Caribou Coffee Company, Inc.

Coffeehouses, Coffee roasting

NASDAQ symbol CBOU

The Short Version

The company has established profitability for 11 consecutive quarters, and despite its large presence in the Midwest, has plenty of room to grow. The company can boast of fun, comfortable coffee shops, and delicious coffee sold both as whole, roasted beans, and in K-cups. While it is still a young company, the upside looks incredible and the downside seems minimal, making Caribou a great speculative purchase.

The Long Version

I had my first experience with Caribou Coffee on a recent trip to Chicago. After getting off the plane and hopping on the subway, I realized it had nearly been 4 hours since my last cup o’ joe. This seemed like a problem for me, so I hopped off the “L” when I got to the city, and looked around. There I found my first Caribou coffeehouse, right across the street from a Starbucks. I walked in, and was immediately impressed by my surroundings. The atmosphere was warm, bright, and open. People sat together at long wooden tables, and on the wall as I walked in was a bulletin board announcing local events. The whole place seemed cool! I walked up to the barista and ordered my favorite: café au lait. As I walked out with the cup in my hand, I took a sip – pretty good!

When I arrived at my friend’s apartment later that night, I mentioned how much I liked their cafe au lait; few coffee shops make them well. My host replied that she was a Caribou fan. “That’s my favorite coffee chain. I love their brand.”

Instantly I was intrigued. “Brand? They’re a chain?”

I found out that Caribou was one of the most popular coffee chains in the Midwest, and that they have started selling their roasted coffee to grocery stores, both as whole beans, and in K-cups for the Keurig single cup brewer. This immediately struck me as a screaming Peter Lynch-esque opportunity. That evening I went to the internet to find that Caribou is publicly traded. Hot-dog!

Of course, I had to calm myself (by drinking yet another cup of coffee) and remember the fundamentals; A good investment must pass a qualitative and quantitative analysis. And so I began my research.

Qualitative

This was the most fun I’ve had so far qualitatively analyzing a company. Once I learned that it was public, I decided to visit any Caribou coffeehouse I walked by, and since I spent the better part of two days walking around the neighborhoods of Chicago, I got to do a lot of market research. I ended up visiting four different coffeehouses and one kiosk during my stay in the city. At each one, I was impressed by the friendly service, the quality of the coffee, and the great environment.

Walking into a coffeehouse, I immediately felt comfortable. They were all decorated with warm colors, featured cool furniture, and had lighting that was bright enough to read in. Every Starbucks I have ever visited has been far too dim and too pompous for my taste. Even though there were hipsters in each Caribou coffeehouse, I always thought “this is a chill place. I can stay here a while and relax.” In Starbucks, I constantly get the feeling that the shop (and its patrons) are thinking “we’re too cool for good lighting, too cool for big tables, and too cool for you.” Each Caribou shop I saw featured a bulletin board for community activities and groups. Even the kiosk in the park had some flyers posted on it. Caribou coffee houses feel local, despite the fact that there are over 500 of them. Maybe that’s why the hipsters weren’t afraid to hang out there.

In fact, despite my distaste for “meggings” (and I’m not alone in that opinion), the large number of hipsters was a good sign for my purposes. Good coffee and hipster culture are like peanut butter and jelly. Apparently I wasn’t the only one who liked the taste of good café au lait. But there were not just hipsters in the various coffee houses. Every shop I visited had a line, full of diverse people, wearing everything from pinstripe suits to sweat suits. As far as I can tell, this meant that the coffee was in demand, and appealed to a wide range of demographics. Definitely positive qualitative factors.

I managed to try a cappuccino, a latte, and a few plain ol’ cups of coffee. Not once was I disappointed. Caribou simply makes a solid cup of coffee. This was a stark contrast to my experience with most of Caribou’s competitors. Dunkin’ Donuts has improved its coffee, but I only drink it under duress (mostly in airports). My experience with Starbucks has been disappointing as well. Its coffee tastes weak or burnt, and is over-priced. The last time I ordered a cappuccino at Starbucks, the milk had been overheated, and the espresso tasted like ash. Caribou simply makes a great product.

This caffeine bender was a fun research experience for me, and as luck would have it, it can continue here in Boston! True, there are no Caribou coffee houses in Massachusetts, but the company has expanded into another mainstream retail outlet: the supermarket. Recently the company has placed a heavy focus on expanding its sales nationally in grocery stores, both through selling whole roasted beans, and K-cups. Caribou made a brilliant move by expanding into the homemade coffee market. “You like our product? Here, take some home with you!” Fantastic. Now the company has two streams of profit that can build upon each other. As more people discover the company’s great coffeehouses, those people will buy beans to take home. When they take beans home and share them with friends, those friends get to discover Caribou as well! It’s a lovely upward cycle, and since 30 states don’t have any Caribou coffee houses, there is plenty of room to let the growth take place. Caribou is positioned to expand rapidly into a high-demand market.

My experience with Caribou may have been limited to the city of Chicago, but the way I see it, the coffee is the same whether they ship it to Chicago, Nebraska, or Canada. The company has a piece of every part of the retail coffee market, and their product is simply superior to their major competition. Maybe my love of caffeine clouded my judgement, but Caribou Coffee is a clear qualitative thumbs-up for me.

Of course, any investment has to be quantitatively investment grade as well, so when I returned to Boston, I bought myself some Caribou K-cups, started reading the accounting statements.

Quantitative

The quantitative analysis of Caribou Coffee was not nearly as difficult as GE or GM. The company was good enough to keep its annual report to a measly 54 pages, and did a good job keeping things clear and concise. However, the full analysis did require some extracurricular activities, and a bit of rational thinking about the future of the business, making it one of the most interesting companies I have researched yet.

From the perspective of a Benjamin Graham value investment purist, the company falls flat on its face. The company has only been publicly traded since 2005, and thus immediately would have made Mr. Graham suspicious. It has not had time to become one of the stable, leading American businesses that Graham was so fond of. He preferred companies that had long, uninterrupted histories of paying dividends. Caribou Coffee is still growing, and has been retaining all of its earnings in order to help expand the company. On top of that, Caribou is not selling at a discount to its book value. On the contrary, Caribou is currently priced at 3.26 times last reported book value, and that number includes intangible assets and certain capitalized leases, both of which are unlikely to fetch a fair price in the event of a liquidation. Even when priced in relation to earnings, Caribou does not justify a high price. Over the last five years, the company has reported a negative average EPS (earnings per share). of  As an investment, Caribou is a clear no.

However, the story does not end there. Caribou has a lot of good qualities, which may be profitable in the future. In 2008, a new CEO was brought in, and he promised to return the company to profitability. By 2010 he had fulfilled that promise, and the company posted earnings of $.46 per share. As impressive as that is on its own, the company has been growing all segments of its business, and expanded into a new market  – K-cups! Caribou recently entered into a partnership with Keurig, to make and sell K-cups containing Caribou’s coffee, which will help Caribou expand into grocery stores nationwide.

This expansion was not random; Caribou planned to move into the retail market two years ago (the company mentioned it in its 2008 annual report), and has been executing its plans flawlessly since then. The annual report and quarterly reports reveal that grocery store sales have been the fastest growing segment of the business, and the most recent letter to the shareholders reveals plans to continue pushing Caribou coffee into new markets, establishing a national brand.

The company is not only growing by expanding into a new market, it is expanding its current business. Reading through its last annual report, I found that the company has increased its number of coffeehouses, and that same-store sales have risen over 4%! Business is growing at existing locations, and expanding to new locations! This is all great news for the company. Peter Lynch would have wept with joy.

Looking through the company’s quarterly reports, I noticed that income has been rising significantly over the last nine months. Overall, the company has earned $.46 per share last year, but in its last quarterly report, the company declared that it has earned $1.46 per share (fully diluted), and that does not even include some of the beginning of winter, when hot beverages really sell! The company managed to triple its earnings in less than 12 months. That is impressive to say the least.

There is one concerning thing about this income, however: of the $234 million recorded as gross income, over 20% ($58 million) was reported as non-recurring income. This concerned me as a potential stock owner, since any investment in a company is made on the presumption that the company can continue to make money. If all of the company’s income is non-recurring, I have no guaranty that the future holds profits. I kept reading the report, and found that (surprisingly), this “non-recurring” income is a good thing.

It seems that most of this non-recurring income is attributable to the sale of new franchise agreements. This is excellent for two reasons; the company is expanding while taking on fewer direct costs, and the company is increasing the number of outlets where it can sell its products. Until recently, the company had been focussing primarily on opening and running company-owned stores. While the company continues to open company owned coffee houses, the decision to sell more franchise agreements will help bring in cash quickly and expand their presence nationwide. Now the company can spend more time and energy on making its coffee and its brand as good as possible, while other people worry about the day-to-day hassles of running the coffee houses. Additionally, each new franchise that is sold represents steady income for the future. Franchises will need coffee from Caribou to sell to customers, and that represents a steady stream of cash coming in and product going out. Yes, technically the franchise fee is “non-recurring” since a franchise owner only pays up once, but the real story is that for the next five to ten years, the company can profit from its new expansion. I decided that the company’s non-recurring income was perfectly acceptable.

Now for the math. Because of Caribou’s quick growth and rather impressive prospects, it is hard to view the past five-year average EPS as a fair estimate of the company’s true value. The new management has made great aggressive moves to grow the company, and shows no signs of slowing up. In fact, the management has managed all of this without taking on a single penny of long-term debt. Even if the company stops growing at its incredible rate, it is not likely to go under, or have any problems adjusting to changes in the market and surging forward again. I love the financial prospects for Caribou Coffee!

Looking that the current earnings, the company has earned $1.65 per share over the past 12 months. For a larger, established company, I would use an earnings multiplier between 15 and 20 to estimate the value of the company. However, with a small company that is looking to grow, that would be excessive. The company has not established its earning power the way that Berkshire Hathaway has, and faces certain risks down the road from competition and commodity coffee prices. Additionally, it is important to consider the “non-recurring” franchise fee income. Yes, the company should make more money down the road with its new franchises, but the total annual income realized each year individual year from those franchises will likely be lower than the initial franchise fee. For safety’s sake, I chose to use an earnings multiplier of 12.

If we grant that Caribou Coffee is worth 12 times its current earnings, given earnings of $1.65 per share, the company’s common stock is worth $19.80 per share. As of the writing of this article, the stock was trading at $17.42 per share. Caribou Coffee gets the quantitative thumbs up.

Conclusion

Caribou Coffee is a great looking company, with a good product, and lots of room to grow. The company plenty of space to expand into New England, the Northwest, and California before it even needs to think about international markets. With an established foothold in the Midwest, rapid growth through the sale of roasted beans and K-cups, and increasing same-store sales, Caribou is a pretty clear buy for me.

Some may point at large coffee chains, and say that Caribou will have a hard time competing with these companies. I respectfully disagree. While I certainly can see that Caribou faces some challenges as a small company, it has a powerful advantage – it provides a better product. As an avid coffee drinker, I can confidently say that anyone who tries Caribou’s coffee will never drink another cup of Starbucks or Dunkin’ Donuts coffee again without grimacing. Yes, Caribou will have to fight for name recognition and market share, but once people taste the coffee, they will realize how much better the product is, and I firmly believe that better products will win out in a capitalist market. Caribou’s competition does not concern me at all.

The one concern that did make me think for a moment was one that Caribou brought up themselves. They mentioned in their last annual report that the company rents almost all of the space for its coffee houses, and if the cost of renting space rises significantly, then the company’s ability to make a profit could be in jeopardy. This was worrisome for me to read. Rental markets can be notoriously volatile, and as a potential stock owner, I worry about variables that could tear away at my company’s earnings. Fortunately, I have been working in real estate for a few years now, and had a chance to look around Chicago, and observe the real estate situation in the company’s heartland.

As I walked around Chicago, I was struck by how many vacant lots and buildings there were. Every block had at least one “for sale” or “for rent” sign. This was not the suburbs, or Boise Idaho, this was Chicago, one of the commercial centers of America, and there was space for lease everywhere. I can’t imagine that its much better anywhere in the Midwest. If Chicago is having trouble filling its buildings, I’ll bet Minneapolis is struggling too. With that in mind, I don’t see rising rents as a potential problem for Caribou coffeehouses. Rents cannot go up quickly, because any landlord who is foolish enough to raise rents in that kind of economy will drive paying tenants away to cheaper space. My guess is that for the next few years Caribou Coffee can count on good deals for its rental space. Granted, that could change rapidly if economic growth explodes tomorrow, but as long as the unemployment rate remains above 8%, I am skeptical that rents (commercial or otherwise) will go through the roof. I could be wrong, but that is one of the reasons the stock is a speculation, not an investment.

Looking at the whole picture for Caribou Coffee, I like the company’s growth, I like its product, I like the small downside, I like the huge upside. Everything I can see about Caribou looks good. Until the common stock hits $19.80 per share, I will happily buy it up. It may take a few years for this speculation to pay off if growth stalls, but fortunately I am young, and have plenty of time on my hands. Caribou is a buy, and it goes in my portfolio.

- The Filosopher in Phinance

Disclosure - I have no financial interest in CBOU, and no plans to initiate any position on the stock in the near future.

Amazon.com

Retail, Publishing, Tablets

NASDAQ symbol AMZN

The Short Version

Despite a solid business model, and attractive growth over the past decade, Amazon.com has been bid up by spectators to a dangerously high price level. The high stock price leaves little room for possible profit, even if Amazon keeps up its current rate of growth (an unlikely event). The company is so highly overvalued that its stock presents a very attractive short opportunity, especially since the company pays no dividends (and has no intention of issuing them in the near future). AMZN goes in the portfolio as a short position.

The Long Version

Amazon.com, Inc. has become one of the retail giants of our time. It offers almost everything you can imagine, and it delivers right to your door. The company represents  the new American dream – you can have everything you want without leaving the bedroom. Joking aside, the company has used the internet to great effect, and built an internationally recognized brand in two short decades. Now, the company can boast that it has one of the easiest websites to use in the world.

As always, a good investment must pass a qualitative and quantitative analysis. Here are my thoughts on Amazon:

Qualitative

Amazon’s underlying business model is enviably simple. “We have product, and you need product; pay us, and we’ll take care of the rest.” Even I could explain that model with a crayon drawing, thereby satisfying Peter’s Principle number three, “never invest in any idea you can’t illustrate with a crayon,” from Lynch’s book Beating the Street. A distinct cost advantage separates Amazon from other major retail competitors; Amazon has no storefront. Amazon.com saves a lot of money by not having retail outlets, which require a large investment in real estate, labor, and inventory. The company passes some of these savings on to customers, which gives it a great competitive advantage over brick and mortar bookstores. The demise of Borders and the retraction of Barnes & Noble is no accident.

These advantages are supported by the large volume of product that Amazon.com moves on a regular basis. The company has is now instantly recognizable as a great place to shop for any of your needs – not just books. If you google “Amazon” (no “.com”), and the first ten results are about the company – the rainforest only appears at number 11. For retail, this name recognition is a major intangible asset. People shop at places they know, and wide spread knowledge of Amazon.com brings in sales, especially given Amazon’s web-centered model. When people need to buy, instead of driving out to a store and shopping, they can simply switch on the computer or phone and have what they need within 2 days. The convenience coupled with the brand name make Amazon a powerful retail engine, which is definitely a good thing for a potential investment.

Some people point to Amazon.com’s Kindle and Kindle Fire as great qualitative factors. I hesitate to do so. By entering a new market (tablets and e-readers), which is fundamentally different from its retail operating model, Amazon is taking on several risks. The company is now a true “tech company,” which dramatically changes its position. When Amazon focussed solely on retail, it was not a true “tech company.” It really was a retail company that used technology instead of real estate to sell products. Amazon’s competition was Sears, Macy’s, Target, and Walmart, now the company is fighting Microsoft, Apple, and Google. These tech heavyweights will be tougher to compete with than retail giants, because Amazon no longer has the price advantage right from the start. Amazon will have to compete on product, rather than on its business model alone, and there is no concrete proof that Amazon.com can win that battle.

You might be quick to point out that Amazon.com’s tablets (and e-readers) are a lot cheaper than competing products offered by the tech giants, and therefore the company should be able to grab the low-price market share. However, Amazon is not alone in that part of the market. Barnes & Noble has released its Nook and Nook tablet which are similar to Amazon’s products and priced similarly as well. This is a place where Amazon is going to have to get used to competing in new and creative ways.

Of course, not everything is rosy and pink for Amazon.com. Amazon’s lack of a storefront has served as a great boon to the company, but could quickly become a drawback. When a consumer knows exactly what he wants, Amazon’s platform serves as a great advantage. When a consumer has questions, or is unsure of what to look for, Amazon’s website falls short of a standard retail outlet. In a store, customers can pick up, observe, try on, and compare different products; these things are more difficult in front of a computer screen. On top of that, the lack of human service that a website can provide may hamper Amazon.com’s competitive edge, especially while the tablet and e-reader market develops. If a consumer has a question or problem with a Nook, he can go to a B&N store, where a friendly customer service agent will smile and say, “welcome, how may I help you today?” This puts customers at ease, and once he feels comfortable in the store, it is hard to walk out carrying nothing. Amazon does not have this edge.

Stepping back to view the big pictures, all my concerns about Amazon’s new product and lack of traditional retail outlets seem like examples of “weekend worrying” (as Peter Lynch called it). Amazon’s underlying business model is still solid, and the kindle may provide an excellent source of revenue through the future sales of e-books, apps, and upgrades. It also may be an excellent vehicle for driving traffic to the website for other technology needs. Sure, the company took a risk with its new product, but at some point growth requires some risk. If the company refuses to innovate, eventually some whiz kid in his basement will find a better way to sell products and Amazon will be left in the dust. Yes, Amazon.com has no storefront, and that sometimes hurts business, but it also has become the core of its business model. No business is going to pick up every dollar of the market, so Amazon is better off simply sticking to its guns and selling cheaply, quickly and conveniently. Amazon.com gets a qualitative thumbs up!

Of course, a good business model is never enough to determine a good investment. That model has to be executed efficiently and consistently in order to satisfy an investor. The only way to determine if the model is working is to look at the results in the financial statements. As Cuba Gooding Jr. would say, “SHOW ME THE MONEY!”

Quantitative

After a careful and thorough examination of the company’s balance sheet and income statement, I only had one thing to say: “Holy Mackinaw!” (that was my grandpa’s favorite exclamation). The books do not paint a pretty picture for the company’s financial management. The deeper I dug, the more uncomfortable I was with the idea of investing my money in Amazon.com’s common stock. I found some methods of financing that looked short-sighted to me, and calculated that the company was highly overvalued. What upset me even more was what I did not find, namely, any discussion about sales and profits generated by the Kindle and Kindle Fire. My analysis leads me to believe that Amazon’s common stock is dangerously speculative with little room for profit. Let me explain why.

The first thing that jumped to my attention was a comment on page 12 of the annual report. The company said, “volatility in our stock price could adversely affect our business and financing opportunities and force us to increase our cash compensation to employees or grant larger stock awards than we have historically, which could hurt our operating results or reduce the percentage ownership of our existing stockholders, or both.” Any business faces risks that jeopardize its operating income, but it seemed very strange to me that the company’s stock price should be a factor in Amazon’s profitability. The stock price should certainly be something the management is concerned about, but as Benjamin Graham pointed out, that concern should be limited to making sure that the stock price is a fair representation of the company’s value. This concern should be independent of the concern for future profitability. I kept reading to learn more.

I found that the company has made a habit of reducing its expenses by issuing shares of stock, and distributing these shares in place of cash. Over the last three years, the company has issued $1.3 billion worth of common stock to pay its expenses, including $557 billion of that total in 2011. This equated to over 5 million shares of common stock issued each year over the last three years – an increase in the number of shares outstanding of more than 1% annually. The figure may not seem significant, and if it were a one-time event, I might have been able to gloss over it. But since the company intends to keep issuing this new stock (as is implied by the page 12 quote), that 1% bothered me as a potential investor. Over 10 years, this pattern would dilute any increase in the “per share” value of the company by over 11%!

More importantly, it seems to me that this method of financing is irresponsible and dangerous. It continually erodes away any real value that the current shareholders have, and dilutes the possibility for future growth. To illustrate, a company that makes $100 million and has 400 million shares outstanding would earn $.25/share. With 500 million shares outstanding, that same profit only yields $.20/share (or 20% less). This method completely ignores the management’s duty to increase shareholder value. After all, it is the shareholders who own the company, not the managers.

Even more concerning is the danger this presents to the company in the future. In effect, by issuing 5 million shares per year Amazon.com is printing its own money. As long as people willingly accept these new shares, the company can get away with it. Eventually, however, investors might decide that there is nothing supporting the value of Amazon.com’s stock other than market demand. When the illusion of value has been shattered, the stock price will decline as investors trade their shares for other securities that have more real value.

As if that wasn’t bad enough, this fall will do double damage to any shareholders who hang on to their stock. First, their shares will lose their market value, and second, the company’s future profitability will be in question. If the company cannot give away its stock at $180/share, it will have to give away more shares, or pay in cash, leading either to further dilution, or to a drop in profit margins and free cash flow. When I invest my money, I want to know that I am buying something real, even if the market won’t pay me full price for it immediately. With Amazon.com, my investment is less sound than an investment in baseball cards. At least baseball cards look nice on the mantlepiece!

This was not the only problem I found while analyzing the company’s books. Constantly issuing shares is a concern, but theoretically if those shares were attractively priced, I could overlook the erosion of value. If a share of common stock is worth, say $400, I would consider paying $200 for it, even if the financial management of the company was less than perfect (the operative word there is ‘consider’). So I went through the books to determine whether or not the company was still a bargain.

On the contrary, it appears to me that Amazon’s common stock is radically overvalued. From the standpoint of book value alone, I found that there are 455 million shares outstanding, and warrants outstanding to purchase another 18 million, leading to an effective total of 473 million shares outstanding (remember, for the sake of the margin of safety you must assume all conversion privileges are exercised). The company reports a total equity of $7.757 billion on its balance sheet at the end of 2011. Using these figures, a quick calculation reveals that the book value of each share is $16.40. The stock is currently selling at $187.68 or over 11 times its book value! Keep in mind that I calculated that price without deducting anything from the book value. That estimation includes the company’s goodwill, and the valuation of the company’s own software, both of which have little to no value outside of Amazon.com, and therefore are not applicable to the calculation of the company’s “scrap value.” Taking these numbers out, and adjusting for some other accounting oddities, I found that Amazon.com has a fire-sale value of approximately $11.11.

Low book value represents an incredible amount of speculative risk. The book value may bot be a fair representation of the company’s true value, but it does provide a rough estimate of risk in the investment. I can only see two possible alternatives. Either the company is highly overvalued, and therefore any purchase of the stock would be a dangerous speculation, or the company is earning huge amounts of money in relation to its assets, and therefore is bound to face lots of competition once other large, diverse companies see the potential for large profit margins (GE comes to mind here). It is fairly easy to figure out which alternative is true by looking at the earnings of the company.

An examination of the company’s earnings is tricky, because a true determination of Amazon’s earning power would have to account for the company’s continual issuing of stock to cut expenses. For the sake of estimation, I took the net earnings from the past five years, and found the average net earnings to be $761 million, or $1.61 per share (fully diluted). Using Benjamin Graham’s maximum average earnings multiplier (for a five year average) of 25, that gives an estimated share price of $40.25/share. That is the absolute maximum investment price that I would be willing to pay for Amazon.com, and that does not account for any expenses that are paid for in common stock, or for non-operating income, or for any other accounting adjustments. At the end of the day, Amazon.com is currently overvalued by at least $147 per share!

A speculator may have a different opinion about the exact price that Amazon.com is worth. She might look at the fact that Amazon.com has little debt and a good business model, and may like the Kindle’s chances in the future. This could lead our clever hypothetical speculator to pay a small premium over the current value of the company. However, this premium would have to be small in order to be profitable. In any speculation, the purchaser of a stock is betting on the value of the company rising significantly, or to put it another way, she is paying for the future. However, paying too much for the future wipes out the possibility of future profit. The more you pay for the future, the less the future yields. A speculator would be paying $147 for the future in the case of Amazon.com. Amazon would have to quadruple in value to make the bet pay off! That is a huge risk. Perhaps Amazon.com would be a decent speculation at $50/share, given the Kindle’s chances, but that leads me to my last quantitative criticism; I have no idea how well Kindle is doing!

The annual report makes absolutely no mention of the sales generated by Kindle and Kindle Fire. As a potential investor, this bothers me. When looking at a company, I want to know that it has plans to grow in the future, and I would like to know what those plans are in enough detail to make an educated decision on the stock. I don’t need to know trade secrets or technology babble, I just want to know the general outline for the future. With Amazon.com, it is clear that tablets are part of the future, but not clear how that future will unfold. The annual report makes no mention of how many Kindles have been sold, how much money they have made, or how much profit has been realized by the sale of e-books and apps for those Kindles. To me, this means that one of two things is true; either the management does not want shareholders to know the details about Kindle, or the idea that investors may want to know about the Kindle’s success did not occur to the management. Neither alternative is attractive. On the first point, if the Kindle is making money, Amazon should be pointing that out as a sign of good things to come for investors (like GM did with the Volt in its annual report), and if it is losing money, then investors deserve to know. Even if the company plans to lose money selling kindles, but make money on all the spin-off industries (like e-book publishing), the investors deserve to know; they do own the company after all. If (on the other hand) the managers simply did not think that investors might be interested in how the Kindle is doing, that is a sign that the managers are not thinking primarily of shareholders and how to add value to shares. To give an example, in Berkshire Hathaway’s annual report, Warren Buffett goes through all of the company’s subsidiaries (over 50 of them!) and explains how well or poorly each one is doing. If the Oracle from Omaha can find time to explain that many companies to his investors, then Amazon.com should make the time to explain its flagship product.

Amazon is far too overvalued to be considered a good investment or speculation, and its management has done nothing to convince me to pay $147 per share for the future. Quantitatively, the company gets a thumbs down.

Conclusion

Even though Amazon.com has an attractive business model, and could make large splash in the new tablet market, the company’s stock is far too overpriced to justify either investment, or speculation. I can’t justify paying a $147 premium for the stock over its true value.

However, unlike Boston Scientific, which I simply placed on my watch list for future reference, there is a great opportunity for a speculative profit from Amazon.com’s stock. Since the company is so highly overvalued, is diluting any value currently held by its shares, and pays no dividend, the stock looks like a great candidate for short selling . The risk with short selling is that if the stock rises in market value, you can lose money, and if the stock pays out any dividends while you hold a short position, you lose that money as well. Fortunately, Amazon.com pays no dividend, and is so highly overvalued that even if the business is wildly successful, the true value of the stock is unlikely to reach even half of the current market price for the shares. To illustrate, let me construct a thought experiment.

Analyst estimates for Amazon’s earnings in 2014 average out to $5.00 per share (according to Thomson Reuters). If we assume that this estimate is correct, and that Amazon suddenly stops issuing new common stock and diluting current ownership values (big assumptions), then what would the stock be worth based on earnings? Using a price-to-earnings ratio of 20 (Benjamin Graham’s maximum 1 year multiplier), this would make Amazon.com worth $100 per share. This estimate does not factor in average past earnings, dilution, or the possibility that estimates could be missed, and it is still only half of the current market price. This does not necessarily mean that Amazon.com must go down, but it does mean that Amazon.com is unlikely to go up in market value any time soon, and the likely result is that Amazon will come down to earth over the next 35 months. Once you add in the fact that the stock is worth far less than $100 now (my estimate is $40.00 per share based on earnings), and the fact that the value per share is consistently being diluted by the management, then it seems clear that even if Amazon.com grows its business, short selling the stock is the right move to make.

Is there a possibility that Amazon.com stays at its lofty heights? Yes. Is there a chance that it could go up over some period of time? Yes. Are either of those things likely? Not at all. At some point, investors and speculators alike are going to realize that Amazon is not worth its market price by any measure. My guess is that the company has been bid up to its current level by speculators, but that speculation has become so extreme that even if the company triples profits, then the stock will still be overvalued. I am skeptical of the idea that the company could double profits, much less send them through the roof. Amazon.com is short in the portfolio.

-The Filosopher in Phinance

Disclosure – I have no financial interest in Amazon.com, and no plans to initiate any position (long or short) on the stock in the near future.

Final Note - Amazon.com’s high valuation not only makes it a great short sell, but also creates a very interesting speculative opportunity in the world of options trading. Click here to learn more.

Boston Scientific Update

In the interest of full disclosure, something has changed since I posted my analysis of BSX – I sold my position and no longer have a financial interest in the company. Now my interest is purely curious.

Of note – that was my first stock sale. Woo-hoo!

Boston Scientific

Medical Instruments Supplies

NYSE symbol BSX

The Short Version

This company from Natick, Massachusetts has many qualitatively attractive factors, including new managers, a highly motivated and dedicated workforce, and a large market share in field with rising demand. The company’s commitment to patient comfort, cost-effective products (for its customers), and minimally invasive procedures could serve it well as the population ages and new healthcare laws take effect. However, the company has been financially mismanaged for a long time and has lost money for the past five years. Until the company cleans its balance sheet and income statement, it is neither a good investment nor a good speculation.

The Long Version

I was first introduced to Boston Scientific (BSX) when I graduated from college and began applying for jobs. As I did some research to prepare my resume and a cover letter, I found that the company has a lot to offer its employees and its clients. The company offers a very thorough benefits package and plenty of room for professional growth. The company’s mission is to focus on improving the quality of life for patients, using minimally invasive procedures to improve health and keep patients comfortable. The company’s flagship products are its stents which are used all over the country, and the world. This company was not only an interesting place to work, it made an interesting potential investment. Of course, to determine if a company is truly worth an investment, it must pass a qualitative and quantitative test.

Qualitative

A qualitative analysis of Boston Scientific reveals a lot of good traits for the company. Right from the start, it is clear that the employees love their employer. The employees I spoke to had a lot of good things to say, the most common phrase used: “you’d love it there.” Apparently the company challenges its employees, but also rewards them extremely well with educational assistance and plenty of chances for vertical movement. Peter Lynch pointed out that when even the entry level employees are excited about the company, that usually means good things for the company in the future.

Among the new employees at Boston Scientific, one stands out in particular; Supratim Bose, the Executive Vice President and President of Asia-Pacific operations for the company. Hiring him early this year was an interesting move because until recently he held a similar position at BSX’s largest competitor, Johnson & Johnson where he enjoyed great success through the 80’s and 90’s (remember what J&J’s stock did over those two decades?). The company is clearly hoping to use is experience, expertise, and connections to expand into international growth markets, such as China, Brazil, and India. This hire was (and is) a very clever one to help the company compete against some of the industry’s juggernauts as the world population continues to grow.

That leads me to another good qualitative point: Boston Scientific is in the healthcare sector, which is (I believe) primed for years of growth. As the world’s population grows, and more people are around, more people will need healthcare. This company could be a great investment if the whole sector does well. President Kennedy once said that, “a rising tide lifts all boats,” and given Boston Scientific’s market share, the tide could prove extremely lucrative. Boston Scientific holds the largest, second largest, or third largest market share in the world for 75 different products (according to its annual report). There is clearly demand, and if demand increases further, BSX is in a great position to grow.

On top of that, it is important to note that Boston Scientific does not compete in pharmaceuticals. The company focusses on minimally invasive, low-cost solutions for patients. This focus could prove to be an immense advantage, especially in tough economic times, and in developing nations. When medical treatment is needed, and money is tight, sometimes a Boston Scientific stent offers an excellent alternative or supplement to invasive surgery or long-term medication. The company’s unique focus is a major qualitative advantage.

To make things better the company just won a large and important court case regarding the viability of its patents. This removes a large qualitative concern for potential investors. While legal action is always a factor in the healthcare sector, this court victory makes BSX’s products look more secure for the long run.

There are, of course, some qualitative concerns with the company. Given the massive amount of innovation in the healthcare sector, patents are a constant requirement, and the legal defense of those patents can be costly or unsuccessful. There are no guarantees in healthcare technology. This is especially dangerous given how small Boston Scientific is as a company relative to its competitors. GE Healthcare, Johnson & Johnson, and Siemens Healthcare (to name a few) are all massive corporations (smallest one has a market capitalization of $84 billion) with deep pockets and diverse product portfolios. They can afford to fight large legal battles, and even lose a few. Boston Scientific, with its current total value of only about $8.8 billion could be seriously hurt by too many legal complications, and if the company lost a patent lawsuit on one of its core products (like coronary stents) it could destroy the bottom line.

Another point that is particularly concerning is the state of flux  that healthcare law is in right now. With President Obama’s successful push for healthcare reform there are many unknowns in terms of how the results will impact companies that produce and supply medical equipment. The whole industry is facing a very serious concern about future profits and limits that the new laws could place on them directly or indirectly. There is a chance that HMOs, Medicare, and Medicaid will stop paying for minimally invasive products, and that could also cripple BSX in the future.

Looking at my concerns, however, they seem like versions of what Peter Lynch called “weekend worrying.” They are certainly possibilities, but they are not necessarily probable results. The chance that BSX loses all of its patent rights, and that new laws make stents legally irrelevant are slim. The realistic probability is that some court cases will be lost, some profits will be cut by new laws and insurance policies, some damage will be done, but most of the continuing business will remain intact. Yes, I have qualitative concerns, but I always have qualitative concerns. Stepping back and looking at the big picture, I like what I see on the surface at Boston Scientific. The company gets a qualitative thumbs up.

That, however, is only half the battle. The company has to pass a stringent quantitative test to be a true investment. Even to be considered a speculation, it should have a firm financial base on which to build. This leads me to the accounting statements.

As always, if you don’t like the nitty-gritty accounting stuff, skip to the conclusion for the cliff notes. That said, this company has some pretty interesting stuff to analyze…

Quantitative

An exhaustive qualitative analysis of Boston Scientific shows that any qualitative advantages the company holds are not helping the shareholders. The company has posted net losses, and losses before taxes for five straight years. It has managed to maintain a positive reported P/E (at least in the recent past) by classifying billions of dollars as “unusual expenses” over the past five years, but it seems evident to me that after five straight years of “unusual expenses,” it is hardly appropriate to think of these costs as “unusual.” In fact, many of these costs are generated from legal battles over patents, and product liability. Given the nature of the healthcare industry, they are unlikely to go away. Boston Scientific simply has not been making money.

There is the advantage of the company’s large market share in all of its product markets, however that advantage is largely unprotected. Unlike GM, which enjoys a wide competitive moat, and therefore can count on being among the largest automotive producers in the world for some years to come, Boston Scientific holds more than half of its asset values in goodwill (which is the premium the company paid  above asset values for its acquisitions), and about a quarter of its total asset value comes from intangibles (such as patents). This means that the amount of capital needed to compete in the company’s markets is fairly low, which attracts the competition of massive medical companies such as Johnson & Johnson, Abbott Labs, and GE healthcare. All of this attention is likely to eat at BSX’s market share and erode its major competitive advantage. Even Uncle Sam could destroy the company’s ability to compete. On page 12 of the annual report, in reference to new healthcare laws, I read the following, “there can be no assurance that our products will be covered automatically by third-party payors, that reimbursement will be available or, if available, that the third-party payor’s coverage policies will not adversely effect our ability to sell our products profitably.” That is not something I want to hear from my investments.

The company is starting to make some shrewd financial moves. In the annual report, BSX revealed plans to cut costs in inventory, R&D, and production. The company has reduced the number of production facilities from 23 to 14, and plans to cut another 2 within the next two years. This is good, as the company is clearly trying to address its the problems it has making money (discussed in detail below), but what concerns me (aside from the cuts in R&D which could hurt the company’s innovative edge) is the total lack of an explanation in the annual report. When reading GM’s annual report, the company takes great pains to clarify why it had been bleeding money under the old management, and then explains its solutions to the problems. Boston Scientific makes no mention of why it has been losing money annually, let alone offer a plan to stop the bleeding. Unlike GM’s documents, BSX’s corporate filings make me nervous.

Boston Scientific also has plans to expand its market share through four major acquisitions from the past two years (Asthmatx, Sadra Medical, Intelect Medical, and Atritech). However, those purchases concern me more than they comfort me. Boston Scientific is currently valued by the market at $8.8 billion; where are they getting the capital needed for four large corporate purchases? Typically when a small company buys too many other companies, bad things follow. GE can get away with it, considering its market value is $200 billion. Boston Scientific has a lot less room for error. Also, I am curious as to why the company feels it has to improve its market share when it already boasts of its market share for 75 different products. The priority should not be gaining more market share, it should be using the current market share more efficiently and profitably.

Beyond its shaky advantages, there are few positive financial facts to highlight. By the standard measures of success, the company has failed for five years running. In no year since 2006 has Boston Scientific recorded a positive cash flow for the year, or positive net earnings. In its best year (2007), the company posted a net loss of $495 million, which equates to 5.6% of its total market value ($8.8 billion)! Even if I make the extremely lenient move of adding depreciation and amortization back into earnings and cash flows, the company still posts a deficit in both cash flow and income for the past three consecutive years. The company has increased the accumulated deficit listed on its balance sheet, meaning that the company is not only failing to grow, it is actively eroding shareholder’s value. This is the antithesis of Benjamin Graham’s definition of an investment operation; instead of a guarantee of the safety of principal, there seems to be a guarantee that the principal will be depleted.

However, this does not necessarily disqualify the company as an investment. A company that is selling for less than its net current assets may still be a good investment even if it has been posting operating losses for the past few years. The reason is simple: if a company could be liquidated, and the current assets could be used to wipe out all of the standing liabilities, then the sale of any remaining assets would yield a profit for the shareholders. By some simple calculations, it is possible to determine the likely amount per share that could be realized in such a liquidation.

Now, this does not necessarily mean that a liquidation has to take place for the shareholder to profit. Three things could happen in such a case. First the company could be bought out, and the purchaser would (typically) offer a price reflected by the fair value of the assets, making the stockholder a nice tidy profit. Second, the company could be liquidated as described above (again, a nice and clean profit for anyone who purchased the shares at a low price). Third, the company could return to profitability as competition goes out of business, resulting in a lovely capital gain for anyone who bought the company at a discount. If the company’s stock is selling for less than its liquidating value, then a satisfactory result is all but assured (thank you Benjamin Graham).

At first glance, Boston Scientific seems to be a good candidate for a discount purchase. The balance sheet lists stockholder’s equity as $11.3 billion at the end of the last fiscal year. That works out to a book value of $7.43 per share. With shares selling at  $5.93 as of the writing of this post, that seems like a pretty fair margin for profit. However, the book value of the stock is not an accurate representation of the liquidating value of the stock. Looking at the assets of the company, I found that they included $10.2 billion in goodwill, and $6.34 billion in intangibles, most of which comes from patents and legal rights. These assets are very unlikely to fetch even a fraction of their reported worth in a liquidation of the company, and so they have to be deducted from the book value if we want to find the true “scrap value” of the company.

Going through the balance sheet, I did some basic calculations, and I found that when the intangibles are subtracted from the company’s book value, the math results in a valuation of $3.26 per share. When subtracting the goodwill (leaving the intangibles in), the math results in a valuation of $.73 per share. When both of these were subtracted, as Benjamin Graham advocated in Security Analysis, the resulting valuation is -$3.44 per share. Granted, a common stock cannot have a truly negative value, since when a common stock goes to zero, the owner cannot lose any more money, but the clear quantitative result is that the company is selling for far more than its liquidating value. Even if some of the intangible assets and goodwill marked on the balance sheet was recovered in a liquidation, it would likely be swallowed up by existing liabilities, and whatever was left for common stock holders would not justify a price of $5.93. Boston Scientific is overvalued, and gets a clear quantitative thumbs down.

Conclusion

Boston Scientific has a lot to offer qualitatively, but offers very little on the quantitative side. Yes, the company makes good products in a good field, but other companies also make good products, and do so profitably. As long as the company keeps posting losses of $500 million or more annually, it does not qualify as an investment. Someone who has a better understanding of the healthcare industry than I may still consider BSX a good speculation. There is the possibility that the company could become profitable very soon, or that its new products will set it far ahead of the competition. However, that sort of judgment would require insight that I simply do not have. I cannot even consider the company a good speculation.

You could look at the annual report, point to all the cost-cutting measures being put into place, and argue that these are good signs for the company’s future. After all, I made almost the same argument about GM a week ago. However, what separates the two companies in my mind is the clarity of their moves, and the tangible results thereof. GM pointed out its old deficiencies, and outlined its solutions very clearly. Boston Scientific did neither in its annual report; it only pointed to where it will cut costs. If those costs were not the original source of financial problems, then cutting them will not be helpful in the long run. In addition, GM has been running profitably on its new business plan for over a year and a half now. Boston Scientific is simply pointing to the future. The company wants shareholders (and potential shareholders) to believe that it can make money. As a potential shareholder, I want them to prove it first. Boston Scientific does not make the portfolio.

All that said, the company could see future profits, and could be making the right moves. This does not look like a good short-selling opportunity, or a definite case where everyone should sell right away. In 6 months or a year, the company could become a very attractive speculative security. In a few years, it may even be investment grade. For those reasons, I’m keeping BSX on my watch list. It may go up in price by the time I am ready to buy (if that time ever comes), but I will be more than happy to pay a little extra for true financial security.

-The Filosopher in Phinance

Disclosure – I am long BSX (oops) but I am seriously considering selling my position.

General Motors

Automotive

NYSE symbol GM, TSX symbol GMM

The Short Version

After emerging from bankruptcy in 2009 with new management, GM seems poised to surge with the next economic cycle. New automotive innovations, coupled with the commitment to maintaining a healthy balance sheet, without crippling levels of debt makes the new GM seem like a great company for the future. While there are too many unknowns to classify GM as a true investment, GM has all the hallmarks of a top-notch speculative security, with little downside.

The Long Version

The higher they fly, the farther they fall. Few companies fell farther than General Motors (GM) in 2009. The worlds largest automotive company was forced into bankruptcy, and as a result, their common stock was wiped out. New management was brought in, and the company was completely overhauled. The old bondholders exchanged their securities for new shares of common stock, and the company had to ask the U.S. and Canadian governments for loans to help with the reorganization. When the public offering for its new common stock was held, GM didn’t have a black eye; it had two black eyes, a broken nose, and was missing several teeth. However, it never pays to hold a grudge on Wall Street (Peter Lynch made a fortune on GM in the late 80′s after deciding that the company was one of the worst run companies in America a few years before). All of that is in the past, and proper security analysis requires an examination of the present. How does new GM look qualitatively, and quantitatively?

Qualitative

New GM certainly is carrying a lot of baggage. The company has developed a lousy reputation after years of making large cars with terrible milage that would fall apart after 50,000 miles. The company’s image is still suffering from its bankruptcy and many Americans have not forgotten the company’s bailouts from T.A.R.P. If a company you are interested in has to go to Uncle Sam and the Canadian government to stay afloat, that usually is a bad sign.

Then, of course, there is the ever present issue of the “Reckoning effect.” That is the name I have given the attitude of people who read and believe the book The Reckoning, which is about how the U.S. automotive industry is doomed to death by a variety of economic factors. The “Reckoning effect” is one I see every day in my own home. I told my parents that I was looking at GM’s stock, only to receive frowns and eyebrows. However, the book is over twenty years old, and after it was published all three major car companies (Ford, GM, and Chrysler), have had booms and busts following economic cycles. Also, GM managed to rework its labor deals, and the new management has cut costs and become more financially efficient. Dad remains unconvinced.

Even my mother was pessimistic about GM brands. “No one I know is fighting over the keys to an Impala.” This may be true, but in fairness, my mother only communicates with a small portion of GM’s potential market. Looking to the data, GM has the largest market share in North America, developing markets, and the entire world. That may be getting a little too quantitative for this part of the analysis, but it shows that at least someone is buying GM.

On top of that, GM seems to understand that it has lost any of its glorious reputation from days of old, and has revamped its entire lineup. The company has phased out most of its brands and is now focussing on only four: Chevrolet, Buick, Cadillac, and GMC. Each of those brands is getting new designs and new technology to compete in a new market. Management has set a goal to make sure that all models get redesigned at least once every three years, and has committed to improving the technology that has made Volt the company’s flagship model for the past year. While the company is clearly banking on the boost in sales and street cred that the Volt promises, consumer reports about the new Chevy have been very promising.

GM’s reputation may not be sterling now, but many of its cars have started to garner attention and win awards. If the company keeps this up, it may well build a reputation worth having, especially if employee morale stays high. Buying the stock of a rebuilding company while it is unpopular for the present time is a move that Benjamin Graham loved to make, and Warren Buffett (his student) loves it too. Mr. Buffett is fond of buying large, well-run companies that are dealing with either one-time, solvable problems, or general economic slumps. Looking at GM, I see them as an entrenched company that is dealing with both an economic slump in America (and Europe), and with the one-time problem of bankruptcy stigma. As time goes on, those problems should go away.

Another qualitative plus is the company’s commitment to a healthy balance sheet. The company has spent an incredible amount of effort in tearing away as much debt as possible, and paying down its underfunded pensions, including a contribution of $4 billion during the fiscal year 2010. While this takes away from earnings in the short term, it decreases the pension liability in the long term. GM’s voluntary contribution to its underfunded pensions shows that the company is very serious about taking any remaining toxic liabilities out of the picture as quickly as possible. That is definitely a promising sign.

The new management has made every effort to establish a strong balance sheet. In fact, they may even be going too far and carrying too little debt. That might sound rather strange, but in a cyclical business (like the automotive industry), it is more efficient to use some debt to carry a company through a down year, then it is to have do debt at all and carry a massive excess of cash. That said, it is undoubtedly better to err on the side of caution and carry too little debt, then it is to get carried away and end up buried in debt. Besides, GM is trying to rebuild itself, and avoiding the fixed charges of debt takes a lot of risk out of the equation.

There are plenty of qualitative concerns for a company with GM’s history, but there are a lot of promising signs with the new management, and so GM gets the qualitative thumbs-up from me (sorry mom, sorry dad). Of course, no security should be bought or sold simply because the company looks good. The accounting statements have to look solid too. TO THE BOOKS!

Quantitative

A quantitative analysis of GM presents an unusual set of challenges. As I said earlier, in 2009, GM’s old common stock was wiped out, and a new common issue was given to the bondholders, and offered to the public. This was accompanied by the retirement of old bond debt, and entirely new management. The result of all these changes, in many ways, means that new GM is a truly new company, and to compare it with the company that declared bankruptcy would be pointless. From that point of view, data regarding the old GM is almost meaningless, and when examining GM, you should treat it as a brand new company.

Of course, it doesn’t take too much brain power to see that GM is not a brand new company. General Motors, and its brands Chevy, Buick, and GMC, have been on this earth longer than I have, and much of the company’s value is based on its past, its size, its brands, and its established business. To evaluate GM as an entirely new company would not do justice to the fact that much of old GM is still part of new GM. The two companies have the same headquarters, the same retail locations, the same employees, even the same symbol on the NYSE. GM is not some startup company selling tech widgets, GM is GM. So how should I make sense of this new GM? I decided to look at GM’s balance sheet without too much attention to the past, since the business has changed fundamentally since 2009, and many elements of the old balance sheet no longer apply. However, in looking at income, I decided to examine the past five years as an average (as I did with GE and Berkshire Hathaway), since the ability of the company to sell cars internationally is still its main asset, and is visible over that period. At this point, I will issue my standard warning: anyone who has no interest in accounting, please skip to the conclusion.

Looking at the new balance sheet in the annual report, there are a lot of promising changes from the time when old GM declared bankruptcy. Long-term debt has dropped to $3 billion, down from $5.5 billion last a year before. Liabilities from pensions have dropped to $21.9 billion, down approximately 17% from last year. While that remains the largest liability on the books (current or non-current), it has been reduced by $5 billion over the last year alone, and as it stands now, GM’s cash and marketable securities are worth $26.6 billion. This means that if the company wanted to, it could wipe the pension liability off the books tomorrow. Granted, there are plenty of financial reasons not to spend all of the company’s cash in one fell swoop, but the numbers indicate a fairly stable corporate financial structure. This is an enormous change from early 2009, when old GM had to reorganize due to its massive crippling debt. The balance sheet shows little risk of the company going under, which is comforting to anyone considering an investment.

Looking through the numbers, GM reports an equity value of $36.2 billion. However, that number is not completely available to the common stock, as approximately $10.4 billion of that figure comes from GM’s two preferred stock issues. Figuring that into the calculation, we see that there is approximately $25 billion in equity available for the common stock. with 1.5 billion shares outstanding, each share has a real value of about $16.66. This number, of course, is rather crude and inexact, because it has not been adjusted for inflated assets like goodwill (valued at $30.5 billion), intangibles ($11.9 billion), or even for write downs of inventory that would have to be sold at a discount in the event of a liquidation. Of course, General Motors does not seem to be in danger of liquidating any time soon (although I may have said otherwise two years ago). The ongoing core business is profitable, and if it remains that way, it will add to the value of the company. The soft assets, like goodwill, may not be easy to cash-in on during a fire sale, but they are real assets for the company. Those intangibles help the company compete in a business environment that is increasingly intangible thanks to modern technology. $16.66 may not represent the real value of the common stock, but it does represent a loose approximation of what the company could get if it decided to liquidate over time, and refused to sell out until it got a fair price on all of its goods.

However, the assets alone do not determine the true value of a company, the earnings play a part as well. Looking through the income statements of the past several years is a real mess, no thanks to the management change. New GM has taken painstaking measures to describe, in great detail, the differences between their accounting methods, and the old accounting methods. The result is an amazingly tedious four hours (minimum) of reading. To their credit, new GM was as complete as possible with their disclosure, and the language they use is consistently clear, making the whole process relatively simple, if tedious. If I have to choose between a long and terribly boring but completely transparent accounting statement, or a short but maddeningly obscure one, I will always pick the boring one.

Looking through the income statement, I was more interested in the figures for the whole corporation than I was in any per share statistics. The elimination of the old common stock, and the new offering make any per-share comparisons irrelevant, however, figures such as the gross revenue, cost of goods sold, S,G&A, and net income are all very useful. Both cost of goods sold and S,G&A have gone down over the last three years by at least 15%, while gross revenue has only declined by about 9%. More importantly, the company went from recording an operating loss of $21 billion in 2008, to recording an operating profit of $5 billion in 2010, an income difference of $30 billion! Total costs and expenses decreased by $40 billion dollars since 2008. That is a massive  savings for the common stockholders. A lot has clearly changed since the bankruptcy, and the company is clearly committed to trimming whatever fat they can find, and running GM as efficiently as possible.

After sorting through all the accounting notes, I found that even in the boom years of 2006 and 2007, GM posted an operating loss. In fact, other than 2010, GM did not have a single year with an operating profit on its balance sheet. Generally, that is not a good sign for an investment. Doing the math out, over the last five years, the company has managed an average operating loss of $18.5 billion dollars per year. This figure does not include any gains from bankruptcy reorganization, but since the goal is to avoid bankruptcy, I decided that throwing in any profit from that event would not help determine how sound the company was as an investment. The bottom line is that over the last five years, GM has consistently taken in revenues of over $100 billion ($204 billion in 2006), but still managed to lose an average of $18.5 billion every year. The numbers are hard to argue with, and so as an investment, GM gets the quantitative thumbs down.

However, that does not end the discussion, especially since GM is a new company in many ways. As a new company, it is almost automatically disqualified as an investment, but still may be a profitable purchase for a portfolio. Let’s put aside the average figures, and focus solely on the present and future.

For the present, the company has made a remarkable turnaround. While revenues have dropped to $135.6 billion in 2010, the company managed to turn a profit of $4.6 billion that year. That means the new management took in less money than the old company, but turned a profit anyway. Clearly the company has started doing something right. Moves to reduce labor costs and excessive inventory have stopped the company from hemorrhaging money, and even left enough over to reinvest in the R&D. GM even managed to voluntarily contribute $4 billion to its underfunded pensions. While these pensions are still the largest liability on the balance sheet, that amount of free cash in a fantastic sign that the company is once again generating money.

On top of that, there were some interesting statistics in the annual report, which make the company look stable for the long term. GM currently makes and sells more cars and trucks than any other company on the planet. They have the largest market share in America, and in the developing world, and in “BRIC” markets (Brazil, Russia, India, China), four or the fastest growing economies in the world. The accounting statements further revealed that GM made handsome profits in all of its geographic divisions except for one: Europe. GM holds the fifth largest market share for cars and trucks in Europe, and posted a loss for the region this year. However, the company has concrete plans to fix the problem. By cutting manufacturing capacity by 20%, GM looks to cut costs in manufacturing, raw materials, and storage, and a new European labor deal should save the company $265 million per year. On top of that, GM hopes to start pushing its electric cars (like the Volt) in the European market, and believes that high gas prices in the region, coupled with environmental sensibility, should give them a larger market share. I am inclined to agree with them.
Even if the company does not take a larger piece of the Euro-pie, two facts scream out at me; 1) In 2010, despite a down economy in North America, GM managed to make a profit for the first time in years, and 2) even after posting a loss in Europe GM still made a respectable profit overall. Granted, these facts could change next year, but GM’s management has proved that it is very cost-savvy, and committed to making good cars which will attract customers. All of this amounts to my decision that GM’s current earnings are likely to grow, but are at least stable. With that in mind, I decided to try to estimate GM’s fair value based on earnings. Given a diluted EPS of $2.89 for 2010, and a conservative multiplier of 15, I could estimate that GM common stock is worth $43.45 per share. However, I won’t use that number.

For all the good moves GM has made, there are a lot of worries that come along with the stock. Sure, I think that sooner or later, the U.S. economy will start chugging along again, but I am not an economist, and I can’t say whether it will be sooner or later. Unemployment is inching down, but that does not imply that car sales will go up. On top of that, GM only takes in 31% of its sales from North America, meaning the company’s earnings are at the mercy of every economy in the world, and there are bound to be a few laggards somewhere on the globe. Simply put, there is a lot that could tear away at GM’s earnings. With this in mind, I decided to use an ultra conservative earnings multiplier, namely 10. Doing the math, I estimate that GM is worth at least $28.90 per share. Keep in mind that this is not an investment figure, it is only my estimation of what I would pay for GM as a speculative interest.

However, speculative or not, GM still sits well under my estimation. If earnings prove to be solid for the next several years, then GM will undoubtedly be worthy of a multiplier of 15, and therefore a price of $45.00 per share. With little long-term debt, and no intention of picking any up, it seems that GM has little downside, and so long as the price is under $28.90 per share, I’m buying GM.

Conclusion

GM still faces an uphill battle. The management has done a good job of strengthening the balance sheet and preparing for the future by casting off financially inefficient brands, and focussing on solid core development, but that is just the beginning of what needs to be done. The company needs to find ways to compete through durable, fuel-efficient vehicles, and needs to do so world-wide. While the company has made some progress, it still is faced with the fact that it is posting losses in Europe, and that is unlikely to change in the near future. While GE does not have to worry too much about the direct impact of the Eurozone debt crisis, GM does not have that luxury.

GM, as a company that sells mainly to consumers, is at the mercy of the economic cycle, and as more European countries try to deal with their debt burdens, taxes will have to go up in those countries. This means less money for large purchases, like cars and trucks, which means GM will really have to fight if it plans to make a profit in its weakest region.

On the other hand, the company has made several good moves in North America, and in the BRIC market. New models and a new cost structure make the company look like it has potential to grow when the economy starts to take off again. Things may be rough for many Americans now, but in economic terms, it is always darkest just before the dawn. GM is ready for the sun to rise.

Can I call GM an investment? The answer is no. By Benjamin Graham’s standards, the company simply doesn’t cut the mustard. Remember, Graham defined an investment operation as, “one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Because of GM’s recent bankruptcy, and all the unknowns in the world, I cannot say that the company’s stock offers any guaranty. BUT, that does not mean the stock is a bad purchase…

While a Graham purist may leave GM for a few years and wait for recovery, I think Peter Lynch might have been willing to stick his neck out a little on this one. Yes, the company faces some challenges, but looking at the risk and rewards on the table, it is tough to walk away from it. The company has eliminated almost all of its debt, and as a result, is financially fairly safe. The company may lose money in the future, but so long as it isn’t paying too much in interest, the company is unlikely to lose much of its fundamental value, and if sales increase as things improve here and abroad, then GM will be reaping the benefits all over the world.
Even with the concerns in Europe, it is important to note that the new management managed to turn a profit even though GM lost money in Europe. Assuming they manage to lose less money, the company stands to make big gains, and if the company keeps bleeding in European markets, then the management seems to have the guts and the business sense to simply sell the division and focus on what it does well. However, I don’t think that scenario is likely, as GM has plans to push electric vehicles across Europe. Given how expensive gas is in Europe, and how eco-friendly Europeans are, it would not surprise me if the technology that GM developed for the Volt leads them to amazing success in European markets.

GM may not be an investment, but as a speculative stock, it looks fantastic. GM goes in the portfolio.

-The Filosopher in Phinance

Disclosure – I am long GM, and I have plans to purchase more in the future.

Final Note – GM has two securities available on the NYSE: its common stock and a preferred issue. Click here to see why I bought the common stock instead of the senior securities.

General Electric Company

Financial Services, Industrial Manufacturing

NYSE symbol GE

The Short Version

An American blue-chip company that has made moves into markets with potential to grow, including energy and healthcare. A low P/E ratio with an attractive dividend of about 3.5% make the company a solid buy, especially with its stable base and growth potential.

The Long Version

The General Electric Company (GE) needs no introduction. It is the bluest of blue-chips, and has been on the Dow Jones Industrial Average since 1907, longer than any other company in history. Recently GE’s common stock has taken a beating, partly due to the credit crisis of 2008, and partly due to a large shortage of cash that hit the company in 2009. The company was forced to reduce its dividend for the first time since the great depression, which dropped the share price below $8.00. It was trading as low as $15.00 in September 2010 (when I first bought the stock… Woohoo!). Since then, GE has made a concerted effort to raise its dividend, and pledges to fully restore it as soon as possible. With several promising business moves, and a large infusion of cash from Berkshire Hathaway, GE seems to be back on the up-and-up.

Any investment must pass a qualitative and a quantitative test. Here are my thoughts and observations:

Qualitative

GE has suffered a lot of bad press in the investing world, due to its dividend reduction. The current management seems to be using this slap in the face to kick the company back into high gear. GE has made solid efforts to reestablish itself as an industrial leader, such as creating intelligent charging stations for electric cars, and increasing R&D by 20% last year alone. The company has focussed on eliminating toxic assets and preparing for a bright future. I said “industrial leader” instead of “industry leader” because there are so few industries that GE does not lead. In the words of one of my co-workers, “I love GE, they have their fingers in everything!” He is right. From appliances to jet engines, to medical equipment, GE has an interest in nearly every field imaginable.

GE’s temporary bad press does not take away from the fact that whenever the company enters a new field (which is often), it dominates the competition. Over half of the jet engines in use around the world were made by GE (taken from in the annual report). GE healthcare has emerged as the company for large medical machinery (Johnson and Johnson can’t be too happy about that). GE Capital has helped the company make bold strides into the increasingly important world of financial services. GE is everywhere, and it does everything well.

I could write forever about the various subsidiaries of GE and their progress (I haven’t even touched on innovations in rail transit and lightbulbs). Fortunately, GE’s tumblr and the GE show take care of that for me. No, I did not just make up “the GE show,” it is real. The bottom line is that GE is as well entrenched a company as you can possibly look for, and its various subsidiaries make up a widely diversified portfolio. Adding GE to a stock portfolio is almost as good as adding a mutual fund. One sector of the company (say appliances or aviation) might do poorly, but there are plenty of other divisions (industrial manufacturing, financial services, energy systems, etc.) to boost the overall performance of the company.

One more qualitative factor is worth considering. When GE was strapped for cash a few years ago, the company issued $3 billion in preferred shares to raise money. All of these shares were bought up by a single company: Berkshire Hathaway. Warren Buffett’s choice to put his money in the hands of the General Electric Company is a very strong statement about the company’s stability and financial health. Of course it does not guarantee that the common stock is a brilliant investment. Yet, Mr. Buffett’s well known love of low-risk value, does indicate a few things; 1) the company has stable earnings well over fixed charges, and that is unlikely to change; 2) Mr. Buffett believes the management to be competent enough to support the fixed charges and eventual retirement of a $3 billion issue; and, 3) Berkshire Hathaway received warrants to purchase the common stock at $22.25 anytime until expiration in 2013. Buffett calls these “a bonus,” but he is clearly betting that the company will be worth more than that in the next few years. It rarely pays to bet against Buffett.

GE may not be perfect, but the signs point to it being a well run and stable company that is not going belly-up in the near future. I give GE the qualitative thumbs up. Of course, that is no reason to buy GE on its own. Any qualitative examination must be matched by quantitative analysis. Now the fun part… making sense of the accounting statements… and we all know how fun accounting is…

Quantitative

The quantitative analysis of GE is, to say the least, thick. GE owns, or has an interest in, many subsidiaries, and has made efforts to purchase and sell several, most notably NBC, in the last year. The rumor around the NBC offices that the company tried to sell the letter “E” to Samsung, never materialized. All kidding aside, there are good reasons that its last 10-K was 505 pages! I’ll try to stick to the highlights. – To those not interested in the number-crunching, mind-numbing details, skip to the Conclusion; don’t go out and buy just because GE is a swell company.

Looking through GE’s filings, it seems evident that the company is ready to move on from the damaging dividend hiccup of 2009. Throughout the annual report, you see words like strength, stability, and growth, along with business statistics to back up those claims (15% earnings increase, increased dividend by 40%, $175 billion in industrial backlog, and that’s all before page 3). For the number-challenged shareholders, there are also lots of very nice color pictures. Actually, the fact that the annual report was nice to look at made me a bit queezy. Peter’s Principle #17 (from Beating the Street) states that “all else being equal, invest in the company with the fewest color photographs in the annual report” (note that Berkshire Hathaway’s annual report is entirely text, except for the cover – which is red). However, putting aside my fear of corporate aesthetics, and  looking through the accounting statements, I found that GE has remained a profitable company (even during the 2008 credit crisis). Not once between 2006 and 2010 did GE post a loss, and that is always a good sign. Weeding through the accounting mumbo-jumbo, and double checking the earnings, I found that even with earnings adjusted for certain accounting procedures, they still earned a comfortable annual profit every year for the past five years. The problem that led to the reduced dividend resulted from a cashflow problem, not an assets deficiency. The earnings went down, yes, but never disappeared.

GE managed to solve this cash flow problem promptly. In its last 10-K and annual report, the company reported that it doubled its short-term assets, and increased cash on hand by a factor of five since 2007. Clearly the company is taking seriously the commitment to reestablish financial stability. On top of that, GE made an absolutely brilliant financial move in selling control of NBC Universal to Comcast.

I wondered what motivated GE to sell NBC Universal. Between its subsidiaries (NBC, CNBC, USA, MSNBC, hulu.com, etc.) I had imagined that NBC was the same kind of cash cow that ABC is for the Walt Disney Company. Unfortunately, NBC has been struggling for the last few years, and GE needed to make an adjustment. However GE did not sell off its entire stake; it managed to retain a 49% interest in this subsidiary, ensuring that when profitable, NBC should still generate plenty of cash for the company. In the short term, GE got a nice chunk of change from Comcast, which it used in several financial moves, including raising its dividend, buying back 53,333,000 shares of common stock, and purchasing some promising new subsidiaries including Met Life Inc’s online bank. The most important aspect of the sale, however, is the buyer: Comcast. GE sold a television network which was struggling (Community was getting bad ratings for God’s sake – #SixSeasonsAndAMovie!) to a company that specializes in television. Comcast is an excellent buyer simply because it has the tools and expertise to come in, revamp NBC, and turn it into a highly profitable network. When they do, GE will reap the benefits thanks to its healthy stake in the company. Best of all, GE can consider it a passive investment. As a passive investment, the new arrangement cuts costs (namely manpower) for GE and shifts them to another company (Comcast); always a good thing.

Speaking of cutting costs, the financial statements also revealed that GE has cut 40,000 jobs over the last 4 years. That number looks scary, but as Peter Lynch points out, this is usually good for shareholders. This massive reduction in the company’s workforce has resulted in lower costs, particularly in the ever toxic area of pension benefits (often unsustainable) and in S,G&A. I take no pleasure in marking job cuts as a good point for an investment. I know that losing a job is a rough experience for an employee and their family. However, job cuts are often necessary for a company’s survival, and the alternative (continually losing money while retaining employees) is far worse; the shareholders (many of them private citizens who bought GE stock with their savings) lose their dividend, then their share value, the company goes under, and all of GE’s employees (304,000 in 2009) hit the unemployment line. It isn’t pretty either way.

Looking to GE’s balance sheet, Benjamin Graham would be disappointed. GE’s book value per share is approximately $11.50. That number, however, includes a large amount of goodwill, intangibles, and non-current assets that (in liquidation) would not sell for full price on the market. Taking all of that out of the book value, I found a “realizable” value of about $5 per share. However, it is important to remember that GE is not likely to be liquidated anytime soon, and so that may not be the best way to evaluate the company. Perhaps it would be best to turn to the earnings…

Calculating GE’s earnings per share is a little tricky, because GE has discontinued or sold off several subsidiaries recently (like NBC), and has acquired a few new ones over the last twelve months. Looking back at the EPS for the company over the last five years, it is possible to calculate the earnings for continuing operations, and for discontinued operations separately. Adding those two numbers, you find the net EPS. For the sake of Benjamin Graham’s margin of safety, I chose to calculate the average EPS using the lower of net EPS or continuing EPS for each year. I also chose not to include any projected earnings, or any earnings from recently purchased companies simply because the future may not be kind to GE’s new children, and in the spirit of investment, it is better not to count any chickens that haven’t hatched. With all this in mind, I found that GE had an average EPS of $1.55 for the last five years.

With this number in hand, we can see that GE was last traded at $18.81, or 12.14 times its five year earnings average. On top of that, the company is earning enough to cover its fixed charges and then some (at least $10.9 million available for common every year). That is a multiplier that Benjamin Graham would have accepted without question. In fact, using a conservative earnings multiplier of 15, I would comfortably pay $23.25 per share of GE common stock. That is quite a jump from $5 for liquidation! While the market price is well under $20, GE gets the quantitative thumbs up. Of course, all of this analysis is predicated on the assumption that things will at least remain as they are for the future. So what does the future hold for GE?

Conclusion

Truthfully, the company could go either way. GE revealed in both its 10-K and annual report that about 16% of its revenues come from Europe, and the Eurozone crisis could put that in jeopardy. On the other hand, GE has made some bold moves into industries that will definitely be in demand in the future. Energy needs are projected to double over the next twenty years or so (admittedly I am quoting the annual report there), and with the American population aging, healthcare looks like an excellent industry for growth. Don’t forget those jet engines – Delta Airlines alone is planning to order 100 new airplanes, and I have no doubt that GE will be making most of those engines (Boeing, who will be making new Delta planes, has several exclusive contracts with GE, and Airbus outsources to GE too). Then again, GE Capital is responsible for a 30% of GE’s revenue, and the debt crisis in Europe could jeopardize that as well. What to do? Well, as any good BC graduate would, I asked myself, “what would Lynch do…”

Peter Lynch would probably look at the debt crisis in Europe as “weekend worrying” (the worrying that happens when stock markets are closed on the weekends, and you can’t focus on buying or selling). Sure, bad things may happen in Europe, and sovereign debt may lose some of its value, but what does that realistically change? If everything goes to Hell, and European revenue is cut in half (yikes!) and no other investments pan out for GE, then the company will still make a profit. Granted, a much smaller one, but a profit nonetheless. On top of that, the odds of European revenue dropping that much are slim, as very little of that revenue is tied to the Italian, Spanish, or Portuguese governments, where the most risk of default lies. The recent wave of S&P downgrades may make some people nervous about multinational companies (like GE), but let’s remember that most governments still have investment grade ratings, and most of GE’s business comes from private businesses and consumers – European junk debt should have little impact on the underlying value behind GE.

On the positive side, the facts are what they are; healthcare and energy will face huge leaps in demand as the population keeps growing, and jet engines are positioned for a boon in the future. That future may not be next year, but it isn’t too far out.

Is GE a sure thing? Despite what some stock pickers will tell you, no it is not. However, it is a deeply entrenched American business, with a diverse group of subsidiaries, each one standing as a leader in its field. Things could go wrong, but that is a risk that you take with any investment, regardless of how safe it seems. Putting aside the nervous anxiety, I see GE as a well run American icon, with a strong commitment to putting money in shareholder’s pockets, a bright future, a healthy balance sheet, and most importantly, an attractive price. Until GE hits $23.25, it remains a buy for me.

-The Filosopher in Phinance

Disclosure – I am long GE. I have no immediate plans to buy more, but if the cash comes my way, I probably will.

PS – Dear Peter Lynch, I hope my projection of your methods was not out of line. Feel free to message me about it either way. Seriously, I’m free for coffee during the day anytime this week.

Berkshire Hathaway

Holding Company/ Insurance

NYSE symbols BRK.A and BRK.B

The Short Version 

Berkshire Hathaway appears undervalued by the market despite consistently increasing its revenues and earnings over the past five years. The company’s investments are solid for the long-term and between its subsidiaries and its stocks, Berkshire looks to have solid and enviable growth for years to come.

The Long Version

As the company is run by Benjamin Graham’s most famous student (Warren Buffett), I figured it would be a good company on which to practice Mr. Graham’s techniques for security analysis. In his books, he claimed “an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return,” and he pointed out that a good investment should pass both a qualitative and a quantitative test of analysis. Let’s see if Berkshire fits the bill.

From a qualitative standpoint, it is hard to find fault with the company as a whole. Berkshire’s many insurance subsidiaries (Wesco Financial Corporation, GEICO, General Re, etc.) have a long and stable record of doing solid business through good times and bad. While Mr. Buffett has been known to keep his cards close to the vest when playing bridge or making business decisions, but he makes no secret of his priorities in running the company. He puts it very well in a letter he wrote to his managers (reprinted in his annual report), “we can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.” He then went on to stress the necessity of running an ethical business beyond reproach. Perhaps that is why Berkshire Hathaway remained (more or less) stable through the financial crisis two years ago, while AIG nearly went bankrupt (Click the link for a comparison).

On top of that, Buffett instituted the company’s first buyback in history. Sticking to his value-based guns, his terms for the buyback would have impressed Benjamin Graham. All qualitative signs point to this being an ethical, stable, far-sighted company run by a talented CEO, with a very highly skilled team of managers running each subsidiary (Buffett himself calls them the ‘all-stars’). For added assurance, that CEO has tied up most of his net worth in the company, so he has a very real interest in its long-term success.

The one qualitative criticism one could make would be Berkshire’s growing tendency to buy control over smaller companies. One might worry that Berkshire Hathaway, as a holding company, had started to stretch itself thin by buying up too many companies too quickly (usually a bad sign). Fortunately, one need not fear with the Oracle from Omaha at the helm. In all of his purchases, Mr. Buffett has brought his value investment principles to the table, shrewdly picking up businesses that added substantially to Berkshire’s true net worth, without overpaying. He has avoided sinking the company into debt to make these purchases, always remaining conservative with the cash Berkshire keeps on hand. An investor in Berkshire can comfortably consider the value of the company to be secure, and that satisfies the first half of Graham’s definition of an investment.

Besides, a quick examination of any of the companies Buffett has purchased makes his reasons clear. The Pampered Chef provides top-notch cooking supplies to cooks all over the country, and Jordan’s Furniture (as any good Bostonian knows) keeps the customers coming in with an IMAX theater, a virtual roller coaster, and unmatched service. One could go on; suffice to say, Buffett only buys quality.

There is one more qualitative concern about Berkshire, or rather its management; they are old. Even by their own admission, Warren Buffett and Charlie Munger are no longer young men. However, Mr. Buffett has made arrangements for what will happen when he stops running the business. He has selected two successful, risk-averse financial managers (Todd Combs and Ted Weschler) to control Berkshire’s sizable portfolio when the time comes. More importantly, Berkshire’s subsidiaries are all run by very talented, independent managers, who could go on running their businesses without him. In fact, all of them do run their businesses with very little interference at all from headquarters in Omaha. Berkshire may be synonymous with Buffett on Wall Street, but the company is poised to keep on rolling without him.

All of that said, Mr. Buffett still confidently declares that he feels fantastic, and that he plans to stick around for a very long time. “Methuselah’s record is in jeopardy!” he said. Don’t worry, I had to google ‘Methuselah’ too. With or without Warren, it is important to note that Berkshire recently made large stock purchases. I will discuss these in more detail below, but on the qualitative side, this is a good sign for long-term future growth. Berkshire has a long-established history of holding stocks for extended periods (often decades) and reaping the benefits for years. If these purchases are anything like his previous ones, then Berkshire looks to have good long-term prospects, even if Buffett isn’t around, which satisfies the second half of Graham’s definition. Berkshire and Buffett get the qualitative thumbs-up!

On the quantitative side, things are a little trickier, but no less promising. Berkshire Hathaway is a holding company, and derives plenty of income from its various subsidiaries. I won’t write out all of the details of the last annual report and quarterly report, but I do highly recommend that you read the letter to the shareholders. Mr. Buffett is a great writer. Going through all of this information, however, one finds that the company has a solid income which makes the stock priced at about 16 times earnings (without extraordinary items). That is a multiple comfortably under 20 (the maximum earnings multiplier that Benjamin Graham would have allowed for an investment).

On top of that, the company is selling at approximately 1.25 times its book value. While book value may be an inaccurate picture of the true worth of a company, it does give a good picture of the risk attached to a company (what value the assets themselves support without income), and in an insurance company with diverse investments, the true value is bound to grow as the assets stay on the books and develop. Basically, there is little risk in the company’s stock, given its price, and that is critical of a good investment.

Looking to the future, Berkshire Hathaway has some very promising prospects for increasing its value. Though the stock is already undervalued (as discussed above), Mr. Buffett did not stop with the buyback this year. Recently, announcements have come out that Warren has bought large stakes in several major companies, most notably IBM (Berkshire now owns about 5.5% of the company!). This is very promising for two reasons. First, a new wave of investments will add to Berkshire’s already sizable (and stable) income. Cash on hand is convenient, but cash in dividend paying stock (like IBM’s) is productive. With the purchase of 64 million shares, each paying a dividend of $3 annually, Berkshire can expect its income to increase by $192 million based on IBM alone. That doesn’t include the other investments Buffett has made this year. And you can bet that he didn’t just buy stocks for their dividend. Buffett’s picks will not only continue to pay out, but also advance in market value substantially, and add to Berkshire’s overall value. IBM itself is currently trading at a current P/E ratio under 16 (below the investment ceiling) with potential for future growth.

With all of that in mind, a good investment is typically priced in terms of its earning power, and thus we are led to a detailed review of the company’s earnings. Looking through the figures published by Berkshire in their annual report and form 10-K, one finds that over the past 5 years, Berkshire has earned an average of $4.25 per share of class B stock (based on data from their income statement). However, this value for EPS appears conservative, and it has not been inflated by typical accounting tricks (no deteriorating expenses capitalized as assets). More importantly, this number includes the rather unusual year of 2008, when the financial crisis and several natural disasters ate away at the earnings for the company (which remained positive). Taking the average earnings for the same time period, but not including 2008 (thus leaving out extraordinary factors), we see an average  EPS of $4.80.

Now, taking the unedited, average EPS ($4.25), and using a P/E ratio of 20, we come to an estimated share value of $90. Granted, 20 is the maximum P/E that Benjamin Graham would have allowed for an investment, and it therefore leaves a very thin margin of error. Thus, it would be prudent to estimate the value of a share with a lower P/E, which would leave some room for error, say 18.5. This would lead us to a share value of approximately $80. Then again, I could comfortably throw out the data from 2008, use the average figure of $4.80, and a conservative P/E of 16.5 still brings about a total of $80/share. A slightly more liberal (but still investment level) P/E of 20 would lead to a share price of $96. One could also account for the income from IBM and Bank of America (discussed above), to project earnings for next year at approximately $5.12, and then use a P/E of 20 to justify a price of $102/share, however, such a calculation would pull us from the realm of investment and into speculation. Better to underestimate this year, and enjoy a pleasant “surprise” when next year’s earnings for the company increase by a half-billion dollars, then to count on that money, and then be victim of some sad twist of fate. Based on the earnings calculated above, I would say that the class B stock is worth at least $80/share (the lowest number I came up with) and could be justified as an investment right up to $96 given the odd circumstances dragging the 5 year average down (note – a share class B stock in Berkshire is worth 1/1500 of class A stock). For the sake of the margin of safety, I am saying the stock is a buy up to $80/share. With the price currently about $76 3/8 per share, we have a quantitative thumbs for Mr. Buffett’s company.

There is one hiccough in the analysis of Berkshire Hathaway. The company pays no dividend. Benjamin Graham pointed out that this was only acceptable if the management could grow the company (and therefore the investor’s money) quickly enough to match (or surpass) the growth that could be achieved on earnings if invested independently at a compound rate. In other words – the management would have to consistently beat the S&P 500. In most large companies, this would be rare, and thus the absence of a dividend would be troubling. However, Warren Buffett and Berkshire have beaten the S&P 500 more often than not (chart from CNBC). In fact, they have crushed the index over the last 30 years. History proves that Buffett is clearly a better investor than I am, meaning the dividend question moot.

Qualitatively and quantitatively, Berkshire Hathaway looks good, and the future looks bright for years to come with Buffett’s new investments. I may be a little overly optimistic about the company, but it is hard to find a real complaint with Mr. Buffett’s past results, and even harder to find a reason to doubt his ability to go on crushing the market. The stock market will fluctuate, as will Berkshire Hathaway’s stock, but the value behind the symbols BRK.A and BRK.B looks solid. Berkshire Hathaway (class B) goes in the portfolio.

-The Filosopher in Phinance

Disclosure: I am long Berkshire Hathaway Class B. If I can, I will buy more.

Allow Me to Introduce Myself…

Who am I? I am a recent graduate of Boston College (GO EAGLES!) with a degree in Philosophy, a knack for numbers, and an addiction to caffeine. I enjoy singing and reading. At this point, I assume you are wondering what makes me want to write about stocks and bonds? What makes me think that I am qualified to make judgments about financial securities, anyway?

I became interested in the market after taking an accounting class and a finance class during my senior year. As I was already set to graduate, I was unable to take advantage of other business classes that were offered. That did not stop me from reading every book I could find about investing in stocks and bonds. Through the literature, I sought the advice of such experts as Benjamin Graham, Peter Lynch, Warren Buffett, Peter Lynch, Paul Mladjenovic, and of course, Peter Lynch. I used the earnings from my first job (Real Estate Salesman – very sexy) to build my first portfolio. Not the world’s biggest holding, but it was a start. So while I start to adjust to the post-college “real world,” I have decided to practice security analysis, and see if I am any good. I take heart from the fact that Peter Lynch once was carrying golf clubs to make money, so with the appropriate attention to detail, I hope to become the next market whiz who wears maroon and gold.

Before I begin, I feel that I should make one thing crystal clear: I do not recommend stocks. In fact, I do not recommend any sort of security. This blog is not designed to point to stocks or bonds that will make anyone rich tomorrow. It is not for stocks that you, personally, should buy. I know absolutely nothing about you, your financial goals, your responsibilities, or how you found this blog. Picking your stocks is simply not what this blog is about. It is about picking my stocks. If you want to know what stocks you should buy, then you need to do your own research.

What I will do in this blog is exactly that: my own research. I will take the time to go through the details of a company’s securities, look into its financial information and history, and slog through the 10-Ks and 10-Qs to find the strengths and weaknesses of a potential investment. Next, I will try to look at the possibilities for the future to try to determine the range of possibilities. I will never try to predict what will come with certainty, but it would be imprudent not to guard against possible future hardships.

Finally, after all this, I will make a decision on whether or not the stock or bond goes in my dream portfolio. Keep in mind that the call I make will be based on the unique factors that play into my financial life, including my age, investment horizon, goals, etc. These details may be different from yours, thus you should never take this as advice. If this blog serves as a first step for your own research, I will be flattered, but remember where I sit right now: I own some stocks, but I am a poor college graduate and rarely have the chance to put my money where my mouth is. Sorry to start on such a dismal note, but all these warnings are for the benefit of my risk-averse, lawyer father. I figure I owe the guy a lot (including my existence), so why not?

With all that said, I will be sure to keep track of my picks with those neat newspaper graphs. Those things are awesome! I hope you enjoy my research, my commentary, and my occasional rants and raves. Check back every week for a new stock or bond, updates on big changes on my picks, and the occasional total portfolio review. And be sure to leave comments, or email me at filosopherinphinance@gmail.com!

-The Filosopher in Phinance

PS – Dear Peter Lynch/ Warren Buffett/ anyone who is hiring,

If you read this, note that I am available for hire and can provide my resume upon request.