Valuing the Washington Post, Revisited

Yesterday, we drew up a laundry list of the Washington Post Company’s assets and discerned the free cash flow (FCF) of Kaplan, its wholly held education subsidiary. Relative to the average FCF multiple of its peers (19.75x), one could make the case that Kaplan itself is worth more than the current market cap of WPO (which stood at 3.38 billion today, 2/27/09).

Yet, that 19.75x FCF valuation may look like a steep price, too high to provide the investor with a sufficient margin of safety. Even if the conservative investor grants that the education business is counter-cyclical and has good growth prospects, he may require future earnings to be more visible than Kaplan’s in order to justify that multiple.

Another way to value Kaplan’s intrinsic value is via a discounted cash flow analysis. Looking through the 10-Ks, we see that Kaplan had FCF of 189.8 million in 2008, 127.7 million in 2007, and 112.7 million in 2006. The older 10-Ks do not break out the depreciation and amortization expense for Kaplan alone, so it is difficult to discern Kaplan’s FCF growth rate. If we posit a modest 10% growth rate in FCF for Kaplan’s next decade, and a lower 5% for the next, and then discount those cash flows at 15% and demand a 25% margin of safety, the investor should feel comfortable buying the whole business for 12 times Kaplan’s 2008 FCF plus its equity. What’s Kaplan’s equity value? Given Kaplan’s acquisition streak, the 10-K shows over 2 billion in goodwill for Kaplan alone. The financial statements do not break out shareholder equity for Kaplan, so we’ll estimate it at half of their stated goodwill, or 1 billion. Thus, an investor seeking a 15% return and satisfied with a 25% margin of safety should be willing to pay 3.28 billion for Kaplan (2.28 billion for the cash flows and 1 billion for the equity).

Of course, while Kaplan is arguably WPO’s crown jewel, its other assets have significant value as well. Cable ONE had FCF of nearly 170 million in 2008. The television stations had over 90 million in FCF. The newspaper and print businesses were breakeven on free cash flow or slightly negative. Even after the market sell-off, its pension was overfunded by 320 million (as of Dec. 31) and its future return expectations reasonable (or, in my lights, low).

If we value Kaplan lower than its competitors, at 3.28 billion, put a cheap 8x FCF multiple on the growing cable business, and a 6x FCF multiple on the television stations, we get a value of 5.18 billion. Add in the 333 million in marketable securities and 320 million in the over-funded pension plans, and the value stands at 5.83 billion. And that’s assuming that we get all of their print and online publications for free.

In sum, we expect that an investor seeking a 15% return and 25% margin of safety would pay at least 5.83 billion for the Washington Post Company, or $622 per share. Though it may not be a dollar priced at 20 cents (like when Buffett first bought WPO), it looks to us like a dollar selling for less than 50 cents.

Disclosure: No position in the aforementioned companies at the time of this post.

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Valuing the Washington Post

Newspapers these days are a tough business. The publically traded ones have significantly cut their dividends, with Gannett being only the most recent. The less fortunate (read—those highly levered) have entered bankruptcy, to be chopped into pieces sized for the auction block. Nor has the Washington Post Company been immune to the challenges of this recession, having seen a significant decline in advertising revenue in recent quarters (with print ad revenue down 21% at the Post and 22% at Newsweek ).

As most are aware, the print newspaper business is in serial decline. As Warren Buffett has noted, “when they take people to the cemetery, they’re taking newspaper readers, but when people graduate from high school, we’re not gaining newspaper readers.”

The Washington Post Company however is much more than a newspaper business. In fact, in our lights, less than a quarter of its intrinsic value lies in its newspapers and magazines. Contrary to appearances, the Washington Post Company is an education business. And the numbers bear this out. In 2008, 52% of its consolidated revenues derived from its wholly-owned subsidiary Kaplan, which operates in three business segments: for-profit higher education, test preparation services, and corporate training. In addition to Kaplan, WPO’s assets include: Cable ONE, a cable service with nearly 700,000 subscribers across 19 states; its namesake newspaper and affiliated publications, which include their website and related investments (e.g., Slate.com, The Root, The Big Money); a 16.5% stake in online classified ad provider Classified Ventures LLC; Newsweek and its thirty affiliated publications; The Daily Herald, which publishes The Herald in Everett, WA as well as other affiliated publications; six VHF television stations located in Houston, Detroit, Miami, Orlando, San Antonio, and Jacksonville; a 49% stake in Bowater Mersey Paper Company; and $333.3 million in marketable equity securities (as of 12/31/08), which includes $218.8 million of shares in Berkshire Hathaway. Whew.

To give a detailed intrinsic value that accounts for all these parts would require more work than we’re prepared to offer today. But let’s just focus on Kaplan. Kaplan generated 206.3 million in operating income in 2008, with 67.3 million in depreciation, and 15.5 million in amortization. After subtracting 99.3 million for capital expenditures, Kaplan had free cash flow of 189.8 million. In 2007, Kaplan posted free cash flow of 127.7 million; in 2006, 112.7 million. For now, let’s ignore Kaplan’s growth rate and the counter-cyclical character of the education business (McKinsey’s research shows a 90% increase in education spending during the past two recessions).

Looking at Morningstar’s numbers, we see that competitor DeVry currently trades at 18x FCF. Capella Education at 21x FCF. Career Education at 12x. Corinthian Colleges at 48x. ITT at 6x. Strayer at 28x. If we throw out the high and the low, we get a sector average of 19.75x FCF. Applied to Kaplan’s 189.8 million FCF, we get a value of 3.75 billion. As of 2/26/09’s close, the whole Washington Post Company traded for less than 3.5 billion.

Now, we recognize that to some, a 19.75 multiple on FCF may seem high. So tomorrow, we’ll take a closer look at the rest of the Post’s assets and give a more comprehensive estimate of its fair value.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

On Buying Castles with Moats

Please permit me to state the obvious. In the last five months, the U.S. stock market averages have sustained a nearly unprecedented decline. Stocks are the cheapest—relative to GDP and trailing earnings—that they have been in more than a decade. And at least some stocks represent ownership shares in highly profitable, wide moat businesses that cater to basic, enduring customer preferences. Yet, as we’ve seen, Warren Buffett has been writing derivative contracts and cutting deals in bonds and preferred stock, rather than adding to his share of Coca Cola. But why?

The simplest and most plausible explanation is that Coca Cola is not yet cheap. Berkshire Hathaway has found Burlington Northern attractive at these prices, and Mid American did make a stab at Constellation Energy, but for the most part, the castles with the widest moats still seem too expensive, despite the market’s current 30-50% off sale.

If we read between the lines correctly, then I think that we see an important facet of buying castles. The most highly desired castles with the widest moats rarely go on sale. In fact, even if the general market declines, they are not necessarily cheap. To get a bargain on the best castles, one needs more than market pessimism–one needs insane, crazy, irrational behavior.

For example, in 1963, when Buffett took his stake in American Express, the business had been swindled out of $50 million in Tino De Angelis’ salad oil scandal. In 1976, Geico announced a loss of $126 million. As the expectations of bankruptcy grew, Buffett was buying.

The most desirable castles with the widest moats receive many covetous glances from an abundance of suitors every day. In today’s market, such castles are rarely cheap, even in a market of overwhelming pessimism. To get a bargain on a castle is no small feat.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

The Moat of Coca Cola

Over the last couple of days, we have explored Microsoft’s moat and intrinsic value, and tried to discern why a successful investor who knows the company intimately might choose not to invest in it. We have concluded that having a truly wide moat likely requires a business to sell a product or service that directly caters to basic, enduring human preferences. If a business does not meet this necessary (though not sufficient) condition, it may be susceptible to a future paradigm shift in customer preferences.

One basic preference—the one that Warren Buffett most often uses as an example—is the enjoyment of a Coca Cola. The average person drinks 64 ounces of fluids per day. Coca Cola sells over a billion servings per day, all around the world. As Buffett muses:

“Cola has no taste memory. You can drink one of these [Coca Colas] at 9:00, 11:00, 3:00 in the afternoon, 5:00. The one at 5:00 will taste just as good to you as the one you drank earlier in the morning. You can’t do that with cream soda, root beer, orange, grape, you name it. All of those things accumulate on you. Most foods do. And beverages. You get sick of them after a while… There is no taste memory to Cola. And that means that you get people around the world that are heavy users, that will drink five a day… They’ll never do that with other products. So you get this incredible per capita consumption.”

So if each person could drink five Cokes a day, and the world population is approaching seven billion people, and growing, then it is quite likely that more servings of Coke will be served in ten years. A century’s worth of days show that the desire for Coca Cola is a basic, enduring preference. So desired, in fact, that thousands of irate fans bombarded the company with complaints when Coca Cola tried to better its taste (see the New Coke fiasco). That kind of event signals a business with a wide moat. Buffett continues:

“I can understand [Coca cola]… Anyone can understand [it]… It’s a simple business. It’s not an easy business. I don’t want a business that’s easy for competitors… Coke’s moat is wider than it was thirty years ago. You can’t see the moat day by day, but every time the infrastructure gets built in some country that isn’t yet profitable for Coke, but will be twenty years from now, the moat is widening a little bit… That’s the business that I’m looking for. Now what kind of businesses am I going to find like that… I’m going to find them in simple products. Because I’m not going to be able to figure out what the moat is going to look like for Oracle, or Lotus, or Microsoft ten years from now…

So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they are going to be ten years from now. And if I can’t see where they are going to be ten years from now, I don’t want to buy them.”

A simple business is key for Buffett, which in our lights, means a business that sells a product or service that directly caters to basic, enduring preferences.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Microsoft–What’s It Worth? Re-examined

Over the last couple of days we have offered a valuation of Microsoft’s future cash flows, under the assumption that in ten years a paradigm shift in communications will occur and render its profitable products obsolete. Yet, as some readers have observed, such an approach is too simplistic to provide a fair valuation. For one thing, even if a paradigm shift could occur, it is not 100% certain that it will. And secondly, it is likely that Microsoft’s research and development teams could develop a viable product for the new paradigm.

At least three future possibilities are conceivable, and for our purposes, let’s assume that the probability of each possibility is greater than zero. On the one hand, let’s say that it is 20% likely that Microsoft will suffer significantly from a paradigm shift in communications in ten years; in this case, the company will be worth 17.08 per share (based on our previous calculations). Call this the pessimistic view.

On the other hand, let’s say that it is 40% likely that Microsoft will continue growing its free cash flow at (what I take to be) its historical 4% annual rate for the next two decades. In this scenario, I estimate the NPV of Microsoft’s cash flows to be worth $21.06 per share, discounted at 15%. Call this the prudent view.

In a third scenario (call it the rosier view), let’s say that it is 40% likely that Microsoft will continue growing its free cash flow at a higher 7.4% annual rate (gurufocus’ numbers) for the next decade, and then grow cash flows at 5% for the next decade (5% is roughly what I would consider a stagnant business since it approximates the rate of population growth plus future annual inflation). In this scenario, I estimate the NPV of Microsoft’s cash flows to be worth $25.15 per share, again discounted at 15%.

So now we have three future scenarios, with three different valuations, and we’ve estimated the likelihood of each. We can combine these scenarios along the lines that commentator Eboro suggests:

Microsoft’s intrinsic value = (Scenario #1 * Probability) + (#2 * Prob.) + (#3 * Prob.)

Or

$21.90 = (17.08 * .2) + (21.06 * .4) + (25.15 * .4)

Of course, investors should seek a margin of safety when deploying their investing dollars. Since we have used a 15% discount rate, a 25% discount to Microsoft’s intrinsic value should be sufficient. So investors should be willing to pay $16.43 per share for Microsoft, even after taking account for a future paradigm shift in communications in which Microsoft’s Windows and Office are virtually obsolete. As of today (2/23/09), Microsoft closed at $17.21.

Disclosure: No position in the aforementioned companies at the time of this post.

Buffett, Technology, and Moats

Yesterday I offered a quick and concise NPV analysis of Microsoft’s future cash flows. At a glance, Microsoft looks like one of those great businesses that holds a near monopoly over an important and necessary product. A confident fortress surrounded by a wide and deep moat, if you will. As Warren Buffett noted, it is almost as if Microsoft “has a royalty on a communication stream that can do nothing but grow.” Yet, interestingly, Buffett did not buy into this seemingly wonderful business; even more, Buffett almost categorically rejects investments in technology companies, considering them outside his circle of competence.

To tip my hand a bit, Buffett’s position strikes me as paradoxical. It is clear that he understands Microsoft’s business well, perhaps more so than the more thoughtful and reflective managers in the company. Further, Microsoft’s business has a wide moat, showing striking similarities to two of Buffett’s best investments—Coca Cola and See’s Candies. So what’s the difference?

Given his analysis, I think any suggestion that Microsoft is outside his circle of competence is evasive. With his experience and abilities, there is no reason that he couldn’t expand his circle, if it isn’t sufficiently wide already. Is it management? Highly unlikely, for he has repeatedly expressed his esteem for Gates’ and Ballmer’s business acumen. Is it the price? Perhaps, but Microsoft did trade at reasonable multiples in the mid-90s and early-00s. At the very least, it has traded at multiples similar to Coca Cola’s in 1988 when Buffett made that investment.

In sum, I think that Buffett’s reticence derives from the greater difficulty in predicting Microsoft’s future two decades out than Coca Cola’s. And the email conversation between Raikes and Buffett bears this out. If a “paradigm shift” were to occur in communication or information processing, Microsoft’s cash stream could run dry and its best businesses be worth very little in liquidation. One begins to imagine a potential future paradigm shift in Google’s recent whispers of “cloud computing.” Or, more immediately, one can see the rapid growth of both open source and web-based word processing and operating systems. For example, Openoffice.org states that its software suite has been downloaded nearly 100 million times.

So the ultimate conclusion that I take away from all this Buffett watching is–for a company to have a truly wide moat, its product must directly cater to basic human preferences that will endure for decades.

Now, I’m not finally settled on whether I think Buffett is right. But I do think that a wide moat for him entails some additional qualitative filter beyond a high return on invested capital, demonstrated earnings power, competent and honest management, and a fair price. Buffett also asks for simple businesses, but I suspect that what he really means are businesses whose products are not susceptible to paradigm shifts in customer preferences.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Microsoft — What’s It Worth?

This past week, we spent some time assessing Microsoft’s moat. Though its Windows operating system and its Office suite are cheap to reproduce, easy to transfer and store, and require only a modest sales force, Warren Buffett acknowledged that a paradigm shift in communications could quickly undermine Microsoft’s position. Today Microsoft’s moat may be wide and deep, but consumer preferences may change rapidly in the next decade.

If Buffett is right, and consumer preferences could change in communications more quickly than their preferences in other areas (e.g., carbonated beverages, razors), then the prospective investor should be more conservative in her valuation of Microsoft, or perhaps, demand a greater margin of safety.

One thing is clear; Microsoft’s margins show that they offer a set of products that grant significant pricing power. Even after lumping all of their marginal products together with their cash cows Windows and Office, Microsoft has averaged over 80% gross margins on sales for the last five years (2004-2008), and a 34% operating margin over that same span. These margin numbers even best those of eBay, one of our favorite wide moat companies.

Yet, even if Microsoft’s future is less certain than Coca Cola’s, what do we think the company is worth today? Following Seth Klarman’s recommendation, it makes good sense to value Microsoft by summing its book value with the net present value of its future cash flows. Many NPV analyses estimate a company’s earnings power over the course of the next two decades. But if we heed Buffett’s warning about a potential paradigm shift, perhaps we should dial back our estimates of future cash flows. Thus, in this valuation, we will only project Microsoft’s future cash flows over the next decade.

So let’s get to work. Using Morningstar’s data, we see that Microsoft generated 18.43 billion in free cash flow in 2008. Let’s conservatively project that Microsoft will grow its free cash flow at 5% over the next ten years (which may seem low, but which is rather close to their FCF growth over the past decade). Using these estimates, the net present value of the next decade of Microsoft’s cash flows, discounted at 15%, should be 115.6 billion. Add the 36.3 billion of Microsoft’s book value, and we get a total value of 151.9 billion. In other words, Microsoft should throw off 243.4 billion in cash over the next decade. But we wouldn’t pay that much solely to have it to trickle back to us over that decade; instead, we want a decent return on your capital outlay—say 15%. Thus, we should be willing to pay 151.9 billion today for 243.4 billion in cash outflows over the next decade. Per share of Microsoft, that amounts to a price of $17.08. With a 25% margin of safety, we should be willing to buy Microsoft today for $12.81—significantly below Friday’s closing price of $18.

Now, I can anticipate some of the objections to this meager valuation for what is today a market leader and cash cow. It is unlikely that Microsoft will have no earnings power after a decade; it is unlikely that a paradigm shift in communications will occur. It may be improbable that cash flows will only grow at 5%.

Leaving such objections aside for now, it is crucial that we highlight what looks to be the most important lesson in this analysis. If we cannot predict what a company will look like in twenty years, our valuation of it and its future earnings should be far lower than we typically expect. And here we see that for an investor like Warren Buffett, what looks today like a wide moat may not be sufficiently wide if we cannot reliably foresee its likely earnings in 2029.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway and eBay at the time of this writing.

Francis Chou’s Best Bargains

Last night I was going through some of Francis Chou’s annual letters to his Associates Fund holders. Chou manages investment funds for Chou Associates Management Inc., and his Associates Fund has compounded annual returns of 15.4% over the last fifteen years, compared to 10.5% for the S&P 500.

In his 2001 annual report, Chou highlights the criteria that he has used to find his best bargains:

“Over time I have sifted through thousands of bargains which have come in different shapes and flavours such as discount to net-net working capital, discount to book value and low P/E ratio. When all is said and done, those which continue to give me the greatest satisfaction are the ones which display the following characteristics:

1) Above-average to excellent companies as measured by high ROE in excess of 15% sustained over 10 years or more.

2) Companies run by skillful managers as measured by good controls maintained on receivables, inventory and fixed assets.

3) Prudent deployment of capital as measured by a company’s capital expenditures, judicious acquisitions, and timely buybacks of its depressed shares.

4) A stock price which is far lower than what a knowledgeable and rational buyer would pay.

BMTC Group met the above criteria in spades. And when companies such as this one are found, the only rational thing to do is buy as much of the stock as the legal limit allows. In these instances it’s not always necessary to be extra careful about the buy price as long as this price falls within a single digit P/E ratio. Even on the sell side, there isn’t a pressing need to time the sale as the stock price nears its intrinsic value – the reason being that the company’s intrinsic value is growing in excess of 15%.”

Chou’s specificity here and his example of BMTC Group are very useful for the aspiring investor. Most simply, Chou needs to see sustained profitability, skillful management, prudent capital allocation, and a fair price. And when he finds it, Chou buys with conviction.

Microsoft’s Moat

Yesterday we saw Jeff Raikes’ analysis of Microsoft’s moat. And many of his observations still hold true today, even though Microsoft has broadened its product line greatly since then—moving to the Web, to video games, mp3 players, and television.

Even today, Microsoft’s most profitable products—far and away—are its Windows operating system and its Office suite. What makes these products so profitable? As Raikes observed, the products are cheap to reproduce, easy to transfer and store, and they largely sell themselves. PC users are most familiar with these programs and reticent to try alternatives. As a result, and most importantly, they offer “pricing discretion.” On Microsoft’s financial statements, these qualities translate into a low cost of goods sold and high margins. High margins and high profitability give a company the resources to widen, deepen, and bolster its moat.

As Buffett observes, it is as if Microsoft has a royalty on an increasingly important communications stream for our society. In a sense, Microsoft is the tollbooth that stands at the gateway to most modern communications and collects its hefty fee. Whereas in the recent past most communication could travel without such fees via typewriters or a pen and paper, Microsoft has positioned itself to command an upfront fee for access to communication, largely because our habits have shifted. Today almost every form of published or printed communication requires paying Microsoft the requisite access fee.

So, should the savvy wide moat investor throw all her capital into Microsoft, so long as the price was right? Perhaps not. For the worry, as Raikes also observes, is that a paradigm shift in communications may break our current habits. For example, if written communications shifted instead to cell phones, Microsoft may not be sufficiently prepared to provide the software and garner the fee. For a wide moat investor like Buffett, an important element of a company’s margin of safety is the durability of its customers’ preferences. For companies like See’s Candies or Coca Cola, Buffett expects that their customers’ preferences will be more enduring than Microsoft’s. If that is true, then Microsoft’s moat may be narrower than it initially seems. And the wide moat investor should wait for a fatter pitch.

Disclosure: No position in the aforementioned companies at the time of this post.

Warren Buffett on Moats

So long as we talk about businesses’ moats on this blog, you should expect to often see Warren Buffett’s wisdom amble by. Today I offer up a couple of extended quotes from an email exchange between Warren Buffett and Jeff Raikes on the topic of Microsoft’s moat. This 1997 email was revealed among the evidence in the trial Gordon v. Microsoft, which Microsoft eventually settled in 2004 for 182 million dollars. Though the Oracle has some interesting comments, I actually find Raikes’ comments on Microsoft more useful for the investor [comments edited for clarity]:

RAIKES: “In some respects, I see the business characteristics of Coca Cola or See’s Candy as being very similar to Microsoft. I think you would love the simplicity of the operating system business. For example, in 1996, there were 50 million PCs sold in the world, and about 80% of them were licensed for a Microsoft operating system. Although I would never write down the analogy of a “toll bridge,” people outside the company might describe the business in that way. Those 40 million licenses average about $45 per, for a total of about $1.8 billion in revenue…

In 2000, there will be about 100 million PCs sold. We think we can reduce piracy to 10% and license 90% or 90 million of the PCs. But we also have “pricing discretion” – I think I heard this term used in conjunction with your pricing decision on See’s Candy. We will be transitioning the world to a new version of our operating system, Windows NT… We can achieve average license revenue of $80. So 90 million licenses at $80 per license totals about $7.2 billion, up from just under $2 billion in 3 to 4 years. And since there are effectively no cost of goods sold and a worldwide sales force of only 100-150 people, this is a 90% plus margin business. There is an R&D charge to the business, but I’m sure the profits are probably as good as the syrup business…

So I really don’t see our business as being significantly more difficult to understand than the other great businesses you’ve invested in. But there is one potential difference that worries me, and it is key part of the reason I spent the time to share these thoughts with you. The difference I worry about is the “width of the moat.” With Coca-Cola, you can feel pretty confident that there won’t be a fast shift in user preferences away from drinking sodas, and in particular, Coke. In technology, we may more frequently see “paradigm shifts” where old leaders are displaced by new. Graphical user interface replaces character user interface, the Internet explodes, etc…

In technology, the moats may be narrower… I am very confident about our business for the next 5 to 10 years. But I will admit it is easier to be confident about Coke’s business for the next 10 years… My theory is that you don’t invest in technology or Microsoft because you see the moats are narrower; too much risk and the potential for a fast paradigm shift that would too quickly undermine your equity position…”

BUFFETT: “Your analysis of Microsoft, why I should invest in it, and why I don’t, could not be more on the money. In effect the company has a royalty on a communication stream that can do nothing but grow. It’s as if you were getting paid for every gallon of water starting in a small stream but with added amounts received as tributaries turned the stream into an Amazon. The toughest question is how hard to push prices…

Bill has an even better royalty [than Coke]—one which I would never bet against, but I don’t feel I am capable of assessing probabilities about, except to the extent that with a gun to my head and forced to make a guess, I would go with it rather than against… If I had to make such decisions, I would do my best but I prefer to structure investing as a no-called-strikes game and just wait for the fat one.”

Disclosure: No position in the aforementioned companies at the time of this post.