Friday, January 29, 2010

Amazon vs eBay

When Amazon (AMZNreports earnings it seems lately nothing can go wrong.

Free cash flow (FCF) at Amazon was $ 2.92 billion and grew at a 114% clip.

Impressive right?

Yes, but in this case, maybe not quite as impressive as it seems. A good chunk of that growth in FCF came from accounts payables increasing faster than accounts receivable and inventories. Not exactly the highest quality source of FCF, but the company does have a rather brilliant negative working capital cycle in place.

Well, at least they do as long as the growth persists.

Essentially, it's a source of "float" that provides lots of cheap funding for expansion as long as the exceptional growth can be sustained. Of course, if invested consistently well, that funding might lead to future earning power that isn't all that obvious today.
(More than a few seem willing to pay what seems a premium valuation for those prospects.)

Now, I happen to think a more conservative and closer reflection of Amazon's full year operating FCF is net income + depreciation - capex = $ 902 + $ 378 - $ 373 = $ 907 million.

That's more than a $ 2 billion difference in FCF and much of it comes down to the working capital model. It is the increases to accounts payable (relative to more modest increases to accounts receivable and inventories) and also additions to unearned revenue (relative to amortization of previously unearned revenue) that make up quite a bit of that gap.

At the current price of $ 129/share, Amazon's Market Cap is ~$ 59.4 billion with an Enterprise Value (EV = Market Cap - Net Cash and Marketable Securities + Debt) of ~$ 53.2 billion.
(Amazon has ~$ 6.2 billion in net cash on the balance sheet.)

So the EV/FCF for Amazon = 58.7x
(vs 18.2x using the reported number)

Look at Amazon's performance over the past 3 years using net cash provided by operating activities minus capex to calculate FCF. Over those 3 years, Amazon averaged FCF of $ 1.82 billion/year.

So using that number the EV/FCF for Amazon = 29.2x

That may or may not seem too expensive for a stellar company, but here's why I think that FCF calculation doesn't reflect economic reality. It's not just that much of the so-called FCF is coming from a great working capital model and unearned revenue that shouldn't really be considered quality operating FCF.

There's also a boost from the company's stock-based compensation.*

If you adjust for these things EV/FCF is, once again, north of 50x.

Now lets try the same calculation for eBay (EBAY), who is currently treated like the "George" compared to Amazon's "Elaine".
(George being the serial underachiever on Seinfeld. Well, at least until becoming transformed in the classic 86th Seinfeld episode: "The Opposite". In that episode, successful Elaine becomes like George and vice versa.)

eBay's average 3 year FCF = ~ $ 2.3 billion

At the current price of $ 23.30/share, the market cap of eBay is approximately $ 30.8 billion and an EV = ~ $ 25.9 billion.
(eBay has ~$ 4.9 billion of net cash on the balance sheet)

So the EV/FCF for eBay = 11.4x

Unlike Amazon, the cash flow of eBay is not boosted by changes in working capital (actually eBay's FCF is reduced somewhat by changes in working capital). Like Amazon, it is boosted by stock-based compensation. Adjusting FCF lower to account for stock-based compensation raises the EV/FCF multiple to more like 13.4x.

Here is eBay's most recent results.

Amazon's operating FCF is currently increasing faster than eBay's (who knows going forward). Using my math, they actually grew it at around 50% year-over-year (not 100% plus, but still impressive). I wouldn't bet that growth rate is sustainable for very long but, who knows, maybe it is. At its current FCF multiple, eBay doesn't need to increase FCF much to justify its valuation. In contrast, to justify its multiple, Amazon has to increase FCF rapidly for a long time. The question comes down to how much confidence one has in the future prospects and what's the appropriate margin of safety.

I like the long run prospects of both businesses but am only comfortable with eBay's stock. This comes down to margin of safety. To figure out what price represents a comfortable margin of safety, the per share intrinsic value must be estimated. Well, someone else may know how to figure that out for Amazon but I don't.**

Amazon seems to be executing brilliantly (even if it's far from easy to judge -- at least for me -- the company's value), while eBay has been working through problems in its Marketplace business. Well, problems are all relative. Even during eBay's struggles, the company sustained very solid free cash flow. The recent results seem to indicate eBay has made some good progress in their Marketplace business while PayPal continues to perform very well.

So, to some degree, Amazon's premium valuation compared to eBay may be warranted, but it at least appears a bit extreme. If nothing else, the premium requires that the company continue doing very well for quite some time to produce even a satisfactory investing result.***

Now, what happens if Amazon ends up like Elaine in that Seinfeld episode and becomes George? Having Amazon's valuation normalize would certainly hurt.

All eBay has to do is keep on being George.

Even if eBay continues to be the seen as underachiever with unexciting growth prospects, it at least seems not much has to go right.

Considering the valuation, it appears that the company need only continue to generate solid free cash flow, solidify its moat, and use its excess capital wisely. No small feat (and far from a certainty) but, if nothing else, not much of its current value looks to be based upon a promising future not quite yet realized.
(Of course, it's also possible that the prospects for eBay -- real or perceived -- might even improve. A bonus when a premium isn't paid in the first place.)

Interestingly, Amazon also announced their intention to buy back up to $ 2 billion of the stock.

Amazing.

Adam

Long position in eBay

* FCF -- if calculated using net cash provided by operating activities minus capex -- for both Amazon and eBay is reduced when you adjust for stock-based compensation (which is added back in operating cash flow since it is a non-cash expense). Stock-based compensation may be a non-cash expense in an operational sense, but cash would have to be used by each company buying back shares to maintain share count (cash paid to buy shares minus what was paid to the company depending on the exercise price). That's a real cost to shareholders. Basically, if stock-based compensation is ignored, both companies boost free cash flow only in appearance. Now, the stock-based compensation number is not a perfect way to estimate the real cost, but the bottom line is FCF should be adjusted lower in order to make a more meaningful if rough estimate of the true economic per share impact on shareholders. There's a number of ways to make an informed though imprecise adjustment but, no matter how one decides to estimate the cost, it plainly can't be ignored.
(The lack of precision comes down to the number of variable involved and the inherent limitations of accounting.)
** Especially when it comes to managing the downside risk of an investment, it's best to only buy what one understands. That's necessarily unique to each investor and dependent on individual knowledge, expertise, and limitations.
*** Not via the skillful trading of price action but via increase to per share intrinsic value. I don't doubt both of these businesses might actually end up being quite valuable down the road. One just seems to have a less difficult to estimate margin of safety at this time. As far as price action goes, premium valuations can proceed to become even more so (and, similarly, a discount to value can become an even bigger discount and stay that way quite a while). In the short run and even much longer, just about anything can happen as far as stock price action goes. No view is offered here on that front. Figuring out how market prices might fluctuate near-term and beyond is difficult at best. I'll leave that game to others. In contrast, figuring out how price compares to intrinsic value is, at least occasionally, more doable. Not easy but doable. Well, at least it can be for certain assets one understands. If value is consistently judged well, and a nice discount is always paid to that estimated value, reasonably good outcomes and fewer mistakes become more likely. 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

eBay 2008 10-K

Wednesday, January 27, 2010

BRKb Joins the S&P 500

Turns out Berkshire Hathaway (BRKb) will replace Burlington Northern in the index. It will also be added to the S&P 100. Stock is up 8% in the pre-market to $ 73.50/share (or what used to be $ 3,675 per share pre-split).

Adam

CNBC article

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, January 25, 2010

Buffett on Wells Fargo

Some thoughts from Warren Buffett in this CNBC interview on Wells Fargo:

They've run into much larger losses than anybody anticipated three or four years ago but they can handle them very easily. Last year we talked about 'em having 40 billion of pre-provision income in 2009, and you know, they had it, and that easily handles 20 billion, roughly, of losses.

Becky Quick of CNBC then asked what he thought of Wells needing to issue a lot more shares. Buffett's reply:

I didn't like it. (Laughs.) No, I mean, the government forced them to issue the shares. The government's done a lot of good things for the economy and net I'm a beneficiary and Berkshire Hathaway is a beneficiary of the things overall they've done. But they cost us real money at Wells Fargo.

Speaking to Joe Kernen of CNBC, he also had this to say about Wells Fargo's revenue...

...actually when the stress test was done in the spring of last year, that's where the people evaluating them were way off, was on the revenue number. Wells did not disagree with them on the possible losses number, but they felt that the people just didn't understand the revenue potential, that were looking at them, and I agreed with them.

Superior revenue generation and low cost deposits allows Wells Fargo to earn higher pre-provision pre-tax income on its asset base than most other banks. As a result, Wells Fargo can absorb more losses during downturns through this earning power and will (all things being equal) earn a higher return on equity across business cycles. I agree that Wells Fargo did not need to raise capital but it still worked out okay for shareholders. The key reason being that they were never forced to raise capital at an extremely low price...just an annoyingly low price.

The stock should be quite a bit higher in 5 years. It's just that this process of forced dilution took some of the upside away. Personally, I don't think it is as unfair as Buffett says. It could not have been handled much better given the circumstances in my view. It would be difficult to have a stress test that was fair to every bank. The big picture here though is that WFC has approximately 50% more shares outstanding (before the crisis they had ~3.4 billion, now they have roughly 5.2 billion). That sounds bad on the surface but consider the following: By my math, they roughly doubled their asset base (from $ 600 billion to 1.2 trillion) and long-term earning power (pre-provision pretax from $ 20 billion/year to $ 40 billion/year) through the acquisition of Wachovia during that time. I'll take 50% dilution with a 100% increase in earning power any day. The bottom line is normalized after tax income should easily exceed $ 20 billion/year and the market value of the bank is $ 141 billion using last Friday's close.

Obviously future forced dilutions would damage this thesis and, though it seems remote right now, that risk of dilution remains out there.

Adam

Long position in Wells Fargo

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, January 21, 2010

Buffett on Kraft-Cadbury Deal

From this CNBC interview on January 20th.  Buffett pulls no punches here.  He doesn't like the deal.

First, he thinks they should not have sold what he thinks is a very good pizza business. In his view, the after tax proceeds (there was little tax basis) was too low relative to the earnings.

Second, he thinks they paid too much for Cadbury.

Basically, he sees it this way. They are selling the earnings of one business for 9 times to buy another at 16 or 17 times.

"...the actual multiple, if you look at the value of the Kraft stock, is more like 16 or 17 and they sold earnings at nine times. So, it's hard to get rich doing that. And I've got a lot of doubts about the deal."

Buffett had a few other comments on Kraft later in the interview...

"...I think Kraft has got a wonderful portfolio of businesses including their pizza business which Nestle now has...And I think Irene has done a good job in operations. I like Irene. I mean, she's been straightforward with me. We just disagree. She thinks it's a good deal. I think it's a bad deal. I think she's a decent person. She could be a trustee under my will. I just don't want her making this particular deal."

He added that he thinks that Kraft is still undervalued just less so after the deal. It wasn't a great deal but Kraft-Cadbury should still have a bright future.

Adam

Long position in KFT

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, January 20, 2010

Shareholders Approve 50-1 Split of BRKb

Warren Buffett took some questions at the meeting at the special shareholders meeting but, according to CNBC, Charlie Munger was not there...

Charlie Munger is not present, but there is a paper cutout with his photo. Buffett also has a recording of Charlie saying, "I have nothing to add" that's been played a few times after Buffett answers a question. (That's what Charlie often says after Buffett answers a question during a lengthy Q&A session at the regular shareholders meeting each May.) - CNBC

He also had some comments on BRKb being added to the S&P 500.

He tells shareholders that it would now be "logical" for Berkshire to be added to the S&P 500 now that the Class B shares will be trading in double-digits with greater liquidity and volume. He thinks that will happen eventually because the company will be so large it can't be ignored. It would be a slight benefit to shareholders, he thinks, to be added to the S&P.

He adds, "The B may be the tail that wags the dog now.- CNBC


In the CNBC article, Buffett also said that the Burlington Northern deal was not cheap and that he would want to split the stock even if that deal did not end up going through.

Adam

Long BRKb

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, January 18, 2010

On Mutual Fund Performance

This recent Wall Street Journal article points out that of the 2,301 stock funds (those with over $ 100 million in assets) just 3% have positive returns (source: Morningstar) over the past two years.

Seems reasonable to look at 2008 and 2009 (at least) to gauge the performance of money managers.

Many lost 40-60% in 2008. Some of the coverage of 2009 mutual fund performance has ignored what happened the year before.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, January 15, 2010

Diageo's Captain Morgan

While Diageo's (DEO) stock price has gotten a bit expensive (not outrageously expensive...but a bit), it remains a very good business with a wide moat, modest but steady growth prospects and by far the best combination of global distribution and brands among spirits makers. Diageo has 8 of the top 20 global brands. In the short run the global recession has caused some trade down to occur away from the firm's premium brands but this should not be a long-term problem. In the long run it seems reasonable to expect the business to go on producing high returns on capital. Growth will probably be steady but not spectacular.

Diageo's operating margins worldwide approach 30% and are even higher in the U.S. Its brand portfolio includes: Baileys, Tanqueray, Smirnoff, Johnnie Walker, Jose Cuervo, Guinness, and Captain Morgan among others. Most of these brands are number 1 or 2 in their respective categories. By my math approximately 60 million servings of Diageo products are consumed everyday.

This Wall Street Journal article describes the history of Captain Morgan, one of the company's many successful brands and the fastest growing rum brand in the world. Captain Morgan has 25% of the global rum market.

From the article:

Long before Captain Morgan became a hit in the States, it was so associated with serious drinking in Canada that Maritime Provinces slang for a bender is to be "out with the Captain."

John Steinbeck's first novel was "Cup of Gold: A Life of Sir Henry Morgan, Buccaneer, with Occasional Reference to History." In it, he writes of Morgan's plundering and... 

...then pulling his fleet of ships up to an island. Morgan tells his men that he wants to reward them: "He rolled out forty kegs of rum onto the beach." The drunken crews are soon too far gone to notice that Morgan and his core group of pirates have sailed off in the night with all the treasure.

The article references William Geist writing about a Rolling Stones concert...

On the way there, he and a friend stopped at a sketchy liquor store "where a gentleman was passed out on the floor with a smile on his face." In a hurry, Mr. Geist said, "Just give us what he's having." They got a bottle of Captain Morgan Original Spiced Rum.

I hear it is pretty good.

Adam

Long position in DEO

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, January 13, 2010

Kraft and Cadbury

Kraft (KFT) filed an 8-K today raising its earnings guidance. In the filing the company's CEO also had this to say:

"As we complete our turnaround, we’re delivering high-quality earnings growth, despite the difficult economic environment,” said Kraft Foods’ Chairman and CEO Irene Rosenfeld. “And we’re doing this while continuing to invest in our brands and businesses. As a result, we’re well positioned to deliver sustainable top-tier performance, with or without Cadbury."

With Cadbury (ADR: CBY) publishing a similar statement yesterday...both company's seem to be trying to win the "I'll be just fine without the other" PR battle.

Commenting on the 2009 performance, Todd Stitzer, Cadbury's CEO said: "Our performance in 2009 was outstanding. We generated good revenue growth despite the weakest economic conditions in 80 years."

The statement by Cadbury also gives more reasons why it believes the Kraft offer is still very unattractive.

Adam

Long position in KFT

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, January 8, 2010

Liquidity

"I think the notion that liquidity of tradable common stock is a great contributor to capitalism is mostly twaddle. The liquidity gives us these crazy booms, so it has as many problems as virtues." - Charlie Munger

Charlie Munger on Reading, Thinking, IQs, and Temperament

Here's an interview with Charlie Munger in Kiplinger's from several year ago. It covers some familiar territory.

Excerpts:

What are your work styles like?
We [Warren and I] have certain things in common. We both hate to have too many forward commitments in our schedules. We both insist on a lot of time being available almost every day to just sit and think. That is very uncommon in American business. We read and think. So Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life. But we've turned that quirk into a positive outcome for ourselves.

How important is temperament in investing?
A lot of people with high IQs are terrible investors because they've got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success.

Check out the entire interview.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Tuesday, January 5, 2010

Berkshire on Kraft Bid

From today's Berkshire Hathaway News Release on the Kraft bid for Cadbury:

Berkshire Hathaway has voted "no" on Kraft's proposal to authorize the issuance of up to 370 million shares to facilitate the acquisition of Cadbury.

...The share-issuance proposal, if enacted, will give Kraft a blank check allowing it to change its offer to Cadbury – in any way it wishes – from the transaction presented to shareholders in the proxy statement. And we worry very much that, indeed, there will be an additional change from the revision announced this morning.

To state the matter simply, a shareholder voting "yes" today is authorizing a huge transaction without knowing its cost or the means of payment.

What we know with certainty, however, is that Kraft stock, at its current price of $27, is a very expensive "currency" to be used in an acquisition. In 2007, in fact, Kraft spent $3.6 billion to repurchase shares at about $33 per share, presumably because the directors and management thought the shares to be worth more.

Does the board now believe those purchases were a mistake and that Kraft's true value is only the current price of $27 per share – and that it is therefore fine to structure a major acquisition based upon that price? Would the directors use stock as merger currency if the price were, say, $20 per share? Surely the true business value of what is given is as important as the true business value of what is received when an acquisition is being evaluated. We hope all shareholders will use this yardstick in deciding how to vote.

Our understanding is that Kraft must announce its final offer for Cadbury by January 19th. If we conclude at that point that the offer does not destroy value for Kraft shareholders, we will change our vote to "yes."


Management teams (and directors) at the acquiring company do this all too often. An undervalued currency (in this case Kraft's stock) ends up being used to buy an asset for "strategic reasons". As the battle unfolds to capture that asset the "animal spirits" kick in and before you know it the management team overpays.

Buffett is attempting to keep this process in check. Asserting some influence to avoid potential destruction of Kraft shareholder value by overpaying with a temporarily weakened "currency".

He obviously knows the game well.

If the transaction goes through at current prices, use of that undervalued stock to buy Cadbury functions as a wealth transfer from Kraft to Cadbury shareholders.

Adam

Long Berkshire Hathaway and Kraft

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, January 4, 2010

Financial Sector Growth

From Grantham's 3rd Quarter 2009 letter:

...in 1965 the financial sector of the economy took up 3% of the GDP pie. The 1960s were probably the high water mark (or one of them) of America's capitalism. They clearly had adequate financial tools. Innovation could obviously have occurred continuously in all aspects of finance, without necessarily moving its share of the economy materially over 3%. Yet by 2007 the share had risen to 7.5% of GDP!

The financial world was reaching into the GDP pie and taking an unnecessary extra 4%. Every year! This extra rent is enough to lower the savings and investment potential of the rest of the economy. And it shows. As mentioned earlier, the growth rate of the GDP had been 3.5% a year for a hundred years. It had proven to be remarkably robust. Even the Great Depression bounced off it, and soon GDP growth was back on the original trend as if the Depression had never occurred. But after 1965, the growth of the non-financial slice, formerly 3.4%, slowed to 3.2%. After 1982 it dropped to 3.1% and after 2000 fell to well under 3%, all measured to the end of 2007, before the recent troubles. These are big declines. It is as if a runner has a growing and already heavy blood sucker on him that is, not surprisingly, slowing him down. In the short term, I realize that job creation in the financial industry looked like a growth driver, as did the surge in financial profits (which we now realize were ludicrously overstated). But in the long term, like a sugar high, this stimulus was temporary and unhealthy.

The financial system was growing because it could. The more complex and confusing new financial instruments became the more "help" ordinary citizens needed from the experts. The agents' interests were totally unaligned with the principle/clients' interests.


Check out the entire letter.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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