Monthly Archives: January 2012

Canadian Pacific – Time to let the stock go?

Let’s look at the math and determine whether to hold the stock.

First, let’s assume the stock is trading at EBV+4, which is $73.95, as at January 30, 2012.  This will be the price we will do our analysis.

Assume the vote goes in favor, of Ackman.  Let’s also assume Hunter Harrison is running CP.  Then let us further assume CP trades at the same valuation as CNR, again on January 30, 2012.  CP would be trading at $86.80 a share.  That would mean an increase of 17.4% gain.  (From $73.95 as stated.)

Go so far.

Second, let’s assume the proxy battle goes in favor of current management and the present board certainly the stock would probably land at support at EBV+3, at $59.13 again at January 30, 2012, a loss of 20%.  CP would probably go lower, as the speculators dump their shares, however EBV+3 would be reasonable price sometime after the vote.

So a 17% upside gain, if all goes perfectly according to my first assumption.  A 20% downside, if the vote is against Ackman.  (Probably in a hurry!)

As you can see the market is a wonderful probability machine.  The market is saying 50-50 (in general) at this point.  Obviously, these odds (and price) can change anytime.

So back to the question, ‘Time to let the stock go?”  The current market is suggesting a coin toss.  Hopefully your odds are better elsewhere.

See our previous post on Canadian Pacific.

Netflix – Three BIG questions (and answers) about Netflix.

1.  Netflix (NFLX) had what we call economic velocity. Has management’s actions killed economic velocity the company once had and more importantly can NFLX regain it?

2.  The company raised $400 million of additional capital during the quarter.  Was this opportune for shareholders?

3.  Have fundamentals underpinning the stock changed?  What does the math say?

Big Question #1

Economic velocity is a concept we talk about all the time in our firm.  We rarely see this concept in action however when we do its footprint is undeniable.  NFLX had economic velocity from January 2010 to August 2011.  NFLX went from $50 to $300 with relative ease.  In our work, NFLX went from a break out of EBV+6 to EBV+10.  In 2011, NFLX was one of the most expensive stocks in our database.

What is economic velocity?

Economic velocity occurs when the fundamentals of the business, aspects of the balance sheet, and price momentum all reinforce each other.  Lighting in a bottle, one would say.  Rarely does an investor capture an investment such as this in their portfolio but when they do – it’s a beautiful thing.  The dark side of economic velocity is also displayed when a corporate action or some outside influence breaks these important self-reinforcing links and gravity takes over.

So the question remains, will economic velocity return to NFLX?  Management quickly overturned very unpopular corporate actions that saw the company lose 810,000 customers in Q3, 2011. Also, surprising, management chose to issue equity.  So before we answer the above question, let’s look at the financing and calculate its implications.

Big Question # 2

The below quote was given to the shareholders in a letter from management.

“Our standard practice with regard to managing our capital structure has been to evaluate on an on-going basis the appropriate cash level and capital structure for the business. In Q4, given the pain from our price changes and the impact to our 2012 outlook, this analysis led us to the decision to strengthen our balance sheet by raising $400 million of additional capital from two long-term oriented shareholders. $200 million was raised through the sale of equity (2.86 million shares at $70 per share), and $200 million was raised through the private placement of zero-coupon convertible notes. We have no intentions to spend this additional capital; it is merely a stronger safety-net for an aggressive, fast moving business with a big opportunity.

After the financing, we finished the quarter with $798 million in cash and equivalents.

Nothing in life is free.  What was the true cost of this financing?  Conventional finance thinks in terms of dilution.  Yes, EPS will be less; rate of return will be lower however if you’re growing quickly – who cares!

We do!

Enter Theoretical Earnings (TE)

This financing boosted NFLX’s theoretical earnings (TE) by 44%.  The TE of NFLX based on the September balance sheet was $1.43.  Post financing TE is now $2.06.  What does this mean?  The bar has been raised.  The company will have to have more in earnings, in order to create valuation.  We like to use an analogy of a marathon runner.  It’s easy to run a marathon at 143 pounds.  However at 206 pounds, the marathon runner is still the same person, can still run marathons, but the runner will have to work harder to run the same race.  More weight to move!

Enter Convexity

Convexity is a concept that may be difficult to grasp, but one we believe to be important as it represents a unique characteristic in model price.  Under “Key Concepts”, and “Model Price” we have the description of model price.  Point 2, in our 3- factor model, we state “The sensitivity of  [the] company’s balance sheet structure to changes in its market value. (Structure)” We call this Convexity.

We calculate convexity for all companies in our database.  This measure determines the sensitivity of the value of the economic structure to changes in market value.  We have found that the more sensitive a company is per our measure (the higher the convexity), the higher the valuation in terms of the stock price.

NFLX pre financing had convexity of 2.44.  Post financing convexity stands at 1.76, a decrease of almost 30%.  This not only decreases our model price calculation but also decreases the feed back mechanism as the stock trades higher.  More friction!

As one can see two key components of economic velocity have been altered with NFLX’s financing.  Financing that in management own words, “We have no intentions to spend this additional capital …”

During economic velocity the market can and will give a company cheap equity capital to expand your business.  The market has selected you, the winner, and will give you all the resources (capital) for your business model.  Issuing equity at EBV+10, ($300) instead of under EBV+6 ($70), theoricatical earnings and convexity impact would have been minimal.

Our point here is that management could have been more optimal for shareholders and less damaging to the internal dynamics, which propelled NFLX skyward in the previous period.

Big Question #3

Model Price has collapsed.

The current model price is calculated at $15.60.  This represents a staggering 87% below the close on Friday, January 28, 2012 of $123.79.  Analysts’ are currently forecasting $2.89, mean estimate, for calendar and fiscal year for 2013.  This brings next years’ model price to $88.14.  Still down significantly from the close on Friday.

As Netflix reported their 4th quarter numbers on January 25, 2012, the company stated it added 610,000 customers, in the fourth quarter of 2011.  This brings their Net Unique U.S. Subscribers, close to their record of 24.59 million subscribers set in Q2, 2011, to 24.4 million.  Investors’ and analysts’ cheered the company is back on track and ready to scale, the previous mountain scaled, on the way back to $300.

Management cut significantly the earnings forecast for fiscal 2012, and that had a big impact on this year’s model price.  However, also included in our model price calculation is theoretical earnings and convexity.

So back to our question, will NFLX re-achieve economic velocity?  We don’t think so.  Why.  We cannot think of one instance in the last 15 years, with economic velocity reappearing at the same company at a different time.  Yes, as we said lighting in a bottle.  NFLX could have all the cheap capital it needed to aggressively expand their business, purchased companies, and heavily marketed to new customers.  Management stumbled.  The stock stumbled.

What do we think will happen to the stock?

NFLX will continue to trade in the zone of EBV+7 and EBV+8.  Currently, these zones are between $102 and $184 dollars per share.  Yes, we know this is a big difference.  But in our world transits are the most important, not the daily ups and downs of market action inter-zone.  However, the farther NFLX strays away from EBV+7 the more risk the investor is taking. (In technical analysis terms this is support.)

NFLX with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

For those interested, a daily updated chart of NFLX subsequent to this post will be maintained on Facebook, here.

Just for fun we will make this prediction!

The more interesting question is what happens when NFLX transits downward through EBV+7. (See chart above $102.30)  If and when this happens we think NFLX will find a more comfortable home at EBV+5 ($47.80).  So when will this happen?  We don’t know. When we have done similar work in the past, sometimes the stock price and the math can take years to play out.  We are sure quarterly reporting of NFLX will be a nail-biter over the next year.  This will be interesting and we will be following.

Bonus Analysis for our Readers:
Just as an aside, just call it a bonus.  We always look at net plant and equipment versus accumulated depreciation.  (This ratio is in the calculation of model price).  We get the impression that investors’ think NFLX is on the vanguard of high technology in terms of streaming videos.  So when we see accumulated depreciation exceeding net plant & equipment we pause.

1)  Why aren’t they investing in their business? (Buildings/Computers/Equipment)

2)  Do they have a lot of old stuff (physical assets) lying around?

3)  What are the barriers to entry here?

See what we mean, having fun with financials.

Apple – Four Actions Management Can Do To Double Their Stock Price (Without Breaking a Sweat)!

On January 24, Apple Computer released its 1st quarter earnings report.  To say it was stunning would be an understatement.  Investors’ enthusiasm was wildly optimistic that these big earnings would translate into a big increase in the stock price.  While Apple did hit new highs on January 25, 2012, the rise in the stock, some would say, was muted.   Can model price explain why Apple isn’t trading at a higher multiple considering the financial results just reported and ever increasing expectations to come, with iPhone 5 and a new iPad scheduled for release sometime in the near future.

Enter Convexity

Convexity is a concept that may be difficult to grasp, but one we believe to be important as it represents a unique characteristic in model price.  Under “Key Concepts”,  and “Model Price” we have the description of model price.  Point 2, in our 3- factor model, we state “The sensitivity of  [the] company’s balance sheet structure to changes in its market value. (Structure)” We call this Convexity.

We calculate convexity for all companies in our database.  This measure determines the sensitivity of the value of the economic structure to changes in market value.  We have found that the more sensitive a company is per our measure (the higher the convexity), the higher the valuation in terms of the stock price.

How did we find Convexity?

The development of this factor began with the inquiry of why certain companies have “price momentum”. These stocks typically have high valuations, as the underlying earnings and/or earnings growth are not sufficient to support or explain their valuations. The result is changes in the securities’ own price seemingly reinforcing itself. Rather than just apply the “momentum” label to these companies and leave it at that, our approach was to determine whether certain types of companies are pre-disposed to higher valuations because of their economic structure. The price momentum observed in the market would therefore be, at least in part, a function of this structure as valuations gravitate to levels dictated by the structure. We also can think of the convexity as analogous to friction. The less friction (the higher the convexity) there is, the higher the potential valuation.

Getting back to Apple

Let’s look at the calculated convexity score for Apple and other large capitalized technology companies.

Companies Convexity Score
Microsoft Corp. 2.15
Oracle Corp. 1.91
Intl. Business Machines Corp. 1.17
Intel Corp. 1.87
Cisco Systems Inc. 2.34
Dell Inc. 4.00
Apple 0.17

As one can see Apple is way to low compared with not only large cap technology but also with other companies in the S&P 500, which has a cap weighted convexity of 1.43.

What are we saying?  Quite simply, the balance sheet of Apple is too big.  Yes, management is performing brilliantly, results were spectacular and they have a bright future.  Yes, Yes, Yes. However, they have a steamer trunk on their backs that the market will discount.  A hundred billion dollars of cash, great if you are paranoid but the market doesn’t pay you for it in terms of valuation.

How can management get convexity up?

  1. Split the stock.  Yes, there are those people who say, splitting the stock will not make any difference.  “Simple division” they say.  Unfortunately wrong in our view.  Splitting the stock will increase convexity, increasing convexity will increase model price.  We believe the share price will increase in recognition of this fact.  Anyone in the business knows intuitively stock splits make a difference however current financial textbooks cannot prove, as yet, what we know intuitively.
  2. Pay out an extraordinary dividend.  Certainly management can get by on say, $50 billion cash on hand.  This won’t change the business one iota, however this distribution will shrink the balance sheet quickly and increase convexity.  Shareholders will get a taste of Apple’s success and we bet the market price will quickly increase to make up any ex-dividend differential.  (Microsoft saw the light, maybe it’s time you did to.)
  3. Buy back your shares.  Over the last ten years has there been any better investment than Apple?  Management could have been purchasing shares with excess cash, making a great investment and increasing their convexity in line with other large cap tech.  That is perfect hindsight you say, what about the next ten years?  Simple, you are purchasing shares at the current model price, i.e., fair value with current convexity.  If management has a 5-year objective to getting convexity to 2, moving the model price substantially higher irrespective of what your business does.
  4. Do all three points above.  (Or some combination would be helpful.)


Apple now trades around its model price (434.31) as of January 25, 2012.  We calculate the model price for next year at $484, implying an 11.5% gain.   Not bad, when treasury bills are zero.  However, Apple could be a whole lot more if management considered the above.  On the back of an envelope Apple could easily double their share price by doing a little “financial engineering” [We know the worst two words one can write post 2008 crash!] and certainly on its way to become the first trillion dollar company post the 2000 technology bubble.


IBM – The Poster Child for Managing Theoretical Earnings (TE)

Yes, we are number freaks but when we see perfection we have to say bravo.  We are knee deep in 4th quarter numbers when we stumbled on IBM.  Man, they manage their balance sheet well.  Let’s get into it.

Under ‘Key Concepts” we have a box called “Theoretical Earnings” (TE), where we explain the concept and how we believe the market observes this differential between a company’s earnings and TE.  We can also say, the equity market gives valuation upside not only because of this differential but also a premium valuation to companies that are increasing this differential on a dynamic basis.  If the spread is increasing, between earnings and TE, the market will value this company higher certainly over the company where this dynamic is stalled or worse falling.

Let’s turn to IBM’s numbers.  In Chart 1 below, we graph each the 12-month forecast earnings per share and theoretical earnings going back to 1989.  For the financial historians, one can see why IBM fell on tough times in 1992 to 1994.  As one can see earnings fell below TE causing the market to lose confidence in the company and management.

Chart 1

In Chart 2 below, we made a differential graph highlighting the difference between 12-month forecast earnings and theoretical earnings including data up to December 31, 2011.  IBM is close to making 4x their TE, which is close to surpassing there all time high of 4.5x during the technology boom of 2000.  Considering they are achieving this in today’s not – so – great economic environment is impressive.

Chart 2

So here is the question.  How does IBM, which has TE of $3.97, as of December 31,2011, keep their theoretical earnings so low?  Keep in mind they will earn $15 per share in 2012.  In 2011, “they returned $18.5 billion to shareholders” – their language, $3.5 billion in dividends and bought back almost 89 million shares for $15 billion.  These people know how much cash to use so their balance sheet doesn’t get too big, and still have cash in their business for operating purposes, as the company gets bigger. Yes, I will say it again impressive.

Unfortunately, IBM trading at a premium to our calculated model price of $140.45, (as of January 24,2012).  We can only hope Europe blows up, or if we get another shock in the market this company deserves to be on someone’s wish list.

Gennum (GND)

Semtech Announces Plans to Acquire Gennum Corporation for $13.55

Last night Semtech Corporation announced plans to acquire all outstanding shares of Gennum for $13.55 CDN per common share.  So what does Model Price say?

The model price of GND is calculated at $13.29.  Not bad!  We get the question all the time, how do you know model price works?  Simple; we see it working everyday.

Dividend Bubble?

Dividend Bubble?

Financial Times, Saturday edition, LEX Column.

Some extracts:

“Any observer of the markets must have grasped by now that it is possible to have too much of a good thing. After the tech bubble and housing bubble, are we witnessing a dividend bubble?”

The very notion is absurd to some value mavens who have long expressed a preference for dividend-paying shares. Lilliputian bond yields, however, are now pushing two particular types of buyer into such shares – income-hungry retail investors, such as retirees, and investment funds with a mandate to focus on current income.

Even if one accepts that dividend-paying stocks, especially non-financial ones, tend to be quality companies, dumb money can inflate them into bad investments.

It probably is too early to call a bubble but there are signs of froth. The reason dividend-payers outperform is that yield correlates with value characteristics. The reverse is not always true, though – particularly when it comes to entire categories such as master limited partnerships and trusts that have high-outs by default.

Investors not desperate for income might be better served by focusing on value rather than on yield.”

“Yield is NOT Value.”

Whenever I’m doing MarketCall ™, I try to say this line at least 10 times. Why? People will be hurt financially by paying too much for yield and nobody, in the Canadian media, seems to be saying this. Obviously this hunt for yield is happening all over the globe as illustrated in the Saturday edition of the, Financial Times talking about the UK market.

Have a look at the undernoted Canadian companies and their respective model prices. We are NOT saying these companies will collapse tomorrow, however it illustrates how far above fundamental value these companies are trading for investors to collect the yields they are offering. Again, this could go on for sometime however, when the world changes and the market rotates towards valuation these companies will be dead money at best, large capital losses at worst.

S&P500 Earnings Update

45 S&P 500 companies will report earnings this week. Look for WFC, and C tomorrow. GS will report on Wednesday. BAC, MS, IBM, INTC, MSFT, GOOG are expected on Thursday. Friday will be GE. Model Price will endeavor to keep up, and of course Model Price Guy will comment when appropriate.

S&P500 Earnings Update

116 S&P 500 companies are reporting this week. Look for Halliburton today. Tuesday, MCD, DD, VZ, AAPL and JNJ. Wednesday, XRX,BA and COP. Thursday, we have CAT, T, and MMM.

J.P. Morgan Chase Earnings

We have an updated balance sheet for JPM, which will appear in tonight’s run. We have reviewed the results. The new EBV-3 is $40.14. Even though JPM stock price took a hit in early trading we are within 10 – 13% of a transit through EBV-3, which would be positive, in light of my previous post.

What the equity market is saying about the US Center Banks?

J.P. Morgan, Citigroup, B of A, and Goldman

When you look at the Model Price charts of each one of these banks they are trading below EBV-3. Looking under “Key Concepts” and select box “Economic Book Value” one can see EBV-3 is the last line we use. What does this mean? Simply put, the market does not believe the stated book values these banks are reporting.

Under normal circumstances, when normal operating companies fall below EBV-3, this will signal future write-off of stated assets on the balance sheet. They’re maybe other reasons as well, and we will do a major blog post on companies that fall below EBV-3. However, the above noted TBTF (Too Big To Fail) banks are NOT normal companies. They depend on “the system” to survive. The system that bailed them out in 2008! Also they rarely ever take write-offs as normal companies do. If they did take write-offs (mark to market), the bank(s) would show huge losses, in-sighting deposit holders to panic and withdraw support, leaving “the system” to save them (again) – which is you the taxpayer.

So we play this game. The regulators turn a blind eye on impaired assets on their balance sheets. The public markets still fund the ongoing operations, and customers still support their bank by leaving their deposits with a bank they think is secure (FDIC insured) and everyone pretends its business as usual. Hopefully, down the road the banks’ assets will become more valuable when the economic conditions change for the better.

When will an investor know, the above noted banks, economic conditions have changed for the better? When the stock price emerges above EBV-3, of course.

There is a positive side to this story. The above noted banks are NOT, what we call “deep in the blue” like their European counterparts (which we will talk about later). Sure, B of A, will have to double in stock terms to get to EBV-3, but we have witnessed worse situations for banks in general over the years. Investors should monitor these money center banks from time to time. When these equities start to transit their EBV-3’s this will be very bullish for the financial system as a whole (finally emerging from the 2008 financial crises) and US equities in general.