagine the US economy is your household. The US economy generates a certain amount of income. That is, the US generates business income in the form of profits, and consumers generate income in the form of wages (and profits too, say from stocks or businesses or loans). (Governments generally get a piece of everyone else's income). Then our economy (household) spends money. That spending number is GDP. Think about that. Nobody really looks at income in our country, we only look at GDP. Sure we call GDP income, but it's not. Economists and politicians strive to grow GDP, not strive to grow NET WORTH or income, which means they just want everyone to spend money, even if anyone and everyone has to borrow that money to spend it.
If you remember your economics, GDP is:
Consumer Spending, plus
Govt Spending, plus
Corporate Spending, less
Net imports.
SPENDING money isn't the same as generating wealth, and really why the US may be one of the poorest countries in the world. Essentially, the problem we have in this country, among others, is that politically its very painful to see GDP decline. People lose there jobs, demand falls, worker's wages decline. Not good. Especially around election time.
So for the past 30 years, Consumers and our Government have been steadily borrowing more money so that they can spend more and grow GDP. Spending has nothing to do with generating wealth however. I find it ASTONISHING when I read things like this: "The economy is suffering because people aren't spending as much as they used to." Or, "the government is encouraging banks to lend more." HOLY CRAP, that is most riduculous thing I have ever seen. Saving money is NOT BAD for our economy, it is the only way to truly generate wealth. This is true of consumers, businesses, governments, and entire economies.
Since we have ignored savings for decades, our infrastructure is declining and educational system are also seeing far too little investment. We aren't competitive in the world in manufacturing, and its not a surprise that we have lost 3mm manufacturing jobs since the year 2000, and China has gained 6mm manufacturing jobs.
So the quandry we have now is that our debt growth has actually fueled GDP growth for about as long as we can remember. Somewhere around the early 1980s we decided that peace time government deficits were ok. The problem is that politicians have entirely ignored that our country's income has been lagging spending grossly. And, just like your house, at some point you cannot borrow any more money, the well runs dry and you have to repay your debts. That is where we are today. GDP will not only revert back to income levels, but likely has to revert to below income levels to begin de-leveraging.
Now, Keynes would have you believe that when the economy hits a rough patch, government spending can make up for slowing business and consumer spending. That is partly true...you lose your job you can make up for lost wages by borrowing a little money. However, what our economic leaders of this country (lead by Bernanke and Tim Geithner and the entire Republican party) believe is that Keynesian economics always works. They take Keynesian economics to the extreme, that you can always turn on the government spending spigot and keep our economy growing forever. Ridiculous, I encourage anyone serious about this subject to do a little work on the Austrian School of Economics, which is what our economic leaders will eventually learn, the hard way.
So, to put some numbers and historical perspective on that, Total US Debt (corporate plus consumer plus government debt), is now at 350% of GDP. In 1980, that number was 150% of GDP. In 1929, that number was 300% of GDP. Take a look at this chart courtesy of Morgan Stanley to see why we will face a New Normal for at least a decade.
http://paul.kedrosky.com/archives/2009/03/us_total_credit.html
(on chart GSE debt is basically mortgage debt backed by the US govt, more govt debt).
That brings up one other side point. The Great Depression wasn't caused by bad monetary policy, as Bernanke would have you believe. It was caused by the after-effects of a decade of de-leveraging. I don't understand how its not abundantly clear that everyone and their brother margined stocks in the late 20's, then got stuck paying back the bill for a decade. The same is going on now, but its mortgage debt turned governement debt that we'll be repaying for a long time. (there is also the problem that we have been shifting mortgage debt to our govt's balance sheet, via bailouts and subsidies on home purchases and guarantees of mortgage debt, much of which will default).
So, why is GDP looking like its going to grow 2.5 to 3% this year? Well, while consumers were net borrowers for years up until the bust of 2008/2009, savings rates have stabilized now, at around the 5% level. However, government borrowing continues to rise to offset consumer saving to keep the debt train going. Tax rates are actually falling in 2011 in the face of more govt spending. I was amazed that our newly appointed Republican House, elected because of American's disgust with large deficits, immediately CUT taxes and basically got on board with even larger deficits. Somewhat a slap in the face in my opinion.
All of this makes me worry what will happen to the US economy come 2012 or 2013, when we are forced to make government spending cuts. GDP will get hurt, government workers will be cut. For a preview, see today what is happening at the state and local level. The muni market is again selling off, dramatically this week. Workers are losing jobs, taxes are going up (Illinois just raised state taxes by 50% or something crazy). Ugly.
So, as we are already seeing, US unemployment isn't really improving. Sure GDP is growing a little, but that isn't necessarily a good thing. It's just huge government spending. We aren't saving anything, we are getting poorer as a country. If you think this is fine, we'll talk in 10 years and compare China's wealth and clout in the world vs ours. China has 15% government Debt to GDP, however Consumers save 50% of GDP, and they have net trade surpluses of another 4% of GDP. Their economy is saving MASSIVELY. Who do you think will be richer in 10 or 20 years? Who owns much of our debt that we have to repay? Foreigners, to the tune of 50%.
As for Japan, much has been made of their declining population, coupled with huge government deficits and pension obligations as their population ages. However, their consumer savings rate is 15% of GDP, and their governments hold large quantities of cash/money market funds, especially at the local level. So while gross government debt is the biggest in the world at over 200% Debt to GDP, their total societal or economic debt is probably around 100-150% I estimate, far less than the US at 350%. And China has net wealth (not debt) of at least 30-50% of GDP.
So what does that tell me about allocating personal savings? Clearly owning non-dollar assets is key. The dollar can only fall in the face of a weak economy, government deficits and debt monetization. Second, it's imperative to find non-dollar assets that will benefit from global growth. Right now the problem with EM stocks is that PE ratios are pretty high, 15-25x, a fair amount higher than the historical valuations in the 10-14x range. That said, growth is higher, but then again, political risk and currency risk are also higher. Brazil was up 83% in 2009 but then only 7% last year. I don't really know enough to want to get long these equities now, they are more expensive, there has been a lot of popular media attention on owning EM stocks. Its tough to add here. Perhaps when they pull back.
That said, I think Jeremy Grantham, one of the smarted investors in the world, makes the most sense. He likes big cap US equities with international exposure. Furthermore, many blue chip companies are trading at near all time valuation lows. (the S&P is flat in the last 10 years, but not because earnings are flat). Now, while the US economy will bumble and stumble for a long time, I think that stocks with low valuations and high international sales offers a good way to get exposure to EM and foreign markets, without paying high multiples. Here are a few I like, and already discussed in prior emails:
IBM, CSCO, HPQ, JNJ, KFT, AAPL (yes 57% of Apple's sales last year were international).
I know these name seem boring, but when you can buy them at 7-10% FCF yields, and benefit from a falling dollar, which is clearly inevitable, then there is much to like. I also think Newmont Mining, NEM is interesting here, its gotten beaten up with the dollar rallying. I see that Gold prices are up 50% in the last 2 years, and this stock is flat. It trades at 12x earnings, a 7.5% FCF yield, and is a good hedge to the dollar falling. While I think gold is a bubble to some extent, the bubble is not over. Consider Argentina in 2001 after the peso devaluation. Gold skyrocketed from $265 to $1120 an ounce, in ONE year. (Aug 1, 2001 to Aug 1, 2002 to be exact).
Oil stocks are another necessity to your portfolio. While oil is priced in dollars, and seems crazy at 90 a barrel, its still well below the 2007 highs of $140 a barrel. There is only a fixed amout of oil in the world, with new reserves clearly declining every decade since the 1970s. If you don't believe in peak oil, send me an email and i'll send you a chart of new oil discoveries by decade for the last 100 years. We peaked 40 years ago. Either way, dollar declines benefit oil prices in addition to simple demand growth for the commodity.
Oil plays to consider are COP, PBR, and XOM. My next task to figure out which one.
Finally, own some non-dollar hedged EM bond funds and currencies. I am today adding a small amount FXA per one of my smart hedge fund buddies. Its an Australian dollar ETF, and actually yields 3.2% given higher rates in Australia. Australia is a $1 Trillion economy, GDP grew 3.3% last year, unemployment is 5.4%, Debt to GDP is 17%, very low. The negatives are a 6-7% current account (trade) deficit, and high real estate prices. The Australian dollar tends to be somewhat correlated to the US stock market, so if it falls as I expect a pullback soon, add more then. But LT its one of the best currencies in the world.
As for EM bonds, I like PLBDX. Also consider TPINX. I have almost 20% of my PA in PLBDX, and it was up 12% last year. Its down 3.2% in the last 3 months, mainly on a bounce in the US Dollar, but I think PLBDX will rally as the dollar starts to decline again.
I also will mention WGRNX, another international stock value fund. Up 20% last year, its down a little in January, again as the dollar has rallied. Its my biggest position and is 68% long non-USD companies.
Net net that gets me well over 60% of my exposure is to foreign currencies, gold or non-dollar denominated assets. Note that that includes the international components of my big cap US stocks and mutual funds. But on the whole its a level of exposure that I think is a necessity.
Friday, January 7, 2011
Shorting Netflix NFLX
I just shorted Netflix, NFLX around $178.50 a share. I have been watching and doing sporadic work on this name for the past month or so. Its been an insane stock to watch. In case you missed it, this traded at just under $50 a share last January, and has gone hyperbolic if you will, reaching a high of $209 a share just last November.
My opinion is that this stock is outrageously overvalued by almost any metric or stretch of the imagination. At $180 a share, its trading at 68x trailing twelve month earnings (TTM earnings), and on a forward basis, is trading at 46x (ie its P/E ratio). On a TTM cash earnings basis, my preferred method of looking at stocks, its a 0.33% FCF yield. Not 33%. 0.33%, less than 1%. I think I can make more with a one year bank CD, but more on that later.
So, to back up for a second, lets discuss the business. Netflix is a very popular DVD by mail rental company. They essentially killed the Blockbuster retail model of distributing rental movies. They have 280 or so distribution centers around the US, so that most of the time you can order a movie online and receive it the next day. You mail it back, pay $16 a month for 3 DVDs at a time, and really its quite brilliant. They reached profitability in 2003, and as you can guess, improved margins as they added subscribers. Its a business model that benefits from economies of scale, and they have gone from a couple million subscribers, to today they have 18mm subscribers.
On a margin basis, between 2005 and 2008 they consisently did 5-6% net income margins. Revenue grew quite nicely from $272mm in 2003 to $1.4BB by year end 2008. Then, their business model evolved. They got into the online business of streaming TV shows & movies. This is different than what Amazon, iTunes are doing, which is offering online movie download rentals. Download time is too long for many people, and at $5 / rental on iTunes, too expensive too. So Netflix came in and offered a deal whereby for $8 a month, you can stream unlimited TV/movie content from their online library. You might have heard of Hulu, which streams TV online, but its an advertising based model that is free.
So, Netflix rolled out its streaming service in 2008, and its been wildly successful. Here's why. To get streaming content, Netflix went to Epix (which owns Paramount, MGM, Lionsgate) and paid them something like $25mm a year fixed for all of their movie content. Then they did the same with Starz paying them something like $30mm a year for all of their titles. Together that got them a good library of movie titles. I believe the company's website lists 2,000 movies available for streaming, and then they have 100,000 in their movie DVD library in total.
Basically it was a major coup, and the guys who cut the deals at Starz and Epix now look like idiots. They didnt realize that movie streaming would be so popular, nor did they realize that this might cut into their market with the cable companies. But now the cat is out of the bag. When the original Epix deal expired last September 1st, they cut a new deal. I could not find the price tag, but reports are that it will cost Netflix $1BB over the next 5 years. Yes, thats a BILLION DOLLARS for 5 yrs, or about $200mm per year. Far higher than the $25mm they paid prior.
The same thing will happen when the Starz contract comes due October 1st of 2011. That deal is $30mm/ year now. Estimates are that it will go to $300mm PER YEAR, up 10 fold.
So what happened to earnings in Q3 with only one month of the new Epix deal? EPS fell from 80c in the June quarter, to 70c in the September quarter. Net income margins which looked great under the prior deals, fell from 8.5% in Q2 2010, to 6.9% in Q3 2010. And that is one month with the new Epix deal.
As for Q4, the company already guided to a very wide range of earnings, from 59c to 74c a share. Recall they did 70c in Q3. Either way, that is a range of margins between 5.5% and 6.7%, still going down.
Now the problem here and the problem with the short is cash vs accrual accounting. You will always hear me refer to CASH based earnings. Cash is all that really matters (unless you like your earnings of the Enron variety, faked). I noted that while Q3 earnings were not great, declining margins, EPS down sequentially, I also noted that D&A didnt change much. However, Capex spending DID. That is, cash went out the door to fund the Epix deal, and yet they havent really starting amortizing it into earnings. (and yet earnings still declined).
So, generally to get to cash earnings, I compare D&A and cash capex spending over time. Netflix has posted D&A of $73mm in Q1, 75mm in Q2, and 86mm in Q3 this year. Capex which should track it reasonably closely, has changed from $101mm in Q1, $92mm in Q2, and $149mm in Q3. So in total they have cash costs of $109mm, that they have YET TO EXPENSE compared to D&A. (ie, total capex less D&A is $109mm).
Well, you should guess that this $109mm of additional capex (movie content mostly), will have to get expensed. D&A will rise next year, and cash costs are going way up (with a new Starz deal). For a company that did a total of $145mm in Net Income in the last 12 months, $109mm of D&A expenses waiting to roll into the Income Statement is a LOT. Hence cash earnings are much lower than real earnings here.
My math is they did $0.60 in CASH EPS in the TTM period, vs reported earnings of $2.65. And with the Starz deal next year hitting them the same way, my basic belief is that they are turning more into a cable company. Yes, Netflix got a 2 year free bye from some major movie programmers to get cheap content and deserves a lot of credit for it. But this business model is very very unsustainable. Costs are going to rise another $270mm per year starting this October probably as the Starz contract is renegotiated too.
Net net, with both new contracts, I calculate EPS will at best be $2.70 per share. That is, you are paying $9.7BB for a company that will do around $150mm in Net income. Thats 67x earnings.
Admittedly I might be early with the short. They might depreciate these cash outlays on a more back end loaded basis. And, since Starz doesnt roll off until next October 1st, earnings until after that date will look decent.
Another item with this stock is internet usage. That is, consumers are in many cases using CABLE company internet service in many cases to get streamed movies/TV, that is Cable type service. The Cable guys dont like this clearly. Some estimates are that Netflix streaming accounts for 20% of all internet traffic in the evening. Networks are getting strained, and there is a high likelihood that within a year or two, Internet Service Providers (ISPs) will start rolling out tiered pricing. Cisco (I like that stock) predicts internet traffic will triple by 2014. Tiered pricing will mean that the $8/ month model cannot continue. Programming costs will have to get passed on to subscribers, and perhaps their internet usage fees will go up as well. ISPs will put up with only so much free riding, especially to the extent that it eats away at their own business (cable co's).
Net net though, I finally assumed that the downside to this stock is that margins stay flat at 7% (although I think they'll normalize at 5-6%). Further I assume that over the next 3 years, they grow 30% per year. That would take the company from 18mm subscribers today to 37mm by 2014. To put that in perspective, there are 99mm total cable/satellite subscribers in the US, and 73mm homes in the US with internet service AND a DVD player. 37mm subs would be over 50% market share of the available market, which is just enormous, and not terribly likely. I am quite sure AOL, Amazon, Apple, and a dozen other big smart companies are going to figure out a way to stream movies over the internet. Barriers to entry are not high. Nobody has this kind of market share.
But even if they achieve this, at 7% Net margins, the company would be generating about $6.25 in EPS. And at $180 per share, still equates to a very high P/E multiple of 29x. Wow, even today, Apple trades at 15x, GOOG trades at 18x, and mature cable companies like TWC around 15x. I estimate that this stock could trade within a range of $240 down to $75. Its hard to guess an upper limit, because irrational stocks like this can continue to trade irrationally. However, I personally would value this stock at 30x 2011 earnings at most, which is around $95, using a more reasonable $3.15 in EPS for 2011. (vs the Street at $3.86 in EPS).
There isnt accounting fraud here, but unrealized expenses on the balance sheet are going to come back to haunt them. Management is very solid here. Their marketing is phenomenal, by all accounts people LOVE their service. The CEO it should be noted though, has sold piles of stock. I couldn't even add it all up, it was many many 10,000+ share blocks every single month last year. He's a smart guy, he knows when to sell too.
My opinion is that this stock is outrageously overvalued by almost any metric or stretch of the imagination. At $180 a share, its trading at 68x trailing twelve month earnings (TTM earnings), and on a forward basis, is trading at 46x (ie its P/E ratio). On a TTM cash earnings basis, my preferred method of looking at stocks, its a 0.33% FCF yield. Not 33%. 0.33%, less than 1%. I think I can make more with a one year bank CD, but more on that later.
So, to back up for a second, lets discuss the business. Netflix is a very popular DVD by mail rental company. They essentially killed the Blockbuster retail model of distributing rental movies. They have 280 or so distribution centers around the US, so that most of the time you can order a movie online and receive it the next day. You mail it back, pay $16 a month for 3 DVDs at a time, and really its quite brilliant. They reached profitability in 2003, and as you can guess, improved margins as they added subscribers. Its a business model that benefits from economies of scale, and they have gone from a couple million subscribers, to today they have 18mm subscribers.
On a margin basis, between 2005 and 2008 they consisently did 5-6% net income margins. Revenue grew quite nicely from $272mm in 2003 to $1.4BB by year end 2008. Then, their business model evolved. They got into the online business of streaming TV shows & movies. This is different than what Amazon, iTunes are doing, which is offering online movie download rentals. Download time is too long for many people, and at $5 / rental on iTunes, too expensive too. So Netflix came in and offered a deal whereby for $8 a month, you can stream unlimited TV/movie content from their online library. You might have heard of Hulu, which streams TV online, but its an advertising based model that is free.
So, Netflix rolled out its streaming service in 2008, and its been wildly successful. Here's why. To get streaming content, Netflix went to Epix (which owns Paramount, MGM, Lionsgate) and paid them something like $25mm a year fixed for all of their movie content. Then they did the same with Starz paying them something like $30mm a year for all of their titles. Together that got them a good library of movie titles. I believe the company's website lists 2,000 movies available for streaming, and then they have 100,000 in their movie DVD library in total.
Basically it was a major coup, and the guys who cut the deals at Starz and Epix now look like idiots. They didnt realize that movie streaming would be so popular, nor did they realize that this might cut into their market with the cable companies. But now the cat is out of the bag. When the original Epix deal expired last September 1st, they cut a new deal. I could not find the price tag, but reports are that it will cost Netflix $1BB over the next 5 years. Yes, thats a BILLION DOLLARS for 5 yrs, or about $200mm per year. Far higher than the $25mm they paid prior.
The same thing will happen when the Starz contract comes due October 1st of 2011. That deal is $30mm/ year now. Estimates are that it will go to $300mm PER YEAR, up 10 fold.
So what happened to earnings in Q3 with only one month of the new Epix deal? EPS fell from 80c in the June quarter, to 70c in the September quarter. Net income margins which looked great under the prior deals, fell from 8.5% in Q2 2010, to 6.9% in Q3 2010. And that is one month with the new Epix deal.
As for Q4, the company already guided to a very wide range of earnings, from 59c to 74c a share. Recall they did 70c in Q3. Either way, that is a range of margins between 5.5% and 6.7%, still going down.
Now the problem here and the problem with the short is cash vs accrual accounting. You will always hear me refer to CASH based earnings. Cash is all that really matters (unless you like your earnings of the Enron variety, faked). I noted that while Q3 earnings were not great, declining margins, EPS down sequentially, I also noted that D&A didnt change much. However, Capex spending DID. That is, cash went out the door to fund the Epix deal, and yet they havent really starting amortizing it into earnings. (and yet earnings still declined).
So, generally to get to cash earnings, I compare D&A and cash capex spending over time. Netflix has posted D&A of $73mm in Q1, 75mm in Q2, and 86mm in Q3 this year. Capex which should track it reasonably closely, has changed from $101mm in Q1, $92mm in Q2, and $149mm in Q3. So in total they have cash costs of $109mm, that they have YET TO EXPENSE compared to D&A. (ie, total capex less D&A is $109mm).
Well, you should guess that this $109mm of additional capex (movie content mostly), will have to get expensed. D&A will rise next year, and cash costs are going way up (with a new Starz deal). For a company that did a total of $145mm in Net Income in the last 12 months, $109mm of D&A expenses waiting to roll into the Income Statement is a LOT. Hence cash earnings are much lower than real earnings here.
My math is they did $0.60 in CASH EPS in the TTM period, vs reported earnings of $2.65. And with the Starz deal next year hitting them the same way, my basic belief is that they are turning more into a cable company. Yes, Netflix got a 2 year free bye from some major movie programmers to get cheap content and deserves a lot of credit for it. But this business model is very very unsustainable. Costs are going to rise another $270mm per year starting this October probably as the Starz contract is renegotiated too.
Net net, with both new contracts, I calculate EPS will at best be $2.70 per share. That is, you are paying $9.7BB for a company that will do around $150mm in Net income. Thats 67x earnings.
Admittedly I might be early with the short. They might depreciate these cash outlays on a more back end loaded basis. And, since Starz doesnt roll off until next October 1st, earnings until after that date will look decent.
Another item with this stock is internet usage. That is, consumers are in many cases using CABLE company internet service in many cases to get streamed movies/TV, that is Cable type service. The Cable guys dont like this clearly. Some estimates are that Netflix streaming accounts for 20% of all internet traffic in the evening. Networks are getting strained, and there is a high likelihood that within a year or two, Internet Service Providers (ISPs) will start rolling out tiered pricing. Cisco (I like that stock) predicts internet traffic will triple by 2014. Tiered pricing will mean that the $8/ month model cannot continue. Programming costs will have to get passed on to subscribers, and perhaps their internet usage fees will go up as well. ISPs will put up with only so much free riding, especially to the extent that it eats away at their own business (cable co's).
Net net though, I finally assumed that the downside to this stock is that margins stay flat at 7% (although I think they'll normalize at 5-6%). Further I assume that over the next 3 years, they grow 30% per year. That would take the company from 18mm subscribers today to 37mm by 2014. To put that in perspective, there are 99mm total cable/satellite subscribers in the US, and 73mm homes in the US with internet service AND a DVD player. 37mm subs would be over 50% market share of the available market, which is just enormous, and not terribly likely. I am quite sure AOL, Amazon, Apple, and a dozen other big smart companies are going to figure out a way to stream movies over the internet. Barriers to entry are not high. Nobody has this kind of market share.
But even if they achieve this, at 7% Net margins, the company would be generating about $6.25 in EPS. And at $180 per share, still equates to a very high P/E multiple of 29x. Wow, even today, Apple trades at 15x, GOOG trades at 18x, and mature cable companies like TWC around 15x. I estimate that this stock could trade within a range of $240 down to $75. Its hard to guess an upper limit, because irrational stocks like this can continue to trade irrationally. However, I personally would value this stock at 30x 2011 earnings at most, which is around $95, using a more reasonable $3.15 in EPS for 2011. (vs the Street at $3.86 in EPS).
There isnt accounting fraud here, but unrealized expenses on the balance sheet are going to come back to haunt them. Management is very solid here. Their marketing is phenomenal, by all accounts people LOVE their service. The CEO it should be noted though, has sold piles of stock. I couldn't even add it all up, it was many many 10,000+ share blocks every single month last year. He's a smart guy, he knows when to sell too.
Wednesday, January 5, 2011
Thoughts on Tech Stocks
As a value investor, I am still amazed at what value names pop up on my screens in various markets. In the early 1990s it was financials, then it was telecom after Worldcom blew up. In the early 2000s it was energy: coal, oil & gas, and power companies were distressed value plays. Then it was financials again in 2008. (OK I was in high school for the S&L crisis, but it was big news in Texas).
There has always been a sprinkling of healthcare too, depending on which medication or device the government decided to cut reimbursements for. But never have I looked at computer and tech companies as distressed or deep value investments. Ever. And perhaps they aren't really deep value, but generally I have never seen so many big, growing, successful blue chip tech stocks trading for ridiculous multiples.
What I hear is that these arent growth stocks anymore. They have been relegated to the bin of cyclicals: companies that just flow up and down with the world economy. And, that is quite true. They dont grow forever. But then again, show me a company that does?
So, yesterday McDonald's got blasted 3%, so I was taking a look. It seemed like the most obvious "grow forever" stock. However, its revenue got hurt in 2009 after being up in 2008. Yea, its countercyclical. Anyway, the stock is going to do $5.00 in EPS in 2010 according to the street, and at 75 bucks a share, is trading at 15x earnings.
Similarly I have been digging into Apple, HP, Intel, Cisco all the blue chip tech bellweather stocks. I mean, CSCO I bought last month, its trading at 8x cash earnings. Apple, taking out the cash (ala Cisco), trades at 15x 2011 earnings. And they grew revenue over 50% last year! Ok that will slow down beyond 2011, but its gotta be far better than 4-5%. McDonalds trades for the SAME multiple on 2011 earnings that Apple trades at, 15x. Astonishing. Everyone should own Apple in their PA.
Similarly, I swapped out of one stock in my personal account and bought some HPQ today, Hewlett Packard. I paid 43.90 thereabout. I didn't really want to add exposure to the markets given where we are, hence selling one of my other names.
So for reference, the market has rallied 25% in the last 6 months, and HP is up 2%. Its gotten crushed on lots of news, including tabloid style tidbits that former CEO Mark Hurd was hitting on a former porn star, etc etc. He got fired last August, and by November he was replaced with Leo Apotheker. Leo formerly spent 20 years at SAP, his last one acting as a relatively forgettable CEO. Hurd was by all accounts a solid CEO, and Oracle quickly hired him after getting fired last August. Primarily that drove the stock down.
Anyway, just last spring HPQ was trading in the $53-54 range, and with the summer correction, really was oversold in my opinion, falling even below $40/share.
So, why am I buying HPQ around $44? First of all, I always do some accounting work to see if earnings are real or not. That means looking at the CF statements, recreating what cash earnings must be to get to a real EPS figure. At first blush, I assumed that HP's reported "non-GAAP EPS" would be some bogus number with so many fake add-backs that real cash earnings were closer to GAAP EPS. And here there is a big difference.
In 2010 (FYE October), GAAP earnings were $3.69 per share. "Non-GAAP EPS" was $4.25. Big difference, so which do you use? Their financials bridge the difference as intangible amortization expenses, plus a smidge of restructuring charges/merger fees (overpaid to some banker like goldman). Since their past acquisitions were cash based, the cash number is already excluded here. Anyway, my point is that on a cash basis, I calculate EPS to be $4.50 per share. In essence, capex spending has been lower than D&A and the company's adding back of intangible amortization is also legit.
So, for 2011, the company has guided to $5.16 in EPS, which is exactly what I get on a cash basis assuming they spend a little more in capex. So, on a $44 stock, that will do well over $5 in earnings, i find this stock to be way too cheap. Thats 8.5x earnings, half the multiple almost of the S&P in 2011. The S&P is around 14x P/E.
Generally speaking, to me an 8.5x multiple of earnings, or a near 12% Free Cash Flow yield is indicative of a business that will decline. Pfizer trades at 8x earnings. But that is because something like 40% of its revenue goes off-patent in the next 4-5 years. Huge revenue declines should follow. As far as HP goes, I dont see high growth, but this isnt declining. 2010 revenue growth was 10%. Next year it should be at least 5%.
As far as revenue risk, 45% of revenue today is Enterprise Revenue. That is servers, storage products and services to businesses. Its not a consumer PC company anymore. In fact only 25% of income is from the PC business. Printers are 20% of the company, and there is a ton of recurring high margin revenue here. Overall revenue has grown from $87BB to $126BB in 5 years. Thats a 15% a year average growth per year. Next year guidance only assumes 5% topline growth. And in fact, the company basically took the january 2011 quarter and annualized it to get to its 2011 guidance. That tells me its pretty likely they'll beat it this year, and do BETTER than the $5.16 EPS number out there.
I am not a techie, never have been. But generally I suspect that the shift to cloud computing is going to be important for these guys. PC sales are under pressure with the increase in mobile computing, but I still think people want a desktop computer at home. Emerging markets are growing, and 65% of HP's revenue is international. This long run will grow at a decent clip.
As far as upside, downside in the stock: I think using a very conservative $5.00 in EPS in 2011 is safe. That's below guidance from the company, and well below the street's estimates of $5.72. At 13x, still below a market multiples, thats $65/share. Downside is that they stay at 4.25 in EPS in 2012 in a recession (EPS was down very small in 2008 vs 2007), and at 9x, that would get you $38 per share. That was also the lows last year. Down $6-8, up $20. Perhaps a more realistic view is high 50s, still good risk reward.
If you are looking at comps, Dell trades at 13x, Oracle 20x, IBM 12x.
I guess the unmentioned problem with this stock, and the true reason for its trading so poorly, is that the market doesnt like how HP uses its cash. One, they have made some acquisitions that were expensive (paid $14BB for EDS in August 2008 at the peak). Two, they pay almost zero dividends, and instead buy back massive amounts of stock with its free cash flow. Oracle had a huge run this year upon upping and announcing their dividend, and that is a big hope here. It could get ugly too if the new CEO, Leo Apotheker, decides he wants to buy SAP, his former employer. It would be tough to pull off, SAP's market cap is 60BB vs HPQ's 100BB market cap. But you never know.
There has always been a sprinkling of healthcare too, depending on which medication or device the government decided to cut reimbursements for. But never have I looked at computer and tech companies as distressed or deep value investments. Ever. And perhaps they aren't really deep value, but generally I have never seen so many big, growing, successful blue chip tech stocks trading for ridiculous multiples.
What I hear is that these arent growth stocks anymore. They have been relegated to the bin of cyclicals: companies that just flow up and down with the world economy. And, that is quite true. They dont grow forever. But then again, show me a company that does?
So, yesterday McDonald's got blasted 3%, so I was taking a look. It seemed like the most obvious "grow forever" stock. However, its revenue got hurt in 2009 after being up in 2008. Yea, its countercyclical. Anyway, the stock is going to do $5.00 in EPS in 2010 according to the street, and at 75 bucks a share, is trading at 15x earnings.
Similarly I have been digging into Apple, HP, Intel, Cisco all the blue chip tech bellweather stocks. I mean, CSCO I bought last month, its trading at 8x cash earnings. Apple, taking out the cash (ala Cisco), trades at 15x 2011 earnings. And they grew revenue over 50% last year! Ok that will slow down beyond 2011, but its gotta be far better than 4-5%. McDonalds trades for the SAME multiple on 2011 earnings that Apple trades at, 15x. Astonishing. Everyone should own Apple in their PA.
Similarly, I swapped out of one stock in my personal account and bought some HPQ today, Hewlett Packard. I paid 43.90 thereabout. I didn't really want to add exposure to the markets given where we are, hence selling one of my other names.
So for reference, the market has rallied 25% in the last 6 months, and HP is up 2%. Its gotten crushed on lots of news, including tabloid style tidbits that former CEO Mark Hurd was hitting on a former porn star, etc etc. He got fired last August, and by November he was replaced with Leo Apotheker. Leo formerly spent 20 years at SAP, his last one acting as a relatively forgettable CEO. Hurd was by all accounts a solid CEO, and Oracle quickly hired him after getting fired last August. Primarily that drove the stock down.
Anyway, just last spring HPQ was trading in the $53-54 range, and with the summer correction, really was oversold in my opinion, falling even below $40/share.
So, why am I buying HPQ around $44? First of all, I always do some accounting work to see if earnings are real or not. That means looking at the CF statements, recreating what cash earnings must be to get to a real EPS figure. At first blush, I assumed that HP's reported "non-GAAP EPS" would be some bogus number with so many fake add-backs that real cash earnings were closer to GAAP EPS. And here there is a big difference.
In 2010 (FYE October), GAAP earnings were $3.69 per share. "Non-GAAP EPS" was $4.25. Big difference, so which do you use? Their financials bridge the difference as intangible amortization expenses, plus a smidge of restructuring charges/merger fees (overpaid to some banker like goldman). Since their past acquisitions were cash based, the cash number is already excluded here. Anyway, my point is that on a cash basis, I calculate EPS to be $4.50 per share. In essence, capex spending has been lower than D&A and the company's adding back of intangible amortization is also legit.
So, for 2011, the company has guided to $5.16 in EPS, which is exactly what I get on a cash basis assuming they spend a little more in capex. So, on a $44 stock, that will do well over $5 in earnings, i find this stock to be way too cheap. Thats 8.5x earnings, half the multiple almost of the S&P in 2011. The S&P is around 14x P/E.
Generally speaking, to me an 8.5x multiple of earnings, or a near 12% Free Cash Flow yield is indicative of a business that will decline. Pfizer trades at 8x earnings. But that is because something like 40% of its revenue goes off-patent in the next 4-5 years. Huge revenue declines should follow. As far as HP goes, I dont see high growth, but this isnt declining. 2010 revenue growth was 10%. Next year it should be at least 5%.
As far as revenue risk, 45% of revenue today is Enterprise Revenue. That is servers, storage products and services to businesses. Its not a consumer PC company anymore. In fact only 25% of income is from the PC business. Printers are 20% of the company, and there is a ton of recurring high margin revenue here. Overall revenue has grown from $87BB to $126BB in 5 years. Thats a 15% a year average growth per year. Next year guidance only assumes 5% topline growth. And in fact, the company basically took the january 2011 quarter and annualized it to get to its 2011 guidance. That tells me its pretty likely they'll beat it this year, and do BETTER than the $5.16 EPS number out there.
I am not a techie, never have been. But generally I suspect that the shift to cloud computing is going to be important for these guys. PC sales are under pressure with the increase in mobile computing, but I still think people want a desktop computer at home. Emerging markets are growing, and 65% of HP's revenue is international. This long run will grow at a decent clip.
As far as upside, downside in the stock: I think using a very conservative $5.00 in EPS in 2011 is safe. That's below guidance from the company, and well below the street's estimates of $5.72. At 13x, still below a market multiples, thats $65/share. Downside is that they stay at 4.25 in EPS in 2012 in a recession (EPS was down very small in 2008 vs 2007), and at 9x, that would get you $38 per share. That was also the lows last year. Down $6-8, up $20. Perhaps a more realistic view is high 50s, still good risk reward.
If you are looking at comps, Dell trades at 13x, Oracle 20x, IBM 12x.
I guess the unmentioned problem with this stock, and the true reason for its trading so poorly, is that the market doesnt like how HP uses its cash. One, they have made some acquisitions that were expensive (paid $14BB for EDS in August 2008 at the peak). Two, they pay almost zero dividends, and instead buy back massive amounts of stock with its free cash flow. Oracle had a huge run this year upon upping and announcing their dividend, and that is a big hope here. It could get ugly too if the new CEO, Leo Apotheker, decides he wants to buy SAP, his former employer. It would be tough to pull off, SAP's market cap is 60BB vs HPQ's 100BB market cap. But you never know.
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