Thursday, April 26, 2007

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.

Sunday, April 22, 2007

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.

Saturday, April 14, 2007

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

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.

Sunday, April 08, 2007

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%.

Tuesday, April 03, 2007

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.