Sunday, June 24, 2007

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

Part 2

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.

Sunday, June 17, 2007

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.

Saturday, June 09, 2007

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.