Wednesday, July 31, 2013

FPA Crescent Fund Commentary: Steve Romick on Microsoft, Oracle, and Cisco

Steve Romick, a managing partner at First Pacific Advisors, LLC, said the following about Microsoft (MSFT), Oracle (ORCL), and Cisco (CSCO) in his 2Q 2013 FPA Crescent Fund (FPACX) commentary:

"These three companies all face real challenges, including poor management and/or competition from new technologies. But we feel, in each case, the prices adequately discount those fears."

Some businesses -- especially those that reside in dynamic industries, with lots of potential competitive threats, and/or frequent technology shifts that can change fundamental business economics -- are wise to have minimal debt and carry lots of cash for defensive reasons. Those that possess a wide economic moat -- large and sustainable competitive advantages -- need no such rainy day fund.

"...all else equal, we prefer companies with strong balance sheets and this group has those. Moreover, even though cash is akin to a lead weight that depresses a company's return on capital calculation, these companies offer a much higher return on capital than the S&P 500."

Whether it makes sense for these businesses to hold on to so much cash or not, it's a mathematical certainty that return on capital is reduced by all the net cash on the balance sheet. The fact these have more than respectable return on capital while carrying all that cash says a lot about their current core business economics. Unfortunately, it says little about what those economics might look like down the road. With the best businesses this is generally not the case. The long run future economic prospects of the highest quality business -- within a range of outcomes, of course -- are far less uncertain and unknowable.

Still, in Romick's view, the three stocks remain far from expensive:

"Our three tech musketeers now trade less expensively than they have versus the S&P 500 median on a historical basis..."

Enterprise Value/Earning Before Interest & Tax (EV/EBIT) and price/earnings ratio (P/E) are the metrics Romick uses to compare the valuation of these tech stocks to the S&P 500.

"These companies had not historically offered a dividend yield, but now with cash flow exceeding internal investment opportunities, they each now pay a dividend and offer yields in excess of the market.

With certain tech stocks an adjustment to earnings (or free cash flow) needs to be made in order to understand the business economics and estimate intrinsic value.

"...our earnings (and revenue) estimates are less than that of Wall Street. We consider "owner earnings" when establishing our base case, rather than GAAP (General Accepted Accounting Principles) earnings. We, therefore, reduce net income by cash used for stock options and further ding earnings for "required" M&A (Mergers & Acquisitions) that we view as imperative to remain relevant and to sustain earnings on a going forward basis."

Adjusting earnings or free cash flow for the cost of options is certainly very important. Some choose to ignore stock-based compensation because it's a non-cash expense.*

Also, what a company spends on M&A sometimes needs to be treated a bit like necessary capital expenditures (required investments to remain competitive and deal with threats to core economics). The problem is that, at times, it's difficult to judge from the outside how necessary the target investment really is and whether management is overpaying for it. In fact, sometimes it's pretty clear they're overpaying. A tendency to overpay for acquisitions has to be subtracted from any useful estimate of intrinsic value. The amount that should be subtracted is necessarily a difficult and imprecise judgment call but very important.**

These points can easily be overlooked. If so, earning power can be made to look more attractive than it actually is. As I've said previously and more than a few times, I'm not a fan of technology businesses though I'll buy shares in them, reluctantly and in small doses, when they're very very cheap.

Romick also added this:

"We can't tell you what the world will look like tomorrow or when Bernanke will raise rates, but we will borrow a line from the investment strategist, Dylan Grice, who said it best when he quipped, 'I'm interested in the possibility of building a profitable portfolio which is robust to my ignorance.'"

Check out the commentary in its entirety. It includes lots of good charts, graphs, and other insights.

Adam

Long positions in MSFT and CSCO established at much lower than recent prices

* I
t's worth noting that adding back stock-based compensation (as is done in cash flows from operating activities section of the cash flow statement) boosts free cash flow but, for certain companies, is potentially a material source of future dilution and likely quite expensive for continuing shareholders over the long haul. Yes, it's a non-cash expense but, unlike some other non-cash expenses, it shouldn't be ignored. One way to think of this is to calculate how much net cash would be needed to keep share count stable over time. Well, that incremental cash expended is a very real cost to shareholders and should be subtracted from free cash flow for a better understanding of the business economics. It's, at the very least, a rather big stretch to consider economically meaningful any free cash flow calculation that doesn't attempt to account for the cost of stock-based compensation. For those companies that make heavy use of stock for compensation the cost is very real even if difficult to estimate. The reality is that these potentially material costs are generally rather difficult to pin down with any precision. Unfortunately, with stock-based compensation, the best case that can usually be expected is an estimated range of costs (the economic costs...not the accounting costs). A bit messy? No doubt, but that messiness doesn't mean the costs can be ignored to make it seem more neat than it is. Not everything that matters economically can be precisely quantified. In fact, some of the most important things can't be quantified at all.
** See the end of the Intrinsic Value - Today and Tommorrow section from Berkshire's 2010 letter on the "'what-will-they-do-with-the-money' factor" for more on this. This explanation can also be found toward the end of the past two Berkshire annual reports.)
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