Microsoft: The Dead PC Beckons From The Grave

For many years, Microsoft (MSFT) has been an investor favourite, making it an expensive purchase for value investors. Today, however, that is no longer the case. Consider the following chart depicting Microsoft's P/E over the last 25 years:

If you remove the company's net cash position of $33 billion from its market cap, the current P/E (based on the company's last 12 months of earnings) is about 9.

Despite efforts at product proliferation and diversification, Microsoft still makes most of its money from two main products, its Windows operating system and its Office family of applications. The stock's low P/E tells you that investors are rather bearish on the combined future of these two products, as well as Microsoft's future position in potential growth areas such as tablets and mobile phones.

On the Windows front, Microsoft continues to dominate share in PCs and maintain a healthy share in servers. But the use of tablet computers is expected to take a bite out of PC sales. Furthermore, continued market share gains by MacIntosh computers could be a threat to Windows' market share in the future.

With respect to Office, Microsoft now competes with a very high profile player in Google. Some enterprises are moving or have moved to Google Docs, having shunned the high fees associated with Office.

In other areas, Microsoft continues to profit from entertainment products/services such as the Xbox console and software, but these just barely make enough money to cover losses in the company's online division, as Microsoft is losing badly to Google in the area of online search.

While all of the above-mentioned challenges represent threats to Microsoft's future profits, it is extremely difficult to predict the future. For example, even if Microsoft loses share in both Windows and Office, has no success in tablets or mobile phones (or any other new products for that matter), and continues to lose money online, Microsoft's share of growth in global PC sales may more than offset any profit declines. For example, Gartner estimates PC shipment growth next year of 15.9% (the vast majority of which will likely run Windows and Office), despite "growing user interest in media tablets such as the iPad".

So while the future is extremely difficult to predict, Mr. Market is nevertheless making a bold prediction. At a P/E of 9, he appears to believe that Microsoft's profits are in decline. This is in stark contrast to the company's latest quarter, which saw earnings growth in the high teens on an apples-to-apples comparison with last year.

Like Cisco, which was discussed yesterday, Microsoft also returns a lot of money to shareholders in the form of buybacks. At the current P/E, further buybacks could turn out to be a terrific investment on behalf of shareholders.

When Mr. Market boldly predicts a high-return company's decline, investors are offered an opportunity to buy an asset for cheap. In the case of Microsoft, investors are offered a company with a dominant position in a growing field, at the price of a company in decline.

Disclosure: Author has a long position in shares of MSFT

Dominant and Cheap: Cisco Systems

Over the last 10 years, shares of Cisco Systems (CSCO) are down over 60%. But that's not because the company has been eroding shareholder value. Cisco earned $1.33 per diluted share in 2010, whereas it earned 36 cents per share in the year 2000. Yet the stock fell over this 10-year period because it had a P/E of 140 back then; today, Cisco has a P/E (adjusted for its net cash position) of just 10.

Companies with P/E ratios in the single digits or low double-digits usually generate low returns on capital as a result of having no competitive advantage. This is not the case with Cisco, as borne out by the following return* on invested capital (ROIC) data over the last few years:

Before panicking at the apparent downtrend, consider that 1) the absolute numbers are still high, and 2) numbers will be weaker during a recession. These high returns do suggest that Cisco has a moat. Further analysis of the company's core products reveals that Cisco dominates several product lines, in some cases delivering market share numbers north of 70% and even 80%. These kinds of numbers will help Cisco maintain and grow its moat, as it is able to spread R&D spend over a much larger number of units than are its competitors.

Sometimes, companies will also trade at low P/E's because a company's industry is in secular decline (e.g. the newspaper industry). This, too, is hardly the case for Cisco. In fact, it may be just the opposite. Networking needs continue to grow worldwide as populations continue to seek higher and higher bandwidth connectivity for a multitude of devices. Cisco is at the forefront of the network hardware architectures required to make this happen.

Finally, companies also trade at low P/E's because of negative short-term sentiment. That appears to be what's happening here. The company's latest quarterly guidance was below estimates, as Cisco expects just 3-5% year-over-year revenue growth next quarter due in part to government budget cuts, as state and local governments look to bring their fiscal houses in order. This caused the stock to fall some 20% over the last two weeks. But annual revenue growth is still expected to come in between 9 and 12%, suggesting the business is still sound, growing and undeserving of such a low P/E.

Cisco's board agrees, as it has now authorized the company to buy back almost 14% of its outstanding shares. A look at the company's cash flow statements shows that Cisco has been quite willing to return cash to shareholders in this manner, and recent management comments suggest this will continue:

"If you look at what we do, we always purchase the stock during periods when we see it sliding a little bit."

When a company with a sustainable and proven competitive advantage trades at a low P/E, opportunity knocks. Investors with an eye for the long term are likely to do well going long in such situations.

Disclosure: Author has a long position in shares of CSCO

* As there are many formulas to choose from when calculating ROIC, it should be noted that here, ROIC is calculated as OpIncome(1-tax)/(Debt+Equity-Cash)

SuperFreakonomics: Chapter 5

Many of our decisions, both inside and outside the investment world, are often based on anecdotal information, anomalies, emotions, or existing opinions. SuperFreakonomics illustrates how applying an economic approach can help us change this. Investors can use the tools described in this book, including better and more prevalent use of data, along with an an understanding of the power of incentives to make better decisions.

This final chapter focuses on the issue of global warming, but draws on many of the other concepts discussed in the book. First, the book debunks many of the misleading and exaggerated facts disseminated by the media. There appears to be scientific consensus that the earth is warming, and that humans are contributing to this. But how humans are contributing appears to be wildly misunderstood. For example, ruminants contribute 50% more greenhouse gases than the entire transportation sector! If humans changed their diets from say beef to kangaroo, it would do far more to help the environment than if they all drove hybrids.

The authors stress that negative environmental effects are due to externalities. In theory, we could determine the negative environmental externalities associated with a particular activity, tax it, and use that money to pay the costs that others experience as a result of the activity. Unfortunately, the world's climate operates under such a complex system that the authors argue this is virtually impossible.

Others believe the problem of global warming can be solved by encouraging (or perhaps forcing) people to make sacrifices. But people are not philanthropic enough to make this happen (this topic was more fully discussed in a previous chapter) and therefore this is unlikely to work on a grand scale.

Instead, they believe the challenges of global warming can be met by the same force that has solved environmental issues of the past: technological innovation. The authors describe various attempts at solving the problem of global warming. Many of them are quite simple, yet still sound effective. For more on some of these solutions and the ensuing controversies that followed, see here.

SuperFreakonomics: Chapter 4

Many of our decisions, both inside and outside the investment world, are often based on anecdotal information, anomalies, emotions, or existing opinions. SuperFreakonomics illustrates how applying an economic approach can help us change this. Investors can use the tools described in this book, including better and more prevalent use of data, along with an an understanding of the power of incentives to make better decisions.

This chapter discusses some of the simple solutions that have improved the lives of humanity over time, and contrasts them with some complex solutions that have actually done more harm than good. While people love to complain and refer to the good old days when everything was better, the authors argue that the reality is that our lives have consistently improved over the last 100 years.

The authors discuss a few examples of innovations that have improved our lives. One of these is the seat belt, a simple but effective solution to what used to be high traffic fatality rates. The authors argue that the seat belt has reduced the risk of driving fatalities by 70%.

One of the sub-themes of this chapter is the contrast between solutions from the private sector and those of the government. Because the private sector is focused on profit, their solutions to problems tend to be fairly simple, low-cost fixes. When governments get involved, however, the complexity rises and often results in unintended consequences that actually make the problem worse (e.g. the American Disabilities Act has reduced hires of the disabled because the disabled are harder to fire, protections for endangered species actually do more damage to endangered species because they encourage land owners to make their properties uninhabitable etc.)

The authors end with a look at a future innovation that may save the US billions of dollars worth of damage annually. A group of researchers is working on a relatively simple method of preventing hurricanes using a simple, low-cost, non-polluting device. More on this device, the man behind it, and some of his firm's other inventions are discussed here.

SuperFreakonomics: Chapter 3

Many of our decisions, both inside and outside the investment world, are often based on anecdotal information, anomalies, emotions, or existing opinions. SuperFreakonomics illustrates how applying an economic approach can help us change this. Investors can use the tools described in this book, including better and more prevalent use of data, along with an an understanding of the power of incentives to make better decisions.

This chapter is about altruism. In classical economics, the belief is that everyone is out for themselves and so people will make decisions only if it helps them out. However, recent studies and experiments (including the Dictator Game) have suggested that people are also altruistic to some degree, which has thrown a wrench into the idea that people are rational, self-interested beings who make decisions that are in their best interests.

The authors spend a fair bit of time debunking the idea that people are unselfishly altruistic. Yes, people will help out others, but they often do so for self-serving reasons, including reducing their own guilt, or because they hope to receive similar benefits when they are in need, or because someone is watching. The authors cite a few variants of the Dictator Game introduced by John List (the economist, not the mass murderer) that suggest people are not as altruistic as originally thought.

Though people may give money away in supervised games, outside of the laboratory the authors suggest the practical evidence suggests people are not all that altruistic (prompting the quip: "sure it may work in practice, but does it work in theory?")

One example the authors use to illustrate this has to do with organ donation. Would a stranger give another stranger one of his kidneys out of the goodness of his heart? To the detriment of those needing a transplant, US law prohibits monetary gain from organ donation. As a result, there are 80,000 people in need of a kidney in the US, but only 16,000 transplants will be performed this year. In Iran, where donors are paid, there is no such gap. While the authors recognize that Iran is not considered a forward-thinking country, it should receive some credit for recognizing that incentives, not altruism, are a more effective method in saving lives.

SuperFreakonomics: Chapter 2

Many of our decisions, both inside and outside the investment world, are often based on anecdotal information, anomalies, emotions, or existing opinions. SuperFreakonomics illustrates how applying an economic approach can help us change this. Investors can use the tools described in this book, including better and more prevalent use of data, along with an an understanding of the power of incentives to make better decisions.

In this chapter, the authors describe several instances of how the use of data can be employed to make better decisions. The authors start by explaining some strange anomalies with respect to one's birth month. Those who believe in horoscopes can point to many cases where birth months appear to play an abnormal role in predicting an outcome; the authors delve into the data to explain why.

For example, babies born in a certain month of the year (for 2010, it would be May) are 20% more likely to have a learning disability. This is because of religious fasting during the month of Ramadan; when pregnant mothers fast, their children are more likely to have disorders.

In other examples, a US-born child is 50% more likely to play professional baseball if he is born in August (vs July), whereas a British-born child is far more likely to play pro soccer if he is born in January (vs December). This is because the cut-off dates for little league baseball and youth soccer are July 31st and December 31st respectively, and so kids that excel under that format are given the most encouragement, confidence and playing time. (That is, a four-year old born in August will be much more able than his teammate born almost a year later in July.)

The authors then detail how such data mining can be applied to help improve our lives. Mining medical records can help identify the best (and worst) doctors. Mining banking data can help identify terrorists.

Using outed terrorists as a guide, the authors sought to create a banking profile to help identify terrorists still living among us. This is a challenging exercise for many reasons, not the least of which is the fact that because there are so few terrorists, inaccuracies in prediction are liable to yield scores of false positives, the investigation of which would overburden authorities. The authors provide some examples of the behaviours of terrorists (and omit some, because of the top secret nature of this work), including the fact that terrorists do not buy life insurance, do not have savings accounts, and were unlikely to use an ATM on a Friday afternoon (potentially due to prayers). This work is ongoing, but the authors believe the progress and future potential of this work is strong.

Silverleaf Golden?

Silverleaf Resorts (SVLF) markets and operates timeshare resorts. The raw stats on Silverleaf are enough to excite any value investor. The company has a P/E under 5, a P/B of 0.2, and a P/S of around 0.15. Furthermore, the company continues to generate a profit throughout this downturn.

But it's no longer March of 2009, so a company trading at such a low price must be spooking investors in some way. In the case of Silverleaf, it is the company's high debt levels in relation to questionable receivables that worries investors. The company has tangible equity (mostly in the form of notes receivable from customers to which it has sold timeshares) of $200 million, and debt of $400 million.

The good news is, the debt owed is staggered in its maturity dates, and much of it isn't due for several years. The bad news is, the receivables are due over several years as well. Silverleaf takes about a 10% down payment from the would-be vacationer, and then spreads the remaining payment over the next 5-7 years.

As such, the situation is a bit of a black box for shareholders, as we don't know how well the customers are going to be able to make their payments, and the leverage employed further clouds the situation. In this way, Silverleaf operates a little bit like a bank, which makes it very difficult to value. It is a well-capitalized "bank", but it is also an un-diversified one, as it caters to just one group: low-end consumers willing to accept annual interest rates in the teens. This is a group that is particularly vulnerable in a weak economy. The loans to customers are, however, secured against the timeshare which can then be flipped to someone else, which does provide some protection to shareholders. (For further discussion of the company's customers, see here.)

With such a low stock price, the company might be better served sitting on its hands and collecting payments it is already due. But that is not what's going on. Perhaps due to vacancies at the company's properties (i.e. a high inventory number), management continues to push sales. But to market the company's inventory of timeshares, the company has to spend money now, while most of the cash from customers isn't received for many years. This situation dries up liquidity and explains why the company's debt position is not really improving, despite the paper profits.

So is management just trying to keep its job, or is there some scale to be achieved by filling up the company's properties? The answer to this question may lie in the company's proxy filing, which details who owns the company's shares. In this case, the CEO owns 25% of the company, suggesting his incentives are aligned with those of shareholders. Nevertheless, there is much uncertainty clouding this company's future due to the long-term nature of receivables, the customer groups Silverleaf sells to, and the leverage employed to finance these future receivables.

Disclosure: None