Microsoft: Left in the Dust - and Brimming with Value

As we watch the Facebook saga unfold in somewhat predictable fashion (see HM Payson Research Note: "Facebook: Buyer Beware," May 17, 2012), we cannot help but notice some compelling values at the other end of the large-cap technology pond. Although widely perceived as a boring - or even dying - destroyer of shareholder value, Microsoft strikes us as one of the more compelling investment propositions in any market sector today.

Microsoft Windows is the dominant operating system in the personal computing market, with a 92% global share. This has been both a blessing and a curse for shareholders as the proliferation of mobile computing platforms (tablets and phones) has caused PC growth to slow dramatically and fueled the popular perception that Microsoft will become irrelevant. The company's fundamental performance tells a very different story, however. For example, over the last five years, Microsoft's revenues have increased by 44%, equating to an 8% compounded annual rate - an impressive feat for any company during this challenging economic period. Even in the fiscal year ended June 2012, in the face of a product cycle lull and Apple's meteoric success, Microsoft's revenues rose by almost 6%. Meanwhile, both net profit margins and returns on capital presently exceed 30%; hardly symptomatic of a dying company!   Underpinning this strong fundamental performance is the reality that Microsoft is much more than just Windows. Its end-markets extend well beyond consumers and the PC. The company has a very strong presence in the corporate environment, including business applications and other related software running workstations, servers and "the cloud". The Business division (the Office application suite) and the Server and Tools division (corporate servers and cloud installations) comprise nearly 60% of total revenue, are growing at healthy rates and are very profitable. Meanwhile, the Windows 8 launch due in October is expected to give the PC business - both consumer and corporate - a significant boost. Despite this strong performance, Microsoft shares have been moribund for more than a decade. In fact, the stock today languishes in the $30 range, 40% below its all-time peak in late 1999. Of course, technology valuations generally were irrational in 1999, but the end result is that today Microsoft represents an impressive investment proposition. The P/E ratio stands at a mere nine times the estimate of the coming year's earnings per share, and the price-to-sales ratio of 3.5 is very reasonable for such a profitable franchise. Using the methodology described in our earlier communication on healthcare stocks (See "Healthcare Stocks: Attractively Valued No Matter What Happens in Washington" July 10, 2012), our conclusion is that the current price implies a growth rate of negative 6%. Granted, Microsoft's growth rate has slowed, and will likely continue to moderate, but this strikes us as overly pessimistic.   What we like most about Microsoft is its balance sheet quality and potential to produce a growing stream of income for our clients. The company holds more than $60 billion in cash and equivalents, and carries very modest levels of debt. The dividend yield today stands at 2.6%, and has grown by an average annual rate of 15% for the last five years. Yet, with a 9% free cash flow yield, the company is capable of committing to a much larger dividend and/or stepped-up share repurchases. In fact, we estimate that a yield of 7% on today's price (combined dividends and stock repurchase) is well within reach, if management is willing. Though the pace of such actions has been frustratingly slow, we suspect Cisco's recent actions (a 75% dividend hike, causing an immediate 10% jump in its share price) have not gone unnoticed in the Redmond, Washington executive suites. Investors are both skeptical about Microsoft's future growth and justifiably impatient with a management team whose acumen for mapping and executing on a strategic direction has been rightly questioned. Failed efforts to organically develop new growth businesses, as well as some ill-advised and expensive acquisitions, have drawn the ire of many critics and caused the stock to fall out of favor with growth-oriented investors. But once again, uncertainty and unpopularity represent the source(s) of many outstanding investment opportunities. For those seeking income, a healthy total return, and quality in an otherwise uncertain, low return environment, Microsoft stands out.

Europe: Uncertainty and Opportunity

The sovereign debt crisis in Europe and subsequent worldwide economic slowdown has been the top news story and at the forefront of many investors’ minds for nearly 3 years. Fiscal austerity, likely restructuring of the debt of the peripheral sovereigns, and a reluctance to implement needed structural reforms within the European Union (namely, more centralized control of member country finances) will present a persistent headwind to global economic growth. Yet, in this environment of uncertainty and pessimism, we believe there are excellent investment opportunities; one simply needs to dig a little deeper to unearth them.

Securities markets are forward looking and often discount good or bad economic news well before the actual economic numbers are published. This swift incorporation of a changing economic outlook into securities prices makes investing based on the timing of economic trends notoriously difficult. For a vivid example of this phenomenon, we need only look back to the market’s behavior leading up to the 2008-2009 financial crisis. Table 1 shows the performance (price only) of the S&P 500 from the end of October 2007 to the end of March 2009. The market fell by 53%, with much of the fall coming well before the National Bureau of Economic Research declared the recession.

A basic tenet of our core investing philosophy is that a bad economic outlook does not always equate to a bad investment outlook. Usually it’s quite the opposite. This is so because investment success or failure is largely determined by the price an investor pays relative to the future cash flows he can expect to receive. A poor economic climate almost always provides great investing opportunities in the way of depressed equity prices rendered by pessimistic market psychology.
In March 2009 the economic outlook looked grim for the United States. The bursting of the housing bubble and melt down in the mortgage market engendered a massive liquidity crunch that froze credit markets. Economic activity fell precipitously; and with so much bad debt in the system, it was hard to imagine business activity wouldn’t continue to deteriorate – never mind see improvement. And yet, as Table 2 illustrates, an investment in the S&P 500 in March 2009 provided a return of 85% (price only) through June of this year. Historic rallies are born in the depths of crises.

Today the MSCI Euro Index, comprised of the countries that use the Euro as their currency, is in the throes of a severe bear market. As Table 3 shows, this index is down 48% from its October 2007 high (price only, local currency), in a bear market similar in size to the 2008-09 S&P bear market (see above). At these levels we see some interesting investment opportunities emerging.

Our process of identifying opportunities begins with yield, which we define as value inuring to the benefit of shareholders – including earnings, cash flow, and dividends – divided by the price of the investment. In times of economic stress and foreboding headlines, markets sell off and yields rise providing opportunity. Conversely, with good economic environments and cheery headlines, prices rise and yields fall, reducing prospective investment returns. As Warren Buffett says “you pay a high price for a rosy outlook”.
A specific example of a European stock that we have liked for several years now is Diageo. It has provided excellent returns since the beginnings of the Greek crisis in October of 2009. As Chart 1 shows Diageo (Ticker: DEO) has provided a total return of almost 72% since October 30, 2009, far exceeding the MSCI Euro Index total return of -1.9%. At the time we found the valuation of the shares of this high-quality company very attractive: the cash flow yield was 8.5%, the earnings yield was over 7%, and the dividend yield approached 4%. This is a perfect example of a great company with attractive yields providing a wonderful investment opportunity in a horrible economic environment.


Looking forward, the MSCI Euro Index looks attractive to us. Table 4 compares where the MSCI Euro Index was in October 2007 and where it is today. Good relative investment returns might come from eventual margin expansion, and the index’s high current earnings and dividend yields.

We continue to look for high quality European companies whose price has fallen more that their business fundamentals warrant. Many large global companies based in Europe generate a majority of their revenues outside of the Euro zone and offer attractive valuations.

We are also finding companies with healthy businesses (using the discounted cash flow models in a method described in detail in our last Research Note, “Healthcare Stocks: Attractively Valued No Matter What Happens in Washington”- July 10, 2012), that are priced as if they are in permanent decline. Two examples that fit this description are in Table 5.

Heathcare Stocks Attractively Priced

We’ll leave the legal analysis of the recent Supreme Court rulings regarding the Affordable Healthcare Act to the pundits on the network news. Our priority is to preserve and grow our clients’ financial assets. In that vein, we continue to find attractive investment values in high quality healthcare companies. Relative to most other opportunities, we believe these investments will perform well whatever form healthcare reform ultimately takes.
The chart below compares the S&P Healthcare Index (the dark blue line, which consists of the largest 52 US healthcare companies) and the S&P 500 (the red line, the most widely used proxy for the US stock market). The date range is from March 23, 2010 – the day President Obama signed the Affordable Healthcare Act into law – and the current date (July 5, 2012).
The chart shows – perhaps surprisingly – that healthcare companies as a group have performed almost exactly in line with the S&P 500. Moreover, on the day of the historic Supreme Court ruling supporting the individual insurance mandate, the healthcare index responded with a big yawn, and performed in line with the overall market. This suggests to us the potential negative impacts of the Affordable Healthcare Act had been priced into healthcare stocks for some time.

The table below is a sample of companies we currently find attractive. As the first two columns show, these companies boast an average free cash flow yield of 8% and an average dividend yield of 3.1%. – which compares very favorably to the 10 year treasury yield of 1.6%.

The last column tells the most interesting story from an investing standpoint but it requires an explanation. The “Price-Implied Forward Growth Rate” represents the future growth rate required to support the current price of each company based upon several simple assumptions and inputs we use to calculate this. We solve a “growth equation” for the future growth rate implied from today’s stock price[1]. This contrasts with the conventional way of applying this equation in which an analyst uses a projected growth rate to solve for a target price (a method commonly used by Wall Street analysts).

By solving for the growth rate instead of attempting to predict it, we can better understand the market assumptions underlying the price and begin to identify the better relative values. As shown in the table, the current prices of the six companies imply that revenues will decline 3% annually, in perpetuity. This seems too pessimistic to us.

Even in an environment of more regulation and less price inflation, healthcare companies will probably experience some growth from new products, aging populations in developed countries, global population growth, and increased exports to emerging markets. Furthermore, the companies mentioned have the cash flows and financial flexibility to enhance shareholder value with increased dividends and share repurchases.
In conclusion, as is so often the case in investing, market uncertainty can present opportunities to invest at lower prices. The ongoing healthcare reform debate is just the latest example. The shares of many quality healthcare companies offer generous yields and the potential for price appreciation as the uncertainty is eventually replaced by actual results. Therefore, we maintain a generous representation of healthcare stocks in our clients’ portfolios.

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[1] This calculation is based upon an equation, widely used in finance, known as the “Discounted Cash Flow Model.“

Stock Market Valuation October 1st, 2011

Stock Market Valuation October 1st, 2011

Investment Idea - Life Technologies (LIFE)

Business

Life Technologies Corp. is a “picks and shovels” type business in the biotech industry. It has three main product groups: 1) molecular systems which produce products used to prepare biological samples and analyze gene functions, 2) cell systems which produce products used to grow cells and analyze cell functions and, 3) genetic systems which produce products used to sequence and analyze DNA.

The business has several attractive characteristics. First, the company sells into diversified end markets including hospitals, commercial applications, biotech and pharma, and academic and government research laboratories. End market uses include forensic testing, molecular medicine, synthetic genomics, food safety, and animal health. Second, the majority of the revenue stream is recurring. Consumables and services make up about 80% of revenues with instruments sales contributing the remaining 20%. Third, the company sells into a diverse geographic footprint. The Americas, which includes North and South America, make up about 50% of sales, Europe 32%, Japan 10%, and Asia-Pacific the remainder 10%. Growth is positive in all markets. Emerging markets, which make up about 10% of revenues, are currently growing at about 30% per annum.

Consensus Viewpoint

The majority of sell-side analysts have included margin and top line growth into their models as evidenced by consensus estimates.

The current share price, however, does not reflect future margin improvement or growth potential. This suggests that the market is either 1) unaware or misunderstands margin and growth opportunity or, 2) is skeptical of the story. As a significant portion of revenue comes from government funded biotech research, perhaps some anticipated funding cuts are already priced into shares.


Investment Thesis

LIFE shares have two main valuation improvement levers: 1) margin improvement and, 2) growth potential.

The creation of LIFE in 2008 through the merger of Invitrogen and Applied Biosciences created an entity with large potential synergies relating to cost reduction. There are several post merger margin improvement opportunities in the areas of manufacturing productivity, supply chain efficiencies, and fixed cost leverage. Management’s goal of expanding operating margins by 230 basis point over the next two or three years seems reasonable given the large redundancies between the legacy Invitrogen and Applied Biosciences businesses. A reading of LIFE’s proxy statement reveals that part of executive compensation is directly tied to ‘synergies’ giving a direct incentive to boost profitability. Using Economic Value Added (EVA) based discounted cash flow models, margin improvements prospects do not appear to be reflected the current share price.

The company makes equipment and consumable products used in the study of genes and proteins. The end uses of these products are growing rapidly, even in slower growth developed economies. LIFE’s products are used in the fast growing fields such as forensic testing, molecular medicine, food and water safety, and synthetic biology. As an example, LIFE products were used in the recent E. coli crisis in Germany. While assuming an above average growth rate in valuation models would seem reasonable, the current price does not reflect a large growth premium. Investors are getting a low cost (or possibly free) growth call option.

Valuation

Using the concept of Earnings Power Value (as defined by Columbia professor Bruce Greenwald in his book Value Investing), we approximate the no growth value of LIFE shares to be between the mid 40’s and 60 suggesting investors are not paying much (if anything for growth) at the current market price.

Our valuation estimate assumes 5% top line growth and continued margin expansion. By 2012 the top line should be about $4 billion with 35% EBITDA margins. Using TEV/EBITDA multiple of 10x with a reduce shares outstanding count of 170 million (management has indicated share buybacks are a cash use priority) we come to an intrinsic value of $70 per share.

Risk and the Value Investor

The continued adherence to efficient market theory ironically makes the market less efficient. The reason: the data hungry models used to describe optimal portfolio asset allocation equate volatility with risk. The models are indifferent to whether assets are cheap or expensive in terms of current relative and absolute yields.

The obsession with this one dimensional measure of risk may actually work against the prudent man rule. In the aftermath of the 2008 credit crunch, many professional fiduciaries, as advised by their consultants, actually increased their allocation to bonds. They did this even as the benchmark 10 year Treasury Bond yielded 2.5% (a multiple of 40 times "earnings").

The value investor's view of risk differs from the conventional view. A value investors' definition of risk is permanent capital impairment. As Dr. Michael Burry puts it in Michael Lewis's book The Big Short "real risk is stupid investment decisions". Investment success always comes down to one thing: the price paid. Everything is a buy at one price and a sell at another. Risk always increases as the price goes up.

An Important Flaw of the Efficient Market Theory

"The same finance scholars who claimed that you couldn't predict future stock price movements by looking at past stock price movements were embracing the idea that future stock volatility could be predicted by looking at past stock volatility."

From The Myth of Rational Markets by Justin Fox

This theory is the cornerstone by which the consultant industry advises institutional investors. The theory, despite the above mentioned flaw in logic (and many other flaws) will be around for some time to come because 1) it provides a C.Y.A. blanket for institutional fiduciaries and 2) a lot of consultant and academic paychecks depend on it.