eBay’s 2009 Analyst Day

Today is eBay’s 2009 Analyst Day, and the meeting will be broadcast on the web starting at 8:00 AM PT. eBay is one of our significant current investments, and we have produced an extended series analyzing eBay’s economic moat and valuation. So we are eager to see what management will have to say for itself; the stock price has certainly been doing its share of speaking for some time now.

In anticipation of the meeting, eBay’s critics and observers have been pounding the web waves over the last week, offering their suggestions and speculating about future asset sales. Among the suggestions include selling the whole company to Microsoft or Google, selling Skype to Cisco, spinning off a portion of Paypal, and transforming the company into eBay 2.0. Trading at near 6x 2008 FCF, it strikes me that the former is most likely.

At any rate, we’ll be watching and eager to evaluate any proposed changes. Foremost in our minds are the strategic options for their cash held overseas, the possibility of creating an “eBay Local” site that concentrates solely on geographic distance (to snipe at Craigslist), and its progress on the current share buyback. Probably the best plan for current investors would be a coordinated debt offering and large stock tender offer. With no long-term debt and strong, cash flow businesses, they are not optimally levered in their current state. With today’s equity price, it seems a no-brainer to replace equity yielding over 15% FCF with debt costing 5-6%.

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

David Einhorn and Return on Equity

Here at Wide Moat Investing our primary task is to pinpoint the characteristics that separate good businesses from the great. So far, we’ve highlighted some qualitative characteristics that may not yield well to quantitative assessment (e.g., Coke has no “taste memory” and appeals to a basic, enduring preference). Yet, many investors begin their search for great businesses by using a handful of quantitative metrics. Margins are often important, for as we observed in our analyses of eBay and Microsoft, high gross margins may signal a business with significant competitive advantages.

Another important quantitative metric for many investors is return on equity (ROE).  For example, Francis Chou looks for excellent companies with a 15% ROE sustained over 10 years or more.*

David Einhorn, President of Greenlight Capital and hedge fund manager, addressed the topic of ROE in his November 2006 talk at the Value Investing Congress. There Einhorn argued that ROE is only a meaningful metric for capital-intensive businesses—like traditional manufacturing companies, distribution companies, most financial institutions, and retailers (4). For businesses that are not capital intensive—whose profits derive primarily from intellectual capital or human resources (e.g., pharmaceutical companies, software companies, etc.)—it is “irrelevant to worry about ROE” (4). Why? Because businesses that are not capital intensive do not generate substantial returns from retained earnings or capital expenditures. For example, if you are an insurance agent, you will bring in much more business and profit by getting on the phone and meeting more potential clients, rather than tripling your office space, or adding that new water feature to the atrium, or buying that highly efficient “document station.” In short, it’s not the “equity” which provides the retums, but the people, the brand, or the proprietary product—things which don’t show up on the balance sheet. ROE then is insignificant. For the most part.

You see, Einhorn observes, and experience confirms, that most non capital intensive businesses have an irresistible urge to direct excess returns back into the business that doesn’t need them, or to acquire businesses that do (i.e., capital-intensive businesses). And so the investment bank, which generates fees upon fees, largely due to its personal relationships with clients and its perceived brand, starts to pour excess capital into lending, trading, hedging, and gambling. Seemingly all of a sudden you have that old investment bank now asking its government for tens of billions of dollars, and it intensely needs the capital!

For Einhorn, the best explanation for such capital (mis)allocations is that such businesses are being run for their employees rather than their shareholders, employees running them just well enough to achieve a respectable 15% ROE, and sure enough, the shareholders’ respect keeps coming.

All told, we find Einhorn quite perceptive on these points. And we find his distinction between capital-intensive businesses and the rest to be crucial. For those numerous investors who use ROE to filter the castles from the shacks, they may be missing valuable investing opportunities. The lesson for the castle lover is clear—while the signs of some moats lurk on the balance sheet, not all do. Quantitative metrics will not uncover them all.

*[In the original post, I said “Joel Greenblatt’s Magic Formula screens for companies with the highest ROE and lowest earnings multiples (i.e., P/E).”  This was sloppy writing.  Greenblatt’s Magic Formula screens for high returns on capital (EBIT/net working capital+fixed assets).  ROE can give misleading numbers for companies with high debt or cash levels.]

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.

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.