Retailers - DDS, COST and SHLD

In the article on retailers, we examined the price/cashflow situation of several retailers. We did miss a few retailers and in this segment, we will look at DDS, COST and SHLD.

DDS - Dillards is a very cheap stock with a price/cash flow of around 4.5. Dillards has been hit by intense competition in the retail sector. With EBIT margin of around 2% and with low ROE, ROA ratios, Dillards main asset is property, plant and equipment. Dillard's equity is more or less the same in the past several years and the property value is most likely understated. A buyout by the likes of Lampert can help unlock the value in this company.

COST - Costco boasts of having Charlie Munger on the board of directors and is indeed a quality company. As is the case with Wesco Financial, costco is not cheap with a price to cash flow of about 15. It has done well compared to other retailers returning about 25% for the year and is overpriced compared to its business fundamentals. There are better bargains out there compared to Costco.

SHLD - SHLD should trade at a premium given that Eddie Lampert is allocating capital for the company. The company generares ample cash to the tune of about 800 million - 1 billion a year and the book value/price is very attractive at current prices. Barron's valued the company at close to $300/share. Even applying a healthy 50% margin of safety to that value will value the company at $150/share.

The current retail environment is offering some great bargains and a prudent investor can make a boatload of money by exploiting the current environment to the maximum.

Lowes vs Home Depot - part 2

In prior articles, we have looked at home improvement retailers - Lowes and Home Depot respectively. Let us compare the two again, based on most recently ended quarter.

Lowes currently sports a P/E of 11, market cap of 32.6 billion, price/cash flow of 6.91 and is trading close to its 52 week low at 22.11.

Home Depot currently sports a P/E of close to 11, market cap of 55.5 billion, price/cash flow of 8.29. Home Depot has better yield than Lowes at the moment.

In the most recent quarter, home depot's margins declined by 2% points from 11.3% to 9.3%. By comparison, Lowes gross margin declined by 1.42 bais points in the same quarter. Similarly, Lowes sales increased whereas Home Depot's sales declined. ( 3% increase to 3.5% decline )

Home Depot's outstanding shares decliend by 11.4%, helped by the sale of HD Supply. Lowes outstanding shares declined by 3.5% in the same period. Home Depot's book value per share is 9.64$/share where as Lowes is 10.9$/share. Clearly, buying back shares after selling Home Supply unit hasnt added more value to the book for Home Depot as the current share price for HD is around $28 where as it is $22 for Lowes.

Home Depot increased its square footage by 5.5% where as Lowes increased its square footage by 11%. Yahoo! quotes a PEG of 0.69 for Lowes and 0.99 for HD.

Lowes has advantage over HD regarding ROE, ROA and price/cash flow ratios. Lowes seems to be a better alternative to HD from both price and business point of view at this point in time.

Overview of Retail Stocks from Cash Flow Perspective

In this segment, we will look at the retailers and see which ones offer the best value from the cash flow perspective. The last week has been pretty brutal on retail stocks and it has hurt several retailers in particular. This survey looks at some ( not all ) retailers of interest to the author. The author has positions in some of the retailers noted below.

AEO - American Eagle Outfitters
Price to cashflow is around 9. ( taking out the cash in the balance sheet ) Price to free cash flow this year is 4.8%. Even without increasing cash flow, this company can payout dividends, buy out shares at a better rate than US treasury bonds. The company has zero debt and it is likely that it will grow free cash flow at a decent rate making it a far more interesting buy than the treasury bond over the next five years.

ANF - Abercrombie and Fitch
Also offers a low price to cashflow ratio of about 9 after taking out the cash from the balane sheet. The company carries little debt but the price to free cash flow yield is around 3.8%. The dividend yield in ANF is less than that of AEO.

GPS - Gap
Gap offers price to cashflow ratio of about 9 and a free cash flow yield of about 5.8%. This is significantly better than AEO and treasury bonds. However, Gap's cash flow hasnt altered a whole lot since 1999.

LTD - Limited
Limited's cash flow has also been stagnant for a few years and free cash flow has been somewhat low compared to other peers this year. Analysts are expecting a turn around in the coming years. However, this year, the stock has taken a hit.

CHS - Chico's Fas Inc
Chico's is cheap and the stock price has fallen off dramatically in the last two yearsbecause of declining sales. Still, JOSB and AEO offer better bargains at this moment.

JOSB - Joseph A Bank
Josb offers a very attractive price to cash flow ratio of 6.38. The company does have some debt but price to free cash flow yield is around 9%. Even taking last years figures, it yeilds a figure of about 6%. Looks like a good buy at these prices.

BBY - Best Buy
Best buy also looks interesting at these prices. However, it seems as though best buy is getting serious competition from WMT and friends.

BBBY - Bed Bath and Beyond
This is not as cheap as some of the others in this list. Also, we looked at this in some detail in this blog.

KSS - Kohl's Corporation
Kohl's is a growth story. It cant be compared to the other retailers in the same way.

WMT - Walmart
WMT offers a price to cash flow ratio of 9. The price to free cash flow yield is 2.1%. While this is hardly spectacular, the company spends a huge amount of money on capex in foreign contries.

TGT - Target
Target is somewhat more expensive than Walmart. This is mainly because of the same store sales have been doing better at Target than Walmart.

JCP - J.C Penney
Looks cheap - cheaper than WMT from a cash flow perspective at this moment. The company has spent a lot of money on Capex this year - hopefully this should show in the coming years.

M - Macy's
Macy's had a decline in cash flow and free cash flow this year. This could turn around in the coming years. In that case, this is a turn around play.

LOW - Lowes
Lowes offers price to cash flow of 7.47. It also yields 2.5% on free cash flow. Incidentally, lowes expects to increase both cash flow and free cash flow this year compared to last.

HD - Home Depot
More expensive than Lowes from a cash flow perspective but better from a free cash flow perspective. However, HD's use of capital and growth are both being questioned by share holders.

One can also play the ETF XRT to play the entire sector.

Microsoft Analysis

Microsoft released its quarterly report recently which beat the analyst estimates. It caused the stock to pop - we look in this section to see if Microsoft has further upside for the next couple of years.

Microsoft is expected to earn 1.81$/share in FY08 and $2.06 in FY09. The uncertainty with the EU has declined significantly after the recent deal. At a low end, Microsoft can trade at $36 - $41.2. At the high end Microsoft can fetch between $40 - $50 at the high end in the next two years.

Let us analyze each of Microsoft's businesses by segment in the latest quarter as reported.

Client: 80 cents of income for $1 of revenue.
Server: 33 cents of income for $1 of revenue.
Online: -39 cents of income for $1 of revenue.
Microsoft Business Division: 65 cents of income from $1 of revenue.
Entertainment and Devices: 8.5 cents of income from $1 of revenue.
Separately, -7.3 cents per dollar is spent on corporate level activity.

This table shows the usefulness of various Microsoft divisions. Windows client is by far the most profitable group followed by Microsoft Business Division. This is followed by Server and Tools. Entertainment and Devices and Online are losing money/marginally profitable as is corporate level activity.

Microsoft's strength is its windows (client,server) and office franchises. These businesses should continue to drive Microsoft for the next five-ten years. As the spending in corporate level activity shows, there is room for improvement in capital allocation. One can also expect stock buy backs to offset further stock dilution. On a positive note, the company is returning capital to the investors in the form of dividends which will allow the shareholders to deploy it in a more meaningful fashion.

However, for the next two years, the downturn in housing and financial sectors would continue to propel technology stocks. This should help Microsoft attain further peaks in its stock price.

Berkshire Hathaway Q3 Analysis

In this blog, we have analyzed Berkshire quarterly reports for quite some time. We will take a look at Berkshire Q3 earnings and take a look at few areas.

Morningstar had the following summary for Berkshire after Q3 in the article titled "Berkshire Puts Some Capital to Work"

On the investment side, it appears Berkshire put roughly $11 billion of its cash hoard to work in equity securities this year. This isn't overly surprising given the tumult in the markets, and chairman Warren Buffett's excellent track record of deftly deploying capital in times of financial stress. In spite of this, though, Berkshire still has more than $40 billion of cash on its balance sheet. While we recognize that roughly $10 billion is required for insurance regulatory purposes, Berkshire still has about $30 billion available for additional investment. We suspect that over time, this will be deployed into business acquisitions or situations requiring an injection of liquidity.





Since this article does an adequate job of summarizing the quarter for Berkshire, we will look at the areas this report doesnt cover.





The book value grew by 3.98% from Q2 to Q3 and by 10.9% for the first nine months of the year. So the stock is clearly on its way to better SP500 in book value growth for the year. Having beaten SP500 in four of the past six years in book value growth alone, (business value growth is greater ) looks like this is another year where Berkshire is going to out perform SP500.



The other metric to look at is operating cash flow. Last year, this came in at 10.195 billion dollars. This year in the first three quarters, this is at 11.351 billion dollars. The run rate is about 40% higher than last year. This excludes gains from investments which is a huge part of Berkshire's cash flow.



Despite investing heavily in equities in the quarter ( and the year ), the gushing cash flow continued to add to the liquidity of the balance sheet.

The intrinsic value of BRK A share is now in the 147 - 152K range when conservatively valued in my opinion. This should grow to 153-158K range by end of this year.

RDN Analysis

Radian operates in the following businesses:


Mortgage insurance business provides credit protection for mortgage lenders and other financial services companies on residential mortgage assets through traditional mortgage insurance as well as other mortgage-backed structured products.

Financial guaranty business insures and reinsures credit-based risks and provides synthetic credit protection on various asset classes through credit default swaps.


Financial services business consists mainly of our ownership interests in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”)—a mortgage investment and servicing firm specializing in credit-sensitive, residential mortgage assets and residential mortgage-backed securities—and in Sherman Financial Services Group LLC (“Sherman”)—a consumer asset and servicing firm specializing in credit card and bankruptcy-plan consumer assets.

In 2006, MI provided 49% of revenue, Financial Guarantee 23% and Financial Services 28% of revenue respectively.

Following the collapse of the subprime market and the scandal with rating subprime debt a lot of the banks and insurers have taken a huge hit to their balance sheets. In this analysis, we look to see if Radian has a future and is an investment at these prices.

In the quarter ending June 30th, each of the above segments contributed to income as follows:
Mortgage Insurance: -28.2 million
Financial Guarantee: 22 million
Financial Services: 27.3 million

The company reported a profit overall despite a negative mortgage insurance segment.

Interestingly enough, MTG also reported a profit in this quarter. But MTG reported a loss in Q3 and issued the following guidance regarding FY08.
MTG is providing the following guidance for the remainder of 2007 and the full year 2008:

•2007 Fourth Quarter paid losses approximating $270 to $290 million
• 2008 paid losses approximating $1.2 to $1.5 billion

This is the worst case loss of 1.8 billion with a shareholders equity of 4 billion for MTG.

Let us now look at Radian Q3. In the business call on 9/5/07, management offered the following scenarios for book value from 2007 through 2010. Book value of $46.9 in 07, $49 in 08, $54 in 09 and $59 in 10.

The Q3 book value came in less than what management predicted at $42.86.

From Q3 onwards, the company will only have two lines of business, mortgage insurance and financial services. In both these sectors, the company took a loss by valuing the derivatives to the mark to market criteria. Excluding this, the loss in the MI division was about 200 million. Financial Services had a slight profit. The company booked a large loss in Q3 and wrote off all of CBass investment. The company also thinks it can pay off the mortgage liability from the reserves and has adequate capitalization.

The stock holder equity was 2.2 billion in the MI division and 1.3 billion in financial services division.

Now let us look at two scenarios. The first one is the normal case as outlined by the company. This involves about 10% loss in the bubble states such as California and Texas. This is also the worst case envisioned by some other independent groups as well. The stress case involves taking 20% loss in these states and the company should do fine in this case. The reduction in book value in Q3 came in as management had expected except for the mark to market of derivatives. In the worst case, one can expect the book value to go to $30 in this scenario.

In the second scenario, we can expect the losses to continue till end of 2008 and mid 2009 at the current rate and another write off of 1 billion from the book value. This should still leave 2.1 billion in book value about 3 times the current market price for the stock. Even writing off the entire mortgage insurance business off still leaves a value of around ~$19/share in Radian.

The great risk for the company is downgrading of its credit from AA to a lower grade by SP and Moody's. In this case, the business may be harmed beyond repair. In the conference call, management was confident that it will be able to maintain its rating.

This stock has high uncertainty and low risk built in. A patient investor may be rewarded handsomely for holding on to this asset.

Four pillars of Tech

The four pillars of tech according to Kramer are:

1. RIMM
2. AMZN
3. GOOG and
4. AAPL

Let us look at each of these to see if they offer good bargains at current prices.

1. RIMM carries a P/E of 76, PEG of 1.56, Price to cash flow of 90.

2. AMZN carries a P/E of 124, PEG of 3.54 and price to cash flow of 42.

3. GOOG carries a P/E of 50, PEG of 1.22 and price to cash flow of 46.

4. AAPL carries a P/E 49, PEG of 2 and price to cash flow of 32.

AAPL is the cheapest from the P/E and P/CF point of view. Google is the cheapest by PEG point of view.

From a discounted cash flow point of view, none of the stocks look cheap and each of them look quite expensive. In the long term, the value is likely to catch up with price - this can happen through stagnant or declining share price.

HOG (Harley Davidson) Analysis

Harley Davidson (HOG) is the iconic American motor cycle manufacturer. It is more than a brand in many ways - many people tattoo HOG on their bodies. It is difficult to find many companies that people are willing to tattoo on their bodies. Of late, HOG stock price has declined because of stagnant or slightly declining year over year sales. Let us analyze the stock in further detail in the rest of this blog. HOG embodies a lifestyle and in some sense beyond a brand.

HOG has a P/E of ~12 and price to cash flow of about 13. Price to book value is about 4. The dividend yield for the stock is about 2%. While the stock is undoubtedly cheap as it is very difficult to replicate the Harley brand for the market cap of the company which is about 13 billion. While the intangibles add significantly to Harley's book value, let us see if the company is a buy at the current prices.

First let us analyze Harley. The number of outstanding shares has been declining by about 1.6% per year for the last ten years. The EPS has grown by about 20% per year for the past ten years - which is clearly not sustainable.

Let us look at the cash flows and return on equity to see how HOG looks like from this perspective. The cash flow from operations for the last five years have been respectively - 936, 970, 960, 762 and 998 million dollars respectively. The free cash flow has varied from 708 million to 782 million respectively. The return on equity has varied from 29% to 39% of late.

The company's YoY sales in the US has declined by about 5% and the company is hoping to expand internationally further. Like other consumer staples such as Coke and Pepsi, HOG will probably see more revenue and profits internationally in the future.

The stock looks cheap compared to its historic P/E of about 19. Even given the stagnant cash flows, the company is returning money to the share holders in the form of dividends and share buy backs. HOG is a good long term buy but may not see immediate upside.

Proctor and Gamble Analysis

PG ( Proctor and Gamble ) is in the consumer staples business. It was the best performing dow jones stocks for the recently ended quarter. Let us quickly take a look at the financials to see if it is a buy at current prices. With a P/E of 23 and Price/Cash flow of close to 18, the stock doesnt appear cheap at current prices. Let us take a deeper look at the numbers to see how things look like.

The company bought Gillette recently, which has helped its cashflow and net margins. The EPS has grown at the rate of 9% a year for the past ten years and is likely to grow at that rate in the future.

The business is doing well on all fronts as noted in the company's 10-Q:

Net sales fiscal year to date increased 14 percent to $57.20 billion behind 11 percent volume growth, including an additional three months of Gillette results during the current fiscal year to date period versus the comparable year ago period. Organic volume grew five percent with broad-based growth across the business. Every reportable segment delivered year-on-year organic volume growth driven by product initiatives including Tide Simple Pleasures, Febreze Noticeables, Pantene Color Expressions, Olay Regenerist and Definity and the Head & Shoulders and Herbal Essences restages. Price increases taken across several segments added one percent to sales growth while favorable foreign exchange trends had a positive two percent impact. Product mix had no net impact on sales growth as the favorable mix impact from the additional period of Gillette results was offset by disproportionate growth in developing regions, where unit selling prices are below the Company average. Organic sales increased six percent fiscal year to date.

Additionally, the per share growth has been impressive partly because of the accretive nature of Gillette's business.

Net earnings increased 19 percent to $8.07 billion behind organic sales growth, the impacts from the addition of Gillette, including financing and other acquisition-related expenses, and profit margin expansion. Diluted net earnings per share were $2.37, up 13 percent versus the prior year. Earnings per share growth lagged net earnings growth due to a net increase in the weighted average shares outstanding in the current year to date period (incremental shares issued in conjunction with the Gillette acquisition on October 1, 2005, net of share repurchases, primarily under the Gillette repurchase program).

The fastest growing business segment was health care products. The gillette razors and blade segment is growing impressively in the developing countries.

Overall, PG is a great business. The current price levels are a bit too high - the right time to buy this was during the summer months during the peak of the credit crisis.

Bed Bath and Beyond (BBBY) Analysis

In this blog, we have looked at retailers such as Walmart, American Eagle and Joseph A Bank. Let us analyze another specialty retailer, BBBY and see if it is a good investment opportunity at this time.



BBBY is a retailer specializing in bedding, bath and kitchen products. It also sells electronics, electrical equipment ( kitchen electrics ), furniture, wall and home decor. It targets the rich to upper middle class customer and competes with a slew of other retailers in this space. Its closest competitors are Target ( which targets the middle class customer ) and Linen and Things. In each of the segments it operates in, there are a slew of speciality retailers that compete for the same business.



Let us look at the latest 10-Q report and past reports to see how BBBY stacks up against some of the other retailers. In the most recent quarter, BBBY saw increase of sales (~11%) through store expansion and through the acquisition of buy buy BABY. Meanwhile, the gross profit margin declined because of rising inventory costs and selling, general and administrative cost went up. The result was a decline in operating profit margins to 9.9% from 10.7% from the same period a year ago. Does the declining profit margins show a fiercer competitive environment? Let us look at the profit margins for the past five years to figure this out.

The operating income for the past five years are as shown below with a compound annual growth rate of 7%.

639.3
792.4
879.2
889.4
895.0 (expected for this year )

The operating margin has declined sharply this year and last compared to the previous two years to the 2003 levels. This is a bit early to say if this is because of fiercer competition. The reduction in margins could also be because of the decline in the housing market. However, this should have been more pronounced in 2007 as opposed to 2006 which is not the case.

The company has decided to buy back about a billion dollar worth of shares in December 2006 and the total number of outstanding shares has declined in the most recent quarter by about 7 million compared to the same period a year ago. The company has about 20 million shares outstanding (options) and about 6 million shares in restricted stock. While many of the options are under water at the moment, the addition of close to 9% of additional shares can dilute the impact of buy back.

On a positive note, the company carries no debt and is funding its expansion through operating cash flow.

From a cash flow perspective, there are cheaper alternatives such as Walmart and Target and a slew of other retailers noted earlier in this blog such as AEO and JOSB.

While the company is healthy, the impact of housing slow down and competitive pressures is not fully clear at the moment. It is our view that there are other retailers that offer a better discount to intrinsic value than BBBY.

Infosys Q1 Analysis

In this blog, we have looked at Indian outsourcer, Infosys quite a few times. We found Infosys to be the best run of the Indian outsourcers with solid management. In the first six months of the year, the Indian currency appreciated by about 10% against the US dollar. This appreciation was partly precipitated by the Indian central bank keen to cut inflationary pressures. The exchange rate of the Indian currency is artificially maintained as the currency is not freely traded. This is similar to the way the Chinese government maintains its peg against the US dollar.

The problem for Indian companies that are exported focussed is that it increases their cost of operations. While some of the cost can be passed on to the customers, it will not be possible to pass on all the costs to the customers. In addition, Infosys and other Indian companies are facing increase in operating costs with wages increasing at double digit rates of 15%. This impact is probably not fully felt yet and show up further in the coming year. The wage increase is expected to be about 15% in the coming year as well.

The operating income margin in Q1 of 2006 for Infosys was 25.75%. The operating margin in Q1 of 2007 was 24.67%. In general, the business did well, with revenues and profits growing strongly. As usual, the stock market looks at future prospects as opposed to past results. Infosys is expected to continue to do well with growth in the 28-31% range for FY2008.

Other points of note is attrition rate of 4% in the quarter and 10% new employees in Q1 alone. Infosys expects to pay new employees higher wages compared to the ones hired before. Infosys now employs about 75000 people world wide. The increase in cost will increasingly be felt in the next couple of years which is reflected in the stock price.

The company has a strong balance sheet with about $1.6 billion in cash. The company is run well and this is reflected in the stock price. However, we feel that the company is fairly valued at current price levels.

Value vs Growth

We are looking at this again after a short gap. Given the disaster in the financial sector and the dominance of financials in the value fund, the value fund hasnt done too badly.

The chart below shows how value, blend (sp500) and growth compare in the large cap arena. The chart below shows the iShares ETFs - IVE, IVV and IVW.
The top stocks in IVE (value etf) are:
AT&T,
GE,
Citigroup,
BAC,
JP Morgan Chase,
Conoco Phillips

The top five stocks in IVW ( growth ETF) are:
Exxon Mobil,
Proctor and Gamble,
Cisco Systems,
Johnson and Johnson and
AIG

The difference between value and growth is not wide with iShares ETFs.


http://finance.yahoo.com/q/bc?t=6m&s=IVE&l=on&z=m&q=l&c=ivv%2Civw

The second chart compares the vanguard funds in the same category. The vanguard funds of interest are VTV, VV and VUG respectively. The mix of stocks in vanguard funds is different than the iShares funds - so the difference in performance is also different. As an example, Berkshire is in vanguard growth fund but not in the value fund. Comparing to iShares ETFs, the stocks and their weights are also different.


The top holdings in VUG are:

Microsoft,
Proctor and Gamble
Johnson and Johnson
Cisco
Intel

The top holdings in VTV are:

Exxon Mobil,
GE,
A&T,
Citigroup and
Bank of America

http://finance.yahoo.com/q/bc?t=6m&s=VTV&l=on&z=m&q=l&c=vv%2Cvug

While the companies in both the lists are good, citigroup and BAC may have to take some charges on the buy out transactions still pending for which commitments are made. While this is a good time to buy - it may be in the doldrums for some time.

The differentiation of stocks to value and growth is quite arbitrary and one should do ones due diligence before selecting one sector over the other. It also depends on which funds one selects and what cost advantages an ETF or a bunch of ETFs provide over the other.

Jos A. Bank Clothiers (JOSB) revisited

Now that all the retailers are in a funk thanks to the subprime mess as well as the Walmart warning, let us look at this section again.

We have looked at JOSB before in this blog and noted that P/E contraction was a major risk to both JOSB and Chico FAS. True enough, even though the sales have done well, people have been dumping JOSB as well as other retailers enmasse creating an opportunity.

Let us look at JOSB business and macro factors first. Jos. A. Bank Clothiers, Inc. is a nationwide retailer of classic men’s clothing through conventional retail stores and catalog and Internet direct marketing. What are the factors that can go right and what are the factors that can go wrong for JOSB?

Things going right:
1. Good job market - always a plus for JOSB. It is unlikely this will falter given the strong growth in emerging markets, europe and Japan. The U.S export growth continues to grow and the dollar will probably decline further if there is a rate cut. This bodes well for JOSB.

This not going well:
1. The housing market. A bunch of ARMs are scheduled to be reset next year - this can cause problems to JOSB and other retails if it impacts the US consumer abnormally.

If the job growth continues and the ARM resets occur in an orderly way - the consumer mix for JOSB is going to determine how well it will do.

For this, let us look at the financial statements.

First cash flows - JOSB has a price to cash flow ratio 0f 7. What this means is that the business can pay out the entire capital back in seven years if nothing is reinvested in the business. However, a part of the capital will have to be reinvested to keep the business going. Another part to look at is the sustainability of the cash flow. Let us look at the balance sheets to gain further insight into these factors.

First let us look at the free cash flow growth. It has been far for uniform - in fiscal 2002 and 2004, the company had negative cash flows. The company is excpected to have free cash flows of ~40 million this fiscal year. So the cash flows are not even meaning some dependency on the economic cycles are present.

Let us look at the latest 10-Q for more details. The company is planning to add more stores this year to expand the number of stores from 366 to close to 500. The company would put the store expansion plans on hold if there is a chance to lose money on the investment or if it is very risky. As noted by other retailers, the sales havent fallen off the cliff yet but people are expecting catastrophe to hit when the ARMs reset.

JOSB looks attractive at this price, with book value of approximately $12/share - it is definitely selling below its intrinsic value and can offer some good upside if the ARM reset doesnt hobble the economy badly. Note: please see the disclaimer part of this blog.

Berkshire Hathaway FY07 2nd quarter results

Berkshire Hathaway, the holding company run by Warren Buffett, reported its 2nd quarter earnings yesterday. In this blog, we will go through the earning report and look at the earnings and the company.

The company had 1,088,878 class A shares and 13,753,590 class B shares for a market cap of approximately 169 billion dollars. Total shareholder equity was 115.27 billion dollars. So the price to equity ratio is less than 1.5. This is a low number for a company that grew the operating earnings and total earnings in the low 20s and 30 percentage respectively showing that the stock is quite undervalued.

There are a few things of note to observe in the consolidated statement of earnings. Let us look each segment and compare it to the perception of analysts and market commentators.

In the insurance and other segment, sales and service revenues increased as well as investment gains. Geico increased its market share managing to increase profits in an environment of falling insurance premiums. General Re and BRK Reinsurance did particularly well. General Re is doing well overall and should continue to do well for the rest of the year. BRK Reinsurance is doing well in the multiline business segment but megacat insurance premiums will decline in the next year. This should be offset to a certain extent by investment gains on the equitas portfolio.

Utility and Energy section saw revenue and earning growth. This section is doing well as expected.

In the finance and financial products section, interest income slightly increased, investment gains declined compared to the year ago period, derivative gains increased and the other section was flat.

The important thing to point out here is that the interest income from treasuries is not significantly higher than last year as many analysts were expecting. In the first six months of the year, 3.3 billion of fixed maturity securities were bought and another 11.5 billion of equity securities were bought. The important thing to note here is that the securities delivered as part of the equitas deal is listed separately in the cash flow statement. The cash and cash equivalents stood around 39.9 billion. This figure is different in the cash flow statement as some of the money is borrowed for mid american subsidiary.

Interestingly enough, the break down of fixed maturity securities showed 3.7 billion of mortgage backed securities. This number should increase in the coming months as the market remains illiquid and the yield spread widens.

As an intelligent investor may recognize, this is Buffett and Munger time. Irrational fear and illiquid markets plays perfectly into the hands of worlds great investors. In addition, many of Berkshires core holdings like P&G, Walmart, HD etc. dont have liquidity problem and are buying back stock. This should help increase the book value and networth of Berkshire in the coming years.

My breakdown of intrinsic value is around 142 - 145 K per A share after Q2. In fact, the stock deserves a premium for the opportunities available at the moment. One should have part of ones portfolio in this stock as it allows for capital preservation and appreciation at the same time.

Four pillars of Tech

Kramer classifies these four companies as the four pillars of tech. According to him these are the standard bearers for the first decade of the 21st century. It is anyone's guess if their dominance will last till the next decade - most likely it wont if we look at tech wonders from the nineties - Intel, Microsoft, Cisco, Dell and Yahoo!

Here are the four companies:
RIMM - blackberry a must for corp execs.
AAPL - iphone and ipod. iphone is getting to be a competitor to blackberry in the longer term.
GOOG - 'nugh said. Goog is planning a free google cell phone with its own apps. Going against apple? May be.
AMZN - virtual warehouse, S3 and EC2 services.

AMZN - market cap of 30 billion and free cash flow of 500 million - ratio 60
GOOG - market cap of 172 billion and free cash flow of 1.8 billion - ratio 95
AAPL - market cap of 120 billion and free cash flow of 3.9 billion - ratio 31
RIMM - market cap of 40 billion and free cash flow of 480 million - ratio 83


Let us take another swap by looking at stock dilution at each of the companies.

AMZN - has remained flat in the last few years probably because of buy backs.
GOOG -should be 6-7% range or higher
AAPL - about 2.5% dilution per year
RIMM - no dilution in last year - most likely because of buy backs.

Berkshire (BRKA/BRKB) on the other hand throws off cash better than most companies in America. Its price to cash flow ratio is less than ten making it a bargain compared to any of these tech stalwarts. Moreover, the stable of businesses that are part of Berkshire are likely to remain solid and kicking long after today's tech titans make way for another round of upstarts in the next decade.

A case for power

PWER - better known as PowerOne is a California based company that specializes in building AC and DC power conversion systems. The stock has seen a high of about 100 during 2000 and has fallen to about 4 at the current time. The implosion in the market caused by dot.com bust played a big part in this plunge.

The company has not been run properly for the larger part either. The company's acquisitions havent really panned out atleast not yet. This caused a sudden plunge in company's stock price from $5.5 to $3.5. Although the stock has recovered somewhat, the stock hasnt recovered fully yet.

However, there are signs that the company is finally on track to recovery. Several factors should help the company.

1. The power market is on the rebound with imprving semiconductor business.
2. The server farms in the US are expanding, so much so that the total power consumed by server farms outstrip the power consumed by all TVs in US homes. Minimizing such power usage is critical is containing operational expenditure of running large data centers.

The company believes it will be profitable in the final quarter of 2007. If so, it would be first such event in the past several years. Sustained profitability can boost the company stock significantly above the current levels.

Even if the company is not profitable, I estimate the lower end of the price to be about $5 for the company's assets. A lot is riding on current earning announcement and a prediction to return to profitability can turbo charge the stock. Another lackluster announcement can present a significant buying opportunity.

Also on a positive note, insiders have been buying at $3.69 levels though in small quantities.

P.S: Please be sure to check the disclaimer of this blog.

Berkshire possible return on investment

Mohnish Pabrai, the author of the book "Dhandho Investor" and a hedge fund manager, recently interviewed with Bloomberg. The pointers to his interviews are noted below:

Part 1 http://wpi.clipsyndicate.com/publish/index/339725

Part 2 http://wpi.clipsyndicate.com/publish/index/339737

In Part 2 of this interview, he values BRKB at around $5000/share and expects 15% return for the next several years. Let us calibrate this with other forecasts and see if this is a good prediction.

For starters, let us assume that the current valuation of BRKB is indeed $5000=00. Currently, the stock is trading at 3578=00. This makes the stock about 40% undervalued compared to its market value. Even without additions to the intrinsic value for the next three-five years the returns would be as follows:
1. 3 years - 11.7%
2. 5 years - 6.9%.

This is the typical - heads I win, tails I dont lose position.

Let us take the second situation where the intrinsic value is a lower value of 4700 per share. Let us assume that Berkshire will be able to grow the intrinsic value at 8% per year for the next three-five years. For a three year period, the IV will be 5920/B share. For a period of five years, the IV will be 6905/B share.

If the per share value catches up with intrinsic value - the growth per share will be.

1. 3 years - 16.7%
2. 5 years - 14%.

Let us take another situation where the intrnsic value grows from the current value of 3578=00. The EPS growth will atleast be 8% a year as SP500 will continue to grow at around 7-8% for the next three years. The Berkshire equity portfolio will do as well or better. Then there is the cash generated by operating businesses which is growing at >20% a year. This should continue at a rapid 15-20% pace for the next five years. At the very minimum, one should continue to see 8% a year growth without doing anything with the existing cash horde.

This is a classic situation of "heads I win, tails I dont lose much". The upside is decent and downside is very low to non existent.

Microsoft DCF Analysis

Here are the estimates of Microsoft free cash flow on a year by year basis.

Free cash flow per year:
2007 - 14.5 billion
2008 - 16 billion (estimate )
2009 - 16 billion ( estimate )
2010 - 17.5 billion ( estimate )
2011 - 19 billion ( estimate )
Terminal market cap - 366 billion

Discounted at 10% per year to now:

2007 - 14.5 billion
2008 - 14.55 billion
2009 - 13.22 billion
2010 - 13.15 billion
2011 - 12.98 billion

Terminal market cap - 250 billion

Summing up: The present value is 318 billion.The current market value is 290 billion. The upside is about 10% from current values.

The downside and caveat to this estimate are as follows:

1. Stock dilution because of heavy payments to management and employees
2. The cost of competing with Google. This could be a drain on the cash flow with XBox and other emerging businesses continuing to be a drain on cash.

If Microsoft is able to meet the EPS estimate of $1.70/share in FY2008, the share price can presumably trade in the $33-35 range. Microsoft has seen a P/E compression in the past few years as its earning growth has slowed down. The above share price range is with the current P/E. Further P/E compression to the mid teens can make the stock price stagnate at current levels.

American Eagle (AEO) - Ready to soar again?

In the recent months, the US retail sector has taken a big beating with many stocks trading in the value category. In this section, we will take a look at American Eagle ( AEO ) Outfitters and see the prospects.

First some basics on American Eagle. American Eagle Outfitters, Inc., a retailing company, engages in the design, marketing, and sale of clothing in the United States and Canada.The comapny has been growing fast with 20%+ growth in the past several years. The company's growth has slowed in this year to ~17% rate. The company also hasnt met the analyst's expectation of 5.8% growth in same store sales in the month of May. The company's sales came in at 5% instead. This coupled with the expectation of a recession/high interest rates has caused almost all the retail stocks in the US to become bargains. The list includes companies such as JCP, WMT, ANF and JOSB.

AEO is particularly attractive compared to this group as it carries zero debt on its balance sheet and its growth rate is still in the double digits. The company has about half a billion dollars of cash on the balance sheet and is buying back about 15 million shares. This should reduce the number of outstanding shares by 7-8% and boost the EPS by 7.5 - 8.5%.

Let us do the discounted cash flow analysis for AEO for the next five years. In the fiscal year ending in Feb, 2007, the company had cash flows from operating activities of 750 million and a free cash flow of 525 million. The company has a current market cap 5.75 billion. Assuming conservative growth rates of 15%, 12%, 10%, 8% and 6% for the next five years and a terminal value of 10 billion for the enterprise.

Adding the DCFs, the value looks as follows with a discount rate of 10%.

525 million
548 million
558 million
548 million
528 million
terminal value 6.2 billion

This yields a value of 8.9 billion for the enterprise without even considering share buy backs. This is a premium of 56% from the current prices for this stock.

To quote Mohnish Pabrai - this looks like a classic situation of "Heads I win, tails I dont lose much!". While the entire sector is battered, AEO seems like an opportunity that is hard to pass up.

Value or Growth?

We have looked at this aspect in some detail in this blog when we assessed different asset classes in the past several months. In this article, we look at the market behavior from last week and compare value vs growth again.

The difference in returns from the three Vanguard funds are noted below for the past one week.

Comparison of VUG, VV and VTV

Typically, increasing interest rates causes the dividend yielding stocks to be less attractive. The stocks with high growth are better preferred. Since the value stocks have a fair degree of exposure to dividend paying stocks, for the week, the VTV lagged VUG by a small margin.

This is a trend I will be watching closely in this blog in the next several months.

The value funds have done well for the past few years on the back of high energy prices and the housing boom. A difference of one or one and a half percentage points between the two funds is made up by the value fund in terms of dividends.

However, the pattern may be changing with money flowing into the tech sector. So far, we have seen only a handful of tech companies benefit by this trend - Google, Apple and Amazon are the ones that come to mind. Since these stocks are already in the stratosphere in terms of valuation, the rally hasnt been very broad.

Overall the U.S and global economy seems to be in good shape and corporate earnings should continue to do well in the second half of the year. This bodes well for SP500 average in general and the broader stock market in particular.

Asian ETF overview

Happy memorial day to all the US based readers. Seekingalpha has an excellent overview of Asian ETFs and their performance to date compared to SP500 index tracking fund IVV.

http://etf.seekingalpha.com/article/36655?source=feed

Whitney Tilson on Learning from Investment Mistakes

Another gem from financial times - http://search.ft.com/ftArticle?queryText=tilson&aje=true&id=070216005308


Whitney Tilson: Learn from your own investment mistakes
By Whitney Tilson, FT.com sitePublished: Feb 16, 2007
Investing is a game of averages: nobody bats 1,000 but, if your analysis and judgment are solid and your winners generally go up more than your losers go down, you can build an outstanding record. The key is not picking big winners; it is avoiding big losers.
That's why learning from mistakes is so important – ideally, as Warren Buffett says, others' mistakes rather than your own. In that spirit, here are 10 traps I've identified – many times the hard way – that are likely to lead to bad investment outcomes:
■Declining cash cows. There can be a fine line between opportunity and trouble when a once-strong business goes into permanent decline. One can profit if the market overestimates the speed of the decline or underestimates management's ability to transform the business. But this is a hard way to make money. Generally speaking, a business in decline – even a cash cow business – is a painful, drawn-out affair. Investors in newspaper stocks in recent years have seen this first-hand.
■High and rising debt. Value investors are naturally drawn to companies in trouble – that's what makes stocks cheap if the difficulties prove to be temporary – but beware of high and rising debt levels. Even if a company is positioned to benefit from improving conditions over time, equity holders won't benefit if its debt levels trigger a bankruptcy or a massively dilutive refinancing in the near term.
■Unions and legacy liabilities. When betting on a turnround, it's critical to understand the flexibility the company has – or doesn't have – in implementing painful but necessary changes. Poor union relations can prevent such changes, and legacy healthcare, pension and environmental liabilities can serve as the same drag on a company's prospects as too-high debt. ■Weak or erratic cash flow. Operating cash flow, because it adds back depreciation and amortisation to net income, should be higher than reported profits. If it's not, figure out why. Are there unusual items consuming cash? Are inventories or accounts receivable ballooning? In the 11 quarters ending in the second quarter of 2000, Lucent reported pro-forma profits totalling $9.4bn. Over the same period, it had a free cash flow deficit of $7bn. This should have been a tip-off for investors, who suffered as the stock plunged from more than $70 to less than $1.
■Over-reliance on one customer. In my experience, one of two things happen to companies that derive a large portion of sales from a single customer: at some point, the company loses the customer or the customer renegotiates the deal – either of which is devastating to the company and its stock.
■Consumer fads. Famed short-seller James Chanos put it well in a Value Investor Insight interview explaining why fad-driven companies often become great short ideas: "Investors – typically retail investors – use recent experience to extrapolate ad infinitum into the future what is clearly a one-time growth ramp of a product. People are consistently way too optimistic and underestimate just how competitive the US economy is in these types of things."
■Deeply cyclical industries. Fortunes can be made by investing in cyclical businesses if you have a deep understanding of the industry and you're buying at maximum pessimism. If neither is the case, discretion is often the better part of valour. Just ask those attracted to the ostensibly low multiples of subprime mortgage lenders before last week's revelations of deteriorating loan-portfolio credit quality.
■Focus on earnings before interest, taxes, depreciation and amortisation (ebitda). Used properly by those who understand its limitations, ebitda can be a useful measure. But too often it's used by unscrupulous management, investment bankers or analysts to make a stock appear cheap – a stock's ebitda multiple is always lower than its p/e multiple – or to deceive investors about the true nature of a company's capital requirements. It's not a coincidence that many big frauds, such as WorldCom, weretouted using ebitda metrics.
■Serial acquirers or mega-acquisitions. Given the research showing that two-thirds of all acquisitions are failures and a wide range of accounting shenanigans that can occur when one company acquires another, it's remarkable how often investors get excited about big acquisitions or roll-up stories. While my funds own Tyco today as a discount-to-the-sum-of-the-parts story as it sheds its conglomerate structure, we fortunately avoided it when it was a serial acquirer.
■Aggressive accounting. Grey areas in US Generally Accepted Accounting Principles (GAAP) leave management with tremendous leeway in how aggressively or conservatively it represents company operations. I have difficulty thinking of a single instance in my entire career of a company that blew up in which there were not signs of aggressive accounting.
Mistakes are inevitable but every savvy investor should at least try to make original ones. Recall the proverb: "Fool me once, shame on you. Fool me twice, shame on me."
Whitney Tilson is a money manager who co-edits Value Investor Insight and co-founded the Value Investing Congress. feedback@tilsonfunds.com

Whitney Tilson on steps for value hunters

From http://www.ft.com/cms/s/cfa86a18-0559-11dc-b151-000b5df10621.html

Whitney Tilson: Not-to-be-missed tips for value hunters
By Whitney Tilson
Published: May 18 2007 18:25 Last updated: May 18 2007 18:25
My recent column detailing the 10 investment traps I’ve identified prompted several readers to ask if I have a comparable list of the opposite – types of opportunities that are likely to lead to good investment outcomes.
I do, and happily it’s a bit longer than the list of traps. Given that the first step to successful investing is knowing which ponds to fish in, here are the 15 most common types of value opportunities I have been able to capitalise on in my investing career:
● Out-of-favour blue chips. Even the greatest companies encounter problems or otherwise fall out of favour. We bought McDonald’s a few years ago when it fell below $13, believing in its assets and that it could return to its former glory through better management. The shares now trade above $50.
● Turnrounds of broken businesses. It’s difficult to fix a truly broken business, but when it happens, the returns can be extraordinary. One of my best investments ever was CKE Restaurants, which engineered a spectacular turnround at Hardee’s due to its new Thickburger menu. The shares, as low as $3 in 2003, are now above $20.
● Cyclicals at the bottom of the cycle. Success here usually involves correctly anticipating when a cyclical industry will rebound, though precision is not necessary as long as the company has a strong enough balance sheet to weather the tough times.
● Distressed industries. Our buying auto-systems maker Lear last year below $20 when its prospects were considered most bleak is a successful example of buying a good company in a distressed industry. Its shares have more than doubled off their lows.
● Overlooked small-caps. Among the 5,000 or so publicly traded US stocks that have no analyst coverage are fine businesses that are cheap because no one is paying attention to them or the stocks are thinly traded. A good example we’ve owned for years is Weyco Group, which makes Florsheim shoes.
● Fallen growth angels. When high-growth companies slow down, growth and momentum junkies often sell indiscriminately, which can create great opportunities for value investors. Just be careful not to anchor on the stock’s previous price or earnings multiple, which are no longer relevant.
● Growth at a reasonable price. These are also high-quality growth businesses, but the stocks haven’t fallen. They may not appear cheap on traditional valuation metrics, but can be excellent investments if the high growth can be maintained. Starbucks over the years has been a great example.
● Piggybacking on activism. There are select opportunities to invest alongside experienced activist investors pushing for prudent change. One of our most profitable investments over the past two years, for example, was following Pershing Square and Trian Group into Wendy’s International, which has more than doubled.
● Spin-offs. Many significant stock-price inefficiencies can occur when a company is spun off. A recent example we currently own is Mueller Water, which operates largely under Wall Street’s radar and is uniquely positioned to benefit from needed investment in US water-system infrastructure.
● Post-bankruptcies. There are also many reasons why companies emerging from bankruptcy can be inefficiently priced, not the least of which is investors’ reticence to back a recent loser. We’ve almost tripled our money in less than two years owning shoe retailer Footstar, which came out of bankruptcy with a solid balance sheet and plan for reviving itself.
● Let someone else do the investing. Certain public companies, including Berkshire Hathaway (which we own), Loews, Leucadia National, Alleghany and White Mountains Insurance are structured as investment vehicles for proven value investors. At a reasonable price, it can pay to let these investors do the heavy lifting for you.
● Free/mispriced option. In these situations, one or more ongoing businesses justifies the current market price and an investor gets a valuable option – in the form of a new market opportunity or turnround of a floundering business – for almost nothing. In Wendy’s, we thought the value of its Tim Hortons restaurant franchise was worth the entire stock price two years ago, so we were getting the Wendy’s brand restaurant and franchising business for free.
● Declining cash cow. At the right price – and if management wisely milks the business and allocates capital – the stock of a declining business can be a great investment. The shares of Deluxe, the leading check printer that many investors had abandoned, have tripled over the past year thanks to cost cutting under a new chief executive.
● Oddball companies. Certain companies have revolutionary business models that are poorly understood, resulting in cheap stock prices. Classic examples are Southwest Airlines, Dell and Kinder Morgan.
● Discount to the sum of the parts. Many companies lend themselves to valuing their different pieces and can be a great buy if the whole is trading at a sufficient discount to the pieces. We own Tyco because we think the three companies that will emerge from it in the next few months are worth more than $40, versus today’s share price below $33.
Whitney Tilson is a money manager who co-edits Value Investor Insight and co-founded the Value Investing Congress. feedback@tilsonfunds.com

India Funds Revisited

In this blog, we have looked at emerging market economies and the options available to US investors to get into such markets. One of the hot emerging markets is India. In this blog we have looked at Indian equities and funds quite a few times. We will revisit the India funds again to see if they present an opportunity or two.

First a note about the Indian economy and stock markets.

The economy has been growing at a fast pace, inflation has also been growing at around 6% range flaming fears of overheating or an outright crash. In order to eliminate this scenario, the Indian central bank has increased interest rates and has not interfered with the strengthening Indian Rupee. The strength in the Indian currency will most likely hurt the Indian exporters but may help reduce inflation.

The Indian stock market is an old institution, the oldest in Asia. However, the market is loosely regulated and has had a couple of major scandals in the nineties. The market is also known for its major peaks and valleys. In FY07, the Indian stock market hasnt done particularly well and this is a good sign for investors. The Indian stock market has been flat for the year while many other indices around the world have hit new highs.

The India funds of interest to us are IIF, IFN, MINDX, ETGIX, EEB, ADRE, EEM and VWO. EEB, EEM and VWO are not pure India plays but provide exposure to India. Let us compare these funds and see the pros/cons of each.

IIF is Morgan Stanley India Investment Fund. It is currently trading at almost 12% discount to NAV. The fund has an expense ratio of 1.35%. The fund hasnt kept up with the BSE Sensex Index in the past and the performance of the fund and charts were discussed in the previous article.

IFN is another India fund. It carries a slightly higher expense ratio of 1.41% and has a lesser discout of 11% to NAV. This fund has also lagged BSE Sensex index. This fund has returned -10% so far this year.

MINDX is a mutual fund and has done better than IIF and IFN thus far in the year. This is largely because the mutual fund doesnt develop a large discount or premium to NAV. MINDX has an expense ratio 1.41% and has a separate management fee of 0.7%.

ETGIX has also done relatively well but has underperfomed MINDX. The fund has a front end load of 5.75% and management fee of 2.14%. This is not a good fund for individual investors with less than a million dollars of capital.

EEM has a 5.68% exposure to India, the lowest amongst the BRIC countries. EEM has a larger exposure to Russia, Chian and Brazil.

VWO has a larger 6.1% exposure to India. Similar to EEM, it has larger exposure to other BRIC countries.

From a performance point of view, EEM has done fractionally better than VWO in 2007 despite a higher expense ratio. In the past, EEM has done somewhat better than VWO.

EEB has a larger exposure of 13.5% to India. EEB is concentraded on BRIC and mainly BIC. The growth of Chinese market has helped this fund out perform both EEM and VWO thus far in 2007.

ADRE has a 7.88% exposure to India but is based off the ADRs. It has a lower expense ratio of 0.3% compared to other funds. This fund has a larger exposure to China and lesser exposure to Russia. This has done better than both EEM and VWO thus far this year.

In comparison, an emerging market fund with a cocktail of countries might prove to be a better investment in the longer term as opposed to one country alone. There are several choices available in this category for savvy investors.

Infosys Analysis

In this blog, we have looked at Infosys and we will take a look again to see how the company is doing.

Infosys is an Indian company that trades on Nasdaq. The businesses the company is into is noted below from its web site.

Infosys Technologies Ltd. (NASDAQ: INFY) provides consulting and IT services to clients globally - as partners to conceptualize and realize technology driven business transformation initiatives. With over 72,000 employees worldwide, we use a low-risk Global Delivery Model (GDM) to accelerate schedules with a high degree of time and cost predictability.

As one of the pioneers in strategic offshore outsourcing of software services, Infosys has leveraged the global trend of offshore outsourcing. Even as many software outsourcing companies were blamed for diverting global jobs to cheaper offshore outsourcing destinations like India and China, Infosys was recently applauded by Wired magazine for its unique offshore outsourcing strategy — it singled out Infosys for turning the outsourcing myth around and bringing jobs back to the US.

Infosys provides end-to-end business solutions that leverage technology. We provide solutions for a dynamic environment where business and technology strategies converge. Our approach focuses on new ways of business combining IT innovation and adoption while also leveraging an organization's current IT assets. We work with large global corporations and new generation technology companies - to build new products or services and to implement prudent business and technology strategies in today's dynamic digital environment.

First, let us look at the financials. For FY07, revenues increased by 44% and profits increased by 53%. For FY08, the company expects revenues to grow by about 30% compared to FY07. Profits will probably grow at a faster pace of about 40%.

The main concern with the outlook is the increased cost of hiring and retaining employees. Infosys pays about $7000 per entry level employee in India and this price is expected to go up by about 15% on the average in the next two years. The company is also increasing the salary of overseas employees by about 5-6% this year compared to about 3% last year. In addition to this, the company is also getting squeezed by the sudden appreciation in the Indian currency of about 10% in the last month and half. Hopefully the company has hedging operations - otherwise this is a double whammy of higher salaries causing 25% increase in costs.

In the conference call, the company talked about some of these challenges. Previously, the company only recruited engineering graduates - now it recruits 10% of its work force from non science and engineering fields. One can see this percentage going up as there is more demand for skilled labor.

Infosys is a well run Indian company - probably the best of the outsourcing companies by far. The management is well known for adding share holder value and for ethical behavior. While the stock is not cheap - given its growth rate, this is a good buy during market dips. It is already the top Indian company in all the emerging market funds that have exposure to India.

Value or Growth?

We looked at different ETFs to invest in December 2006 starting with this article. Let us revisit the large value vs growth segments to see how things are faring in 2007.

We looked at the large cap segment in December 2006 and analyzed a couple of ETFs. In this segment, we will look at large cap segment again and compare a few ETFs available in this space.

From vanguard, we have VTV for large value, VV for SP500 index and VUG for large cap growth.

From iShares, we have IVE for large value, IVV for SP500 index and IVW for large growth.

Comparing the Vanguard ETFs, the value fund VTV has done better than both SP500 and the growth funds. A chart showing the relative performances can be found here.

Comparing iShares ETFs, the value and SP500 index have done better than the growth segment which includes technology stars like Microsoft and Google. A chart that shows the differences is noted along with.

In 2006, value segment far outperformed both the growth and SP500 indices. Although the outperformance isnt as obvious in 2007, let us look at the P/E ratios where available to compare the funds.

VUG has a P/E ratio of 21.1 and P/B ratio of about 3.9. VV has P/E ratio of 16.9 and P/B ratio of 2.8. VTV has a P/E ratio of 14.2 and a P/B ratio of 2.2. These numbers were updated as of 3/30/2007.

From iShares, IVE has a P/E of 18.84 and a P/B of about 3.01. IVW has a P/E of 21.4 and a P/B of about 4.93. IVV has a P/E of 20 and P/B of 3.93. These numbers were updated as of 3/30/2007.

Comparatively, value funds carry less risk because of the lower P/E numbers. One thing to note though is that the value fund is dominated by oil and gas companies who have done relatively well thus far into the year. The growth funds haven't done as well as SP500 or the value funds historically. This year the earnings for the technology companies was expected to accelerate so it will be interesting to see how the rest of the year plays out. Value is definitely the defensive play and growth is more of a speculative play for 2007.

Berkshire Q1 Earning Release

In this blog, we have analyzed Berkshire quite a few times, especially as a stock that has been undervalued and as a good buy. Now, that the Berkshire faithful are getting ready to celebrate another annual meeting at the woodstock of capitalism in Omaha, Nebraska, the Q1 results are out. Let us go through some of the numbers.

Berkshire is a conglomerate with many old economy industries varying from candies to carpets and paint. It also does a significant portion of its business in insurance. Berkshire is run by the iconic figures Warren Buffett and his pal Charlie Munger.

Let us briefly look at the earnings in Q1. The total income after taxes in Q1 was 2.595 billion. This compares to earnings of 2.313 billion in 2006. The year over year increase is 12.19%. In the quarter, the cash flows from operating activities was 4.625 billion dollars compared to 2.359 billion dollars in 2006. 5.3 billion dollars worth of equity securities were purchased in the quarter. Despite the heavy buying, total cash on the balance sheet increased by 1.5 billion dollars.

The Equitas deal also closed in the quarter which added 7+ billion dollars of float to the balance sheet. Berkshire provides an additional 5 billion dollars of coverage expected to be paid out in the course of next forty years. The name of the game here is to make money on the float before the time comes to pay out. The pay out period is expected to be upto 40 years. The company also boosted the loss reserves to conservatively account for the deal.

In Q1, the revenues from operating businesses increased by 47% compared to Q1 of 2006. The earnings from operating businesses increased by 25% in one year. The increase in profits by operating subs with old line businesses would put the dot coms and internet companies to shame.

Given the rise in SP500 since April ( after the quarter close ) of about 5%, one can also expect Berkshire's equity position to also have improved in the same period by a similar or higher percentage. The book value for Berkshire is about 110 billion dollars at the end of Q1 and the overall market cap of the company is only 165 billion dollars. While Berkshire's value has increased, its stock price has dropped in the year. One can expect the stock price to rally at some point in the year.

My estimate of Berkshire's intrinsic value is 139,000 dollars/class A share. The stock is selling at a discount of 27% to its intrinsic value and looks like a good buy at current prices.

MSFT earnings update

In the previous post, we looked at Microsoft valuation from several angles and found Microsoft stock to be not so attractive. In this post, we will take a look at the earnings from the most recent quarter.

The operating margin for the company as a whole declined by 0.25 points in the first nine months of this fiscal year compared to 2006. This isnt a good sign - indicating that XBoX, MSN and other money losing divisions arent executing well.

When looking at free cash flow, the figures arent impressive either. The company gained a bit from exchange rates, increased amortization and slight benefit from stock based compensation. The company spent 5.6 billion issuing new stock and 20 billion buying back stock from the open market. So despite the massive spending on stock buy backs, the outstanding stocks declined only by 4.4%.

Overall, Microsoft's earnings surprise is not built on a solid foundation. The problems with capital allocation continue to persist. In addition, the company isnt making inroads in the search or ad business. The next year would be the make or break year for Microsoft.

MSFT Analysis

Microsoft is an interesting company. It was a feared technology behemoth a few years back but the stock return has been lackluster for the past nine years. In this segment, we will analyze Microsoft from three angles. (a) Discount cash flow analysis (b) Compare it to the 10 year bond and (c) finally analyze it with the option contracts.

One of the main complaints against Microsoft is that it doesnt know how to allocate capital. This part was covered in great detail in the following story. As the article points out, the XBoX division has bled 5.4 billion on 21 billion of investment in the past five years. A 2% return on 21 billion over five years would have yielded 2.1 billion to the share holders. If it were distributed as dividends, it comes to about 21 cents a share, not exactly chump change.

In addition to XBoX, the other divisions such as MSN, Mobile and Embedded Devices and Microsoft Dynamics have been bleeding cash. Only the windows and office divisions have been profitable and have been keeping Microsoft aloft.

First, let us look at Microsoft's discount cash flow model. The cash flow has been declining in the past few years and one can expect the trend to stabilize in the upcoming years but not subside. Let us look at the free cash flow in the past eight years.


9,447.0 13,082.0 12,319.0 13,739.0 14,906.0 13,517.0 15,793.0 12,826.0 11,917.0

As one can notice, the cash flow has been trending downwards primarily because of XBox and MSN divisions.

A discount rate of 8% to 10% range gives a valuation in the range of 175 billion to 225 billion. The valuation is based on free cash flow growing at the rate of 8% per year which is optimistic. The current Microsoft market cap is about 280 billion dollars.

The second approach is based on EPS and comparison to the 10 year bond. If the analyst EPS of 1.47 and 1.64 for FY07 and FY08 holds true, a stock price of 29.4 and 33.4 seem appropriate. Looking at the current price of Microsoft, the upside in a year's time is about 13.6% if the company is able to meet the earning estimates.

The third aproach is based on option contracts. Looking at the option contract for January 2009, a range of values between 30 and 35 seem more likely with the median of 32.5 being more likely. This compares well with the long bond comparison approach noted above.

Looking at all the approaches, the upside in MSFT is somewhat limited even in the best of environments. There is significant concern about the cash flows with XBoX and the MSN/Search divisions burning cash with no return in sight. It is unlikely Microsoft will spin off these divisions and fend for themselves. It would be good to have these divisions compete on their own merit without getting a life line from Microsoft.

Two arbitrage deals

In this article, we will look at two arbitrage deals that may give the shareholder a 6% upside within a month and in the worst case two months.

The first one is FICC and the second one is TNOX. First FICC.

FICC is Fieldstone Investment Corp and is being bought out by CBass, a unit of MTG. ( ticket MTG ). The offer price is $4/share and the deal has got SEC approval. The share holders meeting is scheduled for the 22nd of May and the deal is expected to close soon after. Currently the stock is trading at a discount of 6.3% to the eventual buy out price. While the likelihood of the deal to close is good, it is by no means a done deal. However, low stock volume and steady price indicate that the likelihood of the deal going through is high. If the deal doesnt go through, the share holders wont be left with much.

The second company of interest is TNOX. The company is being bought out by Genentech for $20/share but is currently trading at $18.85. This gives a return of 6.1%. The share holders have already approved the deal but SEC approval is pending. The company is saying that the deal is expected to close in the first half of the year.

Both deals have considerable risk and some upside. If the deals dont go through there is a large downside as well.

Guide to ETF Investing

Seekingalpha has a guide for ETF investing. The guide is worth a read. It covers the following topics:

1. The factors to optimize for higher investment returns.
2. Why Tech stocks dont work
3. Why one shouldnt buy mutual funds?
4. Advantages of buying ETFs
5. How to assemble and manage a ETF portfolio?
6. Analysis for different situations.
7. Putting everything together

Happy reading at http://etf.seekingalpha.com/etfguide.

Conoco Phillips (COP) Analysis

In this analysis, we will look at Conoco Phillips in a bit more detail than we did last time. COP ended FY06 with 51.4 $/share book value compared to 37 $/share book value in 2005. The book value improved by about 38%.

Let us look at some of the different segments of Conoco Phillips and how much they contributed to earnings.

E&P section was the highest contributor to earnings. World wide average sales price per barrel of oil was $60.37. For natural gas liquids/barrel, the earnings per barrel was $41.50. The revenues from abroad was about 5.5 billion dollars and was 4.348 billion dollars from the U.S. The average production cost has also gone up at around $5.57/barrel.

The other segment that contributes heavily to COP bottom line is R&M segment. R&M is the refining arm of COP. The refining segment resulted in 4.481 billion in income in 2006.

The chemicals segment resulted in 492 million dollars of income. This segment produces petrochemicals from natural gas, liquids and other feed stock.

Emerging Business segment has a net income of 15 million in 2006.

For 2007, the company plans to invest 13.5 billion in capital expenditures. The company plans to pay out about 3 billion dollars in dividends. The remaining cash flow is used to pay out debt and buy back shares. Last year, the cash flow in COP was 21 billion dollars. The total cash flow is entirely dependent on the crude oil prices. It is likely that the crude oil prices will hower around $60 for 2007.

The company expects to generate about 3-4 billion dollars from the rationalization of assets and has a plan to buy back stocks worth 4 billion dollars. The capital expenditures for 2007 has been reduced by about 2.5 billion dollars because of the scaling back of cost intensive projects. One can expect the company to reduce debt by about 3-4 billion dollars from the current level of 27 billion dollars. The company has debt obligations of about 3 billion dollars in 2007. The Venezuela liability to COP is about 2 billion dollars in the worst case.

COP is still cheap compared to its peers Chevron, Exxon Mobil and Petro China. However, COP carries significantly higher amounts of debt on its balance sheets.

Google and Doubleclick deal

In this blog, we have looked at google a few times. In this article, we will take a look at the double click deal to see Google prospects.

First, let us look at Google's earning yield. The trailing earning yield is 2.1% and the forward earning yield for 2007 is 3%. The expected earning yield for 2008 is 3.95%. The 10 year bond is yielding 4.76% at the moment and is more attractive as an investment than Google stock.

Secondly, Google's competition is intensifying. Yahoo!'s Panama project seems to have started well and Microsoft's search/ad strategy isnt firing yet. However, Microsoft is not expected to give up easily - expect Microsoft to continue pouring money into this space till it captures some market share or the business itself is no longer relevant. We can take cues from the way Microsoft battled AOL in the last one decade. MSN internet access got to be profitable after losing money for years.

One thing that has changed about Microsoft is that it cant afford to spend money as freely as it did in the past as it has quite a few business divisions that are leaking money.

This brings us squarely to the double click deal. At 3.1 billion dollars a year and 1200 employees, is it a good deal for Google?

First, we have to look to see if the deal is accretive to Google's bottomline. Taking into account its 2007 earning yield, double click must generate about 90 million in profit to be comparable to Google's earnings and grow at around 30% pace in the coming year.

However, it is likely that DoubleClick's profits are far lower as Google paid for the entire deal in cash. Since cash is earning a higher yield in treasury bonds, it was a bit surprising that Google paid cash for the deal.

DoubleClick has about 1200 employees and if Google keeps them all, it will end up shelling out about 150-200 million dollars a year in employee salary/benefits alone. Moreover, this deal is unlikely to provide a moat to Google against Microsoft and Yahoo! as these companies already have a significance presence in the display ads market place.

It is difficult to understand how this deal is beneficial to Google at the price paid. It will be interesting to see how the stock will perform in the next couple of years.

UPS Analysis Update

In previous articles, we looked at UPS and Fedex respectively. Both the stocks have gone down somewhat since then and are relatively cheap. Let us look at these stocks, specifically UPS to consider its prospects for the next several years.

First, some high points from UPS annual report. UPS is going to celebrate its centennial this year. UPS annual report claims industry leading margins at 16.8%. For UPS, management expects 6-10% growth in 2007 over 2006. 2007 is decidely lacklustre year for this segment making it a good time to acquire shares in this industry.

UPS expects organic revenue growth of 6-8% between now and 2010 - getting the overall revenue to about $60 billion. EPS componded is expected to grow between 9 and 14%. This is good news for share holders. At the low end, the upside to share price is 40% from the current levels and at the high end, the upside is more like 70%. This is with a P/E of 18. Meanwhile, UPS will continue to pay out about 40% of the income in dividends - this comes to 2.4% yield per year. Four four years, this comes to about 9.6% over four years - it is likely that dividends will increase and the yield will be will over 10% over four years. In total, one can look at returns of 50% at the low end and 80% at the high end including dividends. This is a good pay out for the current investment.

Looking at the balance sheets - here are some trends for the past five years.


Growth of US Domestic Package - 4.6% per year
International Package - 14% per year
Supply chain and freight - 29% per year

Net income growth for the past five years is - 5.7%
EPS has grown at a rate of 6.4%
Dividends per share has increased at a rate of 15%.

The number of shares has declined in this period by 4%.

Roth 401(k) or Roth IRA?

In this article, we will take a look at two schemes - a Roth 401(k) and Roth IRA and see the pros/cons of both.

Wikipedia has a good description of Roth IRA. There is also a special provision where people not eligible to contribute to Roth IRA can contribute to IRA and then convert the assets to Roth IRA at a later date.

First some background on Roth IRA and IRA.

On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006. This law made permanent increased contribution limits to IRAs (including Roth IRAs) that would otherwise have expired after 2010. It also made permanent the Roth 401(k), which would otherwise not have been available after 2010. For additional information, see the Roth 401(k) Web Site. On May 17, 2006, President Bush signed the Tax Increase Prevention and Reconciliation Act of 2005 into law. This tax bill included a provision dealing with conversions of traditional IRAs to Roth IRAs. Starting in 2010, the existing $100,000 income test for converting a traditional IRA to a Roth IRA will no longer apply. Conversions that occur in 2010 will be able to have half of the taxable converted amount taxed in 2011 and the other half taxed in 2012. For additional information, see the statutory provisions and the conference report.

IRA Taxation:When you take money out of an IRA, you pay income tax on all or part of it, depending on whether your original contributions were tax-deductible or not. If your contributions were taxdeductible (in other words, made from pre-tax income), you’ll pay income taxes on the entire withdrawal. If your contributions were not deductible (in other words, you used after-tax dollars,) you generally will be taxed on the earnings only at the time of withdrawal.

If you made both deductible and non-deductible contributions, then each IRA withdrawal is taxed in proportion to the mix of deductible and non-deductible contributions in all your IRAs. For more information on calculating the tax, see IRS Publication 590.

Contribution Limits:

Year Traditional/Roth
2006 $4,000
2007 $4,000
2008 $5,000
2009 $5,000

The Roth 401(k), is also permanent. Roth 401(k) is similar to Roth IRA except that the plan works as part of the 401(k) plan. One has to forego tax deduction now to participate in the Roth 401(k) plan. Also - one has to live with the limited investment options available in the 401(k) plan.

Is it possible to have the best of both worlds? The answer is yes, absolutely. One can contribute to the traditional IRA and convert it to Roth IRA in 2010. Meanwhile, one can continue contributing to 401(k), maxing out the contributions if possible.

In 2007, there is time till 17th of April to contribute to IRA. I am going to avail this opportunity to open an IRA account. I plan to convert this to traditional Roth IRA in 2010. Meanwhile, I participate in a regular 401(k) at work where I get matching contribution and tax savings.

AIG Analysis

In this segment, we will look at AIG, a Dow component and look at its prospects. AIG's business is described as follows in the 10-K.

AIG’s General Insurance subsidiaries are multiple line companies writing substantially all lines of commercial property and casualty insurance and various personal lines both domestically and abroad. Domestic General Insurance operations are comprised of the Domestic Brokerage Group (DBG), Reinsurance, Personal Lines, and Mortgage Guaranty.
AIG is diversified both in terms of classes of business and geographic locations. In General Insurance, workers compensation business is the largest class of business written and represented approximately 15 percent of net premiums written for the year ended December 31, 2006. During 2006, 8 percent and 7 percent of the direct General Insurance premiums written (gross premiums less return premiums and cancellations, excluding reinsurance assumed and before deducting reinsurance ceded) were written in California and New York, respectively. No other state accounted for more than five percent of such premiums.
The majority of AIG’s General Insurance business is in the casualty classes, which tend to involve longer periods of time for the reporting and settling of claims. This may increase the risk and uncertainty with respect to AIG’s loss reserve development.

Insurance, especially long tail insurance can make the earnings lumpy. So, in this segment, let us look at various business lines to see how things look like.

The various business lines of AIG are:

DBG:

AIG’s primary Domestic General Insurance division is DBG. DBG’s business in the United States and Canada is conducted through American Home, National Union, Lexington, HSB and certain other General Insurance company subsidiaries of AIG. During 2006, DBG accounted for 54 percent of AIG’s General Insurance net premiums written.

Reinsurance:

The subsidiaries of Transatlantic Holdings, Inc. (Transatlantic) offer reinsurance on both a treaty and facultative basis to insurers in the U.S. and abroad. Transatlantic structures programs for a full range of property and casualty products with an emphasis on specialty risk. Transatlantic is a public company owned 59.2 percent by AIG and therefore is included in AIG’s consolidated financial statements.

Personal Lines:

AIG’s Personal Lines operations provide automobile insurance through AIG Direct, a mass marketing operation, the Agency Auto Division and 21st Century Insurance Group (21st Century), as well as a broad range of coverages for high net-worth individuals through the AIG Private Client Group. 21st Century is a public company owned 61.9 percent by AIG and therefore is included in AIG’s consolidated financial statements. During the first quarter of 2007, AIG offered to acquire the outstanding shares of 21st Century not already owned by AIG and its subsidiaries.

Mortgage Guarantee:
The main business of the subsidiaries of United Guaranty Corporation (UGC) is the issuance of residential mortgage guaranty insurance, both domestically and internationally, on conventional first lien mortgages for the purchase or refinance of one to four family residences. UGC subsidiaries also write second lien and private student loan guaranty insurance.


Foreign General Insurance:

AIG’s Foreign General Insurance group accepts risks primarily underwritten through American International Underwriters (AIU), a marketing unit consisting of wholly owned agencies and insurance companies. The Foreign General Insurance group also includes business written by AIG’s foreign-based insurance subsidiaries. The Foreign General Insurance group uses various marketing methods and multiple distribution channels to write both commercial and consumer lines insurance with certain refinements for local laws, customs and needs. AIU operates in Asia, the Pacific Rim, Europe, including the U.K., Africa, the Middle East and Latin America. During 2006, the Foreign General Insurance group accounted for 25 percent of AIG’s General Insurance net premiums written.

For followers of Berkshire, the AIG credit rating is not as good as Berkshires. In 2005, the AIG credit rating was downgraded and as a result, AIG had to put up significantl collateral. In contrast, Berkshire enjoys the top most credit rating that can be given.

2006 was an unusually good year for AIG as was the case for insurance companies in general because of the absence of major catastrophes in the world. In 2005, AIG paid out about three billion for the Katrina and other related catastrophes. AIG's business segment revenues and incomes were as follows for 2006.

General Insurance - 49.2 billion
Life insurance and retirement services - 50.1 billion
Financial Services - 8 billion
Asset management - 5.8 billion

The income was as follows:

General Insurance - 10.4 billion
Life Ins and Retirement Service - 10 billion
Financial Service - 0.5 billion
Asset Management - 2.3 billion

The major uptick in income came in the general insurance section where the income increased from 2 billion to 10 billion. Income from Financial Services declined significantly by about 2 billion in 2006 compared to 2005.

AIG is expanding aggressively in Asia and so far about 20% of its revenue is from Asia. The company is seeing growth opportunities in China, India and Japan.

One can expect the insurance rates to be soft this year - car premiums are staying flat or declining because of the decrease in accidents. The re-insurance sector is also expected to be soft this year because of catastrophe free year of 2006.

The value line investment survey published a survey of AIG. According to valueline, AIG's EPS will be 7.80 by 2011 and book value will be $60.00. Valueline thinks the share price will be 135 to 180 dollars per share in this time frame. However, this assumes the Price/Book and Price to earnings ratios to remain high or higher.

Overall, the value line forecast seems a bit aggressive to me including the low end. While AIG is a good company, my opinion is that Berkshire is a very compelling investment as well. Berkshire does insurance better than AIG and has other well diversified business and stock holdings. Currently berkshire is selling for about 28% discount to fair value.

MMM (3M) Analysis

3M is a diversified technology company with a global presence in the following businesses: industrial and transportation; health care; display and graphics; consumer and office; safety, security and protection services; and electro and communications. 3M is among the leading manufacturers of products for many of the markets it serves. Most 3M products involve expertise in product development, manufacturing and marketing, and are subject to competition from products manufactured and sold by other technologically oriented companies.
At December 31, 2006, the Company employed 75,333 people, with 34,553 employed in the United States and 40,780 employed internationally.

The company is growing at around 7-8% year over year but is facing tough comparisons this year compared to last with lower EPS this year compared to last. This is one of the reasons the stock is down. The analysts are expecting flat to slight growth this year compared to the previous year. Next year is expected to be somewhat better with a growth of about 10-12%.

Let us briefly take a look at the revenues by geographic region and growth by geographic region. The revenues by geographic region look as follows:

US - 38.6%
Asia Pacific - 27.3%
Europe - 25%
Latin America and Canada - 9.1%

The EPS has grown at around 9% for the past ten years. The top line growth is more abysmal at around 4.5% per year for the past ten years. The operating profit has increased at the rate of 6%.

In the same period, the number of outstanding shares has declined by about 8%. One can expect the total number of shares to decline slowly in the upcoming years. The cash flow from operations continues to be strong - growing at around 10% per year. The debt has also increased in 2006 compared to 2005. The dividend has grown at around 8% per year for the past five years. One can expect this ratio to continue in the upcoming years.

Indian market overview

In the previous article, we looked at major India funds and compared their performance against the BSE Sensex Index. We found that the mutual funds werent doing well and were lagging the BSE Sensex by a large margin. When we analyzed the Chinese market, we found the results to be identical - the funds lagged the index by a large margin.

The BSE Sensex index went down by about 15% since its peak and it is a good thing. People may think that the market should go up but this isnt the case. A correction like the one we have seen is very healthy as it ensures the long term health of the market and killing excessive speculation.

Let us take a look at different funds to see how things look like. Let us compare the charts of the various India funds and EEM looks like when comparing against the BSE Sensex Index. The comparative charts of the funds and their performance is noted below:

Chart comparing BSE Sensex vs other funds

Even with this correction - the expected return for Indian stocks in a best case scenario is 10-12% for the next four - five years. A deeper correction will provide more upside if the economy is managed well in the next several years.