Fundamental Analysis Report – Microsoft, Sleeping Giant?

Microsoft is one of my favorite companies. It has a solid track free cash flow generation, decent growth and almost no debt on its balance on its sheets. And best of all, its trading at a ridiculously low valuation over fears that its lagging behind in the technology industry.

Look here if you want a great presentation by Whitney Tilson on Microsoft:

Whitney Tilson Presentation on Microsoft

While I agree that some of the criticism of Microsoft is valid, people seem to be forgetting that Microsoft has an incredible franchise with Offices and Windows. I won’t go into the details (you can find it in the presentation) but suffice to say, I feel that Microsoft is trading at an attractive valuation relative to its current performance.

Let’s look at the fundamentals of the company:

 

Despite all the negative flak,  Microsoft has been growing its bottom line really well over the past few years.

Its average annual growth rate in earnings per share is 13.7%.


Microsoft has done really well in this respect. It has little debt on its balance sheets and recently issued long term bonds at record low interest rates.


Returns on Invested Capital averaged 27.4% over the past few years.

Similarily, Free Cash Flow has been growing a steady rate of 9.3% on average per annum.

Conclusion

One of the criticisms I hear about Microsoft is that the stock hasn’t moved anywhere for the past 10 years (its been hovering around $20 – $30). I would like to highlight an extremely important point in investing.

“Price is what you pay. Value is what you get.” – Warren Buffett

Prior to 2008, Microsoft was trading at an average PE of 25 i.e. it was trading at an extremely generous price relative to its intrinsic value. One of the key principles of value investing is to always demand a margin of safety.

Always remember, no investment is ever worth overpaying for – no matter how good it looks.

Valuation Methods – Discounted Cash Flow Discussion

The entire idea of valuing companies using a discounted cash flow method is based on the premise that the value of a company is the value of its future cash flows, discounted by an appropriate rate to the present.

Now, DCF models provide a very elegant solution to the valuation problem. Simply plug in your implied growth rate, your starting cash flow and tadah! You have the intrinsic value of a company.

However, what most people do not realise is that DCF faces several challenges that can potentially overvalue or undervalue a company.

The first challenge is that DCF is extremely imprecise. Put in garbage and you get garbage valuation. Its notoriously hard to predict whats going to happen the next year, much less 20 years into the future. I would be very suspicious of anyone claiming to be able to do so!

Secondly, if you look at a discounted cash flow model, it only shows results getting better year after year (entirely ridiculous!). There is never a down year. Furthermore, high growth rates are impossilbe to maintain over time due to the law of big numbers. For example, its a mathemtical impossilibty that Apple can keep growing at its current growth rate in the long run so it would be suicidal to use a DCF model here.

Finally, there is the problem of choosing an appropriate discount rate. Academics have debated it to the death and still no firm consensus has been ironed out. I have even seen people deriving a discount rate from beta (which I consider to be a ridiculous concept..) which makes no sense whatsoever to me.

That being said, I still feel that Discounted Cash Flows are still the best method in many situations to evaluate companies. It’s really a situation whereby there are a lack of better tools avaliable to do the job. In other to deal with the flaws of the DCF Model, I normally try to do the following:

1) DCF Valuation should be the last step of your entire evaluation process.
2) Look for a company with relatively stable free cash flow throughout a long number of years.
3) Be extremely conservative in your growth rates. If it looks to good to be true, it probably is. As a rule of thumb, companies that post growth rates exceeding 15% rarely meet expecations.
4) Look at the relative valuations like P/E to see if your valuation makes any sense.

The above discussion highlights why Margin of Safety is the most important aspect of investing. Valuation is really more art than science. Benjamin Graham once valued a company to be worth between $15 – 40 – reflecting how imprecise he knew it to be.

Always demand a Margin of Safety no matter what kind of valuation tool you use.

Conclusion:

In the end, DCF is only one of the methods to go about valuing a company. My advise would be to look at different valuation methods to see where yours stands before making an investment decision.

Company Analysis of ComfortDelgro – Hit or Miss?

Famous for their blue & yellow Hyundai Taxis, ComfortDelGro (C52) is a household name to most Singaporeans. However, many will be surprised to learn that it is in fact one of the largest transport companies in the world. It has operations all around the globe – most notably in the United Kingdom, China & Australia.

2005 2006 2007 2008 2009
Revenue (S$’ Mil) 2497 2786 3013 3120 3052
Operating Expenses (S$’ Mil) 2192 2479 2676 2842 2702
Profit attributable to Shareholders               (S$’ Mil) 202 245 223 200 220
Return on Equity (ROE) 15.4% 17.6% 15.3% 13.2% 13.5%

 

The company has done reasonably well in the past five years considering the financial crisis (2007 -2010). Even though its core customer base in located in Singapore, it also does extensive business overseas.  It has for the past five years, delivered a solid ROE of at least greater than 13%, a definite plus point in my book.

2002 2003 2004 2005 2006 2007 2008 2009
Net Cash From Operating Activities              (S$’ Mil) 546 442 619 515 548 643 574 728
Capital Expenditures        (S$’ Mil) -380 -245 -363 -402 -386 -328 -351 -447
Average Captial Expenditures               (S$’ Mil) -348 -348 -348 -348 -378 -378 -378 -378
Free Cash Flow            (S$’ Mil) 198 94 271 167 170 265 196 350

 

Cash Flow Analysis of ComfortDelGro (2002 – 2009)

Net Cash from Operating Activities has been steadily increasing since 2002. Being a fairly capital intensive company, it ploughs back a significant portion of their cash back into capital expenditures. Free Cash Flow (Net Cash from Operating Activities – Captial Expenditures) is extremely healthy. Armed with a substantial war chest and healthy cash flows, the company has been making a string of acquisitions – the most recent being its attempted takeover of Swan Taxis Ltd in Perth.

Debt Analysis

2005 2006 2007 2008 2009
Shareholder Equity 1345 1441 1483 1557 1690
Total Assets 3,058 3,085 3,316 3,352 4,052
Financial Leverage (Total Assets/S.Equity) 2.27 2.14 2.24 2.15 2.40

 

As of 2009, ComfortDelGro has a financial leverage ratio of 2.4 – healthy by my standards. I do not foresee debt repayment to be a significant problem as the industry is relatively stable. Furthermore, strong cash flows help to facilitate interest and debt repayment for the foreseeable future.

Economic Moat Analysis

Despite the deregulation of the taxi industry in Singapore, ComfortDelGro continues to maintain its leadership status in the industry (63% as of 2009). Its subsidiaries, VICOM & SBS Transit also maintain similar market shares – a plus point. One of the biggest strength of ComfortDelGro is its sheer size and strong financial health. It enjoys significant economies of scales compared to its local competitors.

It must be noted however, that the transport industry (in my opinion) is highly competitive in nature. Consumers taking taxis tend not to have distinct preferences in the company of the cab they are flagging down.  Their competitive edge is further eroded overseas, where they have a much smaller foothold.

The Bear Case

Geographical Segment %
Singapore 56.7
UK/Ireland 24.5
China 9.3
Australia 9.1
Vietnam 0.3
Malaysia 0.1
Group 100.0

 

With local growth stagnating, ComfortDelGro has looked outwards to expand.  Despite the healthy growth of its businesses in China & Australia, the outlook is much more lackluster in the UK, Vietnam & Malaysia. As these are not main income contributors, I do not foresee a significant impact on its core business.  Rising fuel costs and currency translation effects will also continue to hamper their growth both locally and overseas.

Conclusion:

Despite the challenges ahead, I feel that ComfortDelGro will be able to leverage on its strong financial health and continue to expand overseas.  Potential investors should look forward to capital appreciation in the long run. Coupled with its dividend yield (about 3%), I feel that it remains an attractive investment at this point of time.

 

Economic Moats of Locally Listed Companies

Here are some locally-listed companies that possess economic moats.

Singpost

Singpost possesses a great economic moat – namely it’s the virtually the only provider of mail services in Singapore. No other close competitor exists to rival it due to regulatory constraints. In other words, as long as regulations do not change, Singpost has pretty much been given a license to print money.

 

Do note however that Singpost has also branched into other businesses whereby it possesses little or no economic moat whatsoever.

SMRT

SMRT is pretty much the dominant MRT operator in Singapore. It also runs certain bus routes in Singapore.

Like Singpost, SMRT also posts extremely healthy numbers and growth despite the down turn. The nature of the service – being a necessity more than a luxury good guarantees this. Capital expenditures are much higher in SMRT than in other companies mainly due to the nature of the industry.

SPH

SPH is the dominant provider of printed newspaper and magazines in Singapore. It has done extremely well over the years. However, its economic moat has weakened somewhat in recent years with the rising popularity of the Internet.

As you can see, companies with economic moats tend to do extremely well over the years. Some of the hallmarks of economic moats (by no means exhaustive) are good ROE (>12%) and ROA (5 – 7%) with moderate leverage. Do note that economic moats are not always impenetrable and can be eroded over time.

Starhub – Irrational Debt Levels; Irrational Management?

There has been much speculation & confusion regarding the significant amounts of debt that Starhub now carries on its balance sheets. As of September 2010, Starhub possessed an astounding financial leverage ratio of 33.8. This means that for every dollar in equity, the firm had $33.8 in assets (anything above 4 or 5 is a potential red flag.)

So what’s going on here?

Bank loans made up 0.9 billion dollars in 2009! Let us take a closer look at the footnotes.

Even in a world awash with cheap money, I found the interest rate that Starhub was borrowing at to be extremely low. In 2009, their floating rate loans bore i/r of only 1.24% to 2.13%. This already low interest rate was reduced further in 2009 to only 0.92% to 1.39%. In opinion, it makes perfect sense for Management to leverage on the historically low rates to fund their capital expenditures.

Healthy Cash Flow Levels in Starhub:

Starhub is one of the few companies that use Free Cash Flow figures in their annual reports (a plus point for me) and for good reason. Even in the wake of the financial recession, they have posted impressive results.  I do not foresee a problem with loan repayments at this current point of time.

The Bear Case:

Starhub paid $20 Million in interest from bank loans last year (taken from the Cash Flow Statement of 2009’s Annual Report). Assuming that interest rates suddenly quadruple (highly unlikely in the near future but let’s take the worst case scenario here) to 5.6%, Starhub would have to fork out $80 Million in interest payments. A sizeable increase of $60 Million – but still within tolerable limits. I envision that as long as interest rates remain at their current levels, Starhub will have no qualms about maintaining the status quo.

 

Cash Flow Statement from Starhub Third Quarter 2010.

I want to bring your attention to another point – Refinancing. Judging from their cash flow statements, I suspect that Starhub is refinancing significant portions of their debt as the maturity date loans. This is akin to what REITs do when their debt is about to expire. In other words, they will be able to extend their loan maturity dates as long as they remain credit worthy.

I came across a post in another blog stating that Starhub was not making enough in FCF to cover their monthly 5.0cents dividend payment. The more risk adverse among you (it could be just me though..) might be wondering why Starhub doesn’t reduce its dividend payment in order to give itself a greater buffer or margin of safety. The argument is that once a company has started paying a regular dividend (in this case Starhub has committed itself to 5.0cents a quarter), the market will expect it continue the cycle at regular intervals forever. Any disruption to this cycle will be perceived as a potential sign of financial difficulties and a loss of confidence.

Conclusion:

In my opinion, debt levels while significant, should not pose much problem for Starhub. Close monitoring of their financial performance in their years to come is in order however. I feel that management has delivered solid returns up till this point of time and I see no reason why they wont in the years to come.

Tell-Tale Signs That Investors Should Look Out For in Reconsidering Their Investment in Starhub:

  1. Significant drops in Free Cash Flow over a sustained period (i.e. 1 – 3 years)
  2. Starhub being forced to raise additional amounts of money (i.e. through bond issues) AND refusing to cut its dividend yield
  3. Starhub taking on even more debt despite a significant rise in interest rates.

When faced with special situations such as these, its always good to dig deeper into the financial statements. Always make sure you understand the debt structure of the company. If its too complex, skip it. There are plenty of other companies that are much easier to understand.

Disclaimer: The author is vested in Starhub.