Category Archives: Level IV

Is Apple a ‘No Brainer’ Investment?

Both Icahn and Apple, the company, seem to think so.

Billions of dollars have been invested and divested in Apple stock since their earnings release on January 27th and two parties on the buy-side have gone public.

Mr. Carl Icahn, who I affectionately call Uncle Carl because of his crazy unshaven look these days, tweeted this on January 23rd, the Thursday before the Apple’s earnings release on Monday night, the 27th.

From Twitter @Carl_C_Icahn

From Twitter @Carl_C_Icahn

The day after Apple’s earnings release and with Apple stock down 8% (and having a negative transit of EBV+5 that I will get to later in the blog), Uncle Carl tweeted this.

From Twitter @Carl_C_Icahn

From Twitter @Carl_C_Icahn

Hope you’re with me so far?

Then on Thursday night, February 6th, 2014, Mr. Tim Cook, Apple’s CEO announced through the Wall Street Journal – not Twitter thank goodness – that Apple, the company, purchased $14 billion of its own stock or 3% of the company subsequent to its earnings release on the 27th.

Folks, this is business history occurring here.  Rarely, if ever, have I seen two major buy side buyers making very public comments on what they were doing – spending (investing) billions and telling everyone what they are doing.  This is unprecedented and real-time disclosure.

If this couldn’t get any better Uncle Carl writes two more tweets on Friday afternoon, February 7th, 2014 stating:

From Twitter @Carl_C_Icahn

From Twitter @Carl_C_Icahn

In the old days of the stock broking business it was not uncommon that someone out of the blue or a casual acquaintance would telephone you and whisper about a penny mine company had hit the mother lode of one precious metal or another (diamonds were popular once) that was not publicly known.  We called these men – they were never women – touts.  Well-funded touts opened brokerage accounts with you and purchased a hand full of shares to give you the feeling of being authentic.  The goal for the tout was to get you and your clients purchasing the stock creating demand thus driving up the stock price.  Yes, almost like a chain letter.  The early participants were rewarded the others suffered financial losses.

I’m sure the act of touting still thrives in some dark corners of the equity markets but Uncle Carl takes touting to a whole new level calling his investment in Apple a ‘no brainer’!

So what do we make of this activity?  Billions of dollars are flying around with unprecedented disclosure by buy-side participants.  Both parties, Uncle Carl and Apple, are not only making claims as to the valuation of the company but also backing their claims or assumptions with cold hard cash that each controls.

The Greatest Spectator Sport There Is!

This is where I have the most fun asking myself questions:

Did Apple make the right decision for shareholders by being so aggressive with its stock purchases?  Is Uncle Carl’s assertion correct that an investment in Apple is simply a ‘no brainer’ for every investor/trader?  Apple, being the most valuable company on the planet, can afford the best finance brains in the world in making this buy back decision.  Who did they consult and what was their logic?  Uncle Carl makes an assertion that if Apple had the same P/E ratio as Google, now the second most valuable company on the planet, as of Friday, that Apple would be worth $1,245 per share.  Is this assertion correct?  Who is going to argue with Uncle Carl’s analysis?  Are both parties using the same analysis that Apple shares are undervalued and if so what is this analysis?

And most importantly can financial math solve any of these questions?

So many questions, so little time.

Model Price To The Rescue!

Our goal and business idea was to have a unique service where financial participants could readily observe what we consider model price or fair market value of the public company in question.   We have created a database of companies that inputs selected pieces of financial information and calculates, through our algorithms, robust and unbiased – no matter the company or industry it participates – fair market value for each company.  This is a service we call Model Price.

Critics will charge that such a calculation is not possible with the current state and knowledge of finance.  We agree.  We had to create and acquire new financial concepts that are not known nor written about in finance textbooks.  For skeptics we have included these new financial concepts under our ‘Key Concepts’ tab, above.

Back to Apple

Let’s start with our model price chart on Apple, Inc.

Apple, Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Apple, Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

What’s the fair market value of Apple?  We have calculated Apple’s fair market value or what we call model price at $596.42 on Friday, February 7th, 2014.  Friday’s market close on Apple was $519.68, representing an upside potential of 14.8% for investors.  Nice upside, but would I mortgage the house on this upside potential, no.

As users of Model Price know we provide two pieces of original financial information for users.  The first is our calculation of model price as I have mentioned.  The second is our calculation of parallel lines we call EBV’s or Economic Book Value lines.  These parallel lines come from the balance sheet of the company.  By charting a company’s stock price along with our EBV lines gives users of model price unique perspective on how the fundamentals of the company interact with the publicly quoted stock price.

When Apple reported their earnings on January 27th, Apple had a negative transit for EBV+5 or our yellow EBV Line.  (See arrow on chart above)

What does this negative transit mean?

This is not the first time Apple has had a negative transit of EBV+5.  I noted the first time here in a blog and explained its significance.  In summary, the significance of this negative transit is the fundamentals of Apple are deteriorating.

Here is a more thorough analysis of Apple earnings and its calculated Theoretical Earnings (TE) value.  (For more on Theoretical Earnings and what TE means see Key Concepts.)

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For ease of analysis we calculated a ratio between EPS and Theoretical EPS.

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Apple has been a massively profitable company in the past.  With the invention of the iPhone and especially the iPad you can clearly see in this chart how profitable Apple has been.  Much of these past profits reside on Apple’s balance sheet in the form of cash – $158.8 billion as at the end of Apple’s 1st quarter.  The critical question that nobody knows, probably including Tim Cook and his management team, is what products can Apple invent or produce in the future that will produce as much earnings as the iPhone and iPad have produced in past years.

Well, unbelievably, we do have an answer to this question.  Apple, the stock price, had a negative transit of EBV+5 after its 1st quarter earnings release.  The market is taking away valuation and a negative transit of an important EBV level are signs that the collective wisdom of the market says we have seen peak earnings from this company probably for the foreseeable future.

Was Tim Cook’s purchase of Apple’s shares a wise move?

There are two issues here that need to be separated when thinking of this question.  First, what happens to the past profits accumulated by Apple?  How are the spoils of past innovation and great products to be divided?  Interested groups include shareholders, of course; future R&D (product innovation) and payment of past and future management.  Apple initiated a dividend, the first in company history.  Management also last year initiated a share buy back program, again rewarding shareholders.  This latest news of Apple management spending $14 billion is by far the most aggressive share buyback to date.  Mr. Icahn point is that shareholders of the company should get this cash as owners of the company.  He does have a point.

The second issue is how Apple should be valued going forward based on future prospects, products and earnings.  This again has been answered by the negative transit of EBV+5.  This action, in my opinion, is the ultimate arbiter on the future prospects of the company.  Collectively, through the buying and selling of Apple’s shares, the market is making its’ decision in taking away valuation of the company.  Even with the buying power of both Apple and Mr. Icahn couldn’t help support Apple’s shares above EBV+5.

So what is the answer?

The answer from our perspective would be for management of Apple to achieve a stable and balanced EPS/Theoretical EPS ratio, if at all possible.  If earnings do start to fall then Apple’s theoretical earnings should also fall in direct proportion thereby keeping the ratio stable and balanced.  (This can be illustrated when we do an analysis on Google later in the blog.)  Apple’s EPS/Theoretical EPS ratio has been very cyclical in the past 20 some years probably reflecting the inherent nature of the product life cycle of each for Apple’s very successful products.  This ratio’s cyclicality probably ultimately reflects in the low simplistic Price/Earnings ratio market watchers comment on repeatedly.

Mr. Icahn compares Apple with Google

Finally, Mr. Icahn tweets that if Apple had a Price /Earnings multiple of Google (19x) Apple’s shares would be $1,245.  This rather simplistic ratio, Price/Earnings, can and will get investors in trouble and can lead to massive investment losses.  Hopefully and I truly believe Mr. Icahn, a veteran of many decades in the investment game, wouldn’t rely on this simplistic ratio to invest billions for himself and others in his hedge fund.

First, let’s look at our model price chart on Google, Inc.

Google Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Google Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

As you can observe Google now trades at a substantial premium (35%) above its calculated model price.  As discussed previously, Apple trades at a slight discount (15%) to its calculated model price.  So does comparing Apple with Google with a very simplistic ratio relevant to anything valuation wise?  Of course, Mr. Icahn assumes the market is valuing Google correctly and not Apple.

Again, this is why we invented our model price algorithm.  We are comparing apples to apples (no pun intended) in terms of valuation.  So comparing a slightly undervalued stock (Apple) with an overvalued one (Google) is a stretch.

For fun, let’s wave a magic wand and say Apple trades at Google’s P/E ratio as Mr. Icahn suggests, this would place Apple’s shares above EBV+7.  (For readers to get this reference you have to go to our Facebook app and see where a stock price $1,245 would place Apple in terms of our EBV zones (link here).)  Apple never traded close to these levels even when the company was delivering peak earnings back in 2012.  Can Apple shares trade at $1,245?  Absolutely!  Markets can and will do anything.  However Apple would trade around 50% above its fair market value.

For fun, and to finish this blog, let’s have a look at Google’s EPS and our calculated Theoretical Earnings since the company went public almost 10 years ago.

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Ratio of the two variables

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Hopefully the difference in the fundamentals of these two companies is illuminating.  Google, Inc. provides a service – search.  Google is a dominant player in this space (near monopoly) and provides shareholders with an ever-increasing earnings stream.  Apple, in comparison, is mainly a product company highly dependent on new and high margin innovative products.  Apple has a formidable challenge of revisiting past peak earnings with new products.  Google, on the other hand, as yet to show any signs of peak earnings.

Compare these two companies for valuation reasons?  Not a chance.  Mr. Icahn probably knows better but a tout is always very cavalier with facts and figures, even though they seem to cite them for authenticity and credibility sake.

Conclusion

So where does all this analysis leaves us.

First, my main goal here is to talk about valuation.  Implied and explicit claims and counter claims have been made both in the market reaction to Apple’s 1st quarter earnings report and two individuals response to this market reaction.  If you’re interested in corporate maneuvering our Model Price App can help keep score in terms of actual valuation of the companies in question and the likely winners and losers.

Second, tens of billions have been flying around in the last two weeks surrounding Apple.  Apple has become a battleground and with two of Apple’s biggest proponents going public in their actions is, as I said, unprecedented.

Mr. Icahn wants Apple’s cash.  This is the ‘no brainer’ of which he talks about.  Mr. Tim Cook was repurchasing shares of Apple at an accelerated pace over the last two weeks because he thinks he’s being opportunistic and appeasing Uncle Carl at the same time.  This repurchase move was probably a good political strategy but not necessarily a financial one.  (This strategy clearly worked because on Sunday night Proxy-advisory firm Institutional Shareholder Services (ISS) Inc. on Sunday recommended that Apple shareholders reject a proposal by Mr. Icahn that the company buy back $50 billion of its stock.  Subsequent to this announcement by ISS Mr. Icahn dropped his proposal.  Mr. Icahn said he also supported Apple’s recent move to repurchase $14 billion in shares within the last two weeks.)

For me, a past owner of Apple shares, the decision is straightforward.  A negative transit of EBV+5 was my sell signal and I will wait on the sidelines until either Apple has a positive transit of EBV+5 (again) or probably more likely when Apple trades at support in its current zone or EBV+4.

Valeant (VRX) – Rollups, Math and How to become a Multimillionaire! (Reblog)

(J. Michael Pearson is now a billionaire!  So the title of my original blog is a little off.  Back on September 13th, 2012 I blogged about the company Valeant Pharmaceuticals International Inc. (VRX) when the stock was trading at $56 USD.  Friday, January 10th VRX closed $133.50 USD.  What is going on here?  Well I explain it all in my original blog back in September 2012.  A body in motion stays in motion, Newton tells us and J. Michael Pearson is doing exactly this.

Rolls ups are fun to watch and profitable if an investor knows what is going on and you have the right jockey (CEO).  Thankfully we have been part of the move (Acker Finley), but ‘tress don’t grow to the sky’.  In roll up situations the law of large numbers finally catches up to the consolidator, in this case VRX.  Have we reached that point in time?  We will have to wait to see what acquisition Mr. Pearson pulls off to keep up the growth the market now expects along with our calculated Model Price Theory math of course.  Again, this should be interesting to observe.

I have updated our chart (analysis) showing expected earnings of Valeant (one-year forward) with our calculation of Theoretical Earnings (TE) that I included in my original blog for all to see.

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If Mr. Pearson can make future acquisitions keeping the ratio between Theoretical Earnings (TE) and EPS intact – or better still expanding – the market, I’m sure, will reward shareholders tremendously – as it already has.  The antithesis is also true.  If future acquisitions inflate TE significantly without a proportional increase in expected earnings the share price of VRX will be adversely impacted.

Mr. Pearson is one smart cookie and rightfully a billionaire.  Very few CEO’s have this ability and the market is giving its blessing on VRX’s growth strategy with a positive transit of EBV+6 (see model price chart below).  This will be interesting to watch.

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

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

Valeant (VRX) – Rollups, Math and How to Become a Multimillionaire! – Reblog from September 13, 2012

Last Monday – Labor Day, Valeant Pharmaceuticals International Inc. (VRX) announced that VRX agreed to buy Medicis Pharmaceutical Corp. for $2.6 billion.  The share price of VRX jumped 15%, Tuesday, September 4, 2012 when the markets opened.  This is very rare, that an acquiring company’s stock price gets this share price pop after an acquisition announcement.  Usually shares of an acquiring company fall dramatically after such an announcement.  Ever wonder why?  It’s all in the merger math and the markets seem to know it instantly even though the CEO’s and CFO’s don’t.

I like positive stories, and seeing VRX increase dramatically on this news signaled to me there had to be some sort of story here behind the numbers.  So I took some time to do my research.

Financial markets are about math. The current financial universe focuses on discounted cash flow, enterprise value and valuation tools, which don’t really explain a good acquisition (Good in terms of an acquiring company shares appreciating on a deal announcement) from a bad one, (Bad in terms the acquiring company shares trading down – sometimes dramatically – while the acquired company shareholders get a substantial premium) at least to me.

Have you wondered why the difference?

Remember Harvard MBA’s and CFA’s don’t have model price math.  So let’s see what is going on here and I will explain why Valeant had such a good day, through the math of model price.

Theoretical Earnings (TE)

As a review, our calculation of theoretical earnings represents a specific earnings number that a company needs in order for its’ balance sheet to maintain “state” or stay constant in the future.  Every balance sheet is different, just as a fingerprint, so every calculation of theoretical earnings is unique to the company’s balance sheet.  No finance book I have seen has this concept of TE.  However give this concept some thought and I believe TE makes sense on two levels.  The first level is comparing TE to the current level of earnings.  The company may have some patent or industrial process that produces additional earnings over the company’s benchmark.  We believe the differential between the two, earnings and TE, represents the market value the equity market is giving the company as a whole.  It is the “x” factor in the market value of the company.  We calculate TE on every balance sheet for every company, and keep a database of this number with the financial history of the company.

[Current financial industry practice use rather simplistic ratios like price/earnings, and compare ratios to similar companies in their own industry.  I have never found this particularly relevant compared to theoretical earnings concept.]

The second level is the dynamic between TE and actual earnings per share.  If the spread between TE and actual earnings is increasing the market will reward this company with market value – share price appreciates.  To us this is the most important driver of security prices going forward.  Tell me whether this dynamic is expanding, contracting and I can predict with certainty whether a company’s stock is increasing or decreasing.

So let’s have a look at Valeant and see what the market liked so much.

First let’s look at our long-term chart of Valeant (VRX) since 2005, using monthly price bars.

Valaent Pharma with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

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

Along with the above price chart, let’s review what was going on with theoretical earnings and estimated earnings since 2005.

Let’s also do a ratio chart of the above.

Discussion of the above charts

As observers can see before the selection of the current CEO, J. Michael Pearson, the spread between earnings per share and theoretical earnings was decreasing.  As the ratio was decreasing VRX was losing valuation or market value.  With Mr. Pearson as CEO, one can observe stability between this above noted ratio.  We highlight the merger with a Canadian Pharmaceutical Company  – Biovail – because the balance sheet increased in size dramatically thereby increasing theoretical earnings.  Since the Biovail merger VRX has been acquiring companies, WSJ notes 50 acquisitions since Pearson was rewarded the CEO position, with the above noted ratio of TE and estimated earnings expanding greatly, as one can observe

So let’s take this one step further.  Let’s look at the personality behind Valeant in one CEO named J. Michael Pearson.

Mr. Pearson earned his MBA from the University of Virginia, then went to work for McKinsey & Company.  Having worked at McKinsey for 23 years, rising to Director advising companies in the healthcare field including Valeant. Mr. Pearson left McKinsey for Valeant Pharmaceuticals (VRX) in February 2008.  In other words, he spent his 10,000 hours learning and advising individuals in the healthcare industry and found a vehicle in Valeant to try a business strategy that “went against the grain” of current industry practice, as, noted in publicly available articles.

As reported in the Wall Street Journal, Valeant directors began seeking a new CEO in December 2007. The Chair of the Board, at the time, told Mr. Pearson and two other finalists that he liked the private-equity model for executive pay “because it aligns management’s incentives with those of the investor,” he recalls.  The Directors required the winning candidate to buy at least $3 million in stock, and forgo routine annual equity grants and hold many shares for years before selling.  Mr. Pearson already was advising Valeant as head of the global pharmaceutical practice at McKinsey at the time and had the cash to meet the stock purchase requirement.  He ended up buying $5 million dollars worth of shares at the time.

Skipping to the present according to the latest proxy material Mr. Pearson has beneficial ownership of 5.6 million shares.  Plus with other restricted stock units and performance restricted stock units bring the total shares to 7.6 million shares.  So at the close on September 11, 2012 Mr. Pearson has $430 million in Valeant shares.  Mr. Pearson also will be getting $1,750,000 annual salary in 2012 for his efforts.

Remember this all happened since he joined the company in February 2008.  As we all know not exactly a friendly economic environment to garner this type of wealth.

Great story!

Valeant fits the definition of a “Rollup”

What Mr. Pearson is doing is not unique in finance.  Google the word “rollup”, and you will find in Wikipedia a “rollup” is a technique used by investors where multiple small companies in the same market are acquired and merged by a consolidator (VRX).  No mystery here.  As I mentioned earlier and reported by the Wall Street Journal, Mr. Pearson has overseen 50 transactions since becoming CEO in 2008, expanding the company’s annual revenue from $600 million to around $3.5 billion.  If the Medicis acquisition is completed, Mr. Pearson said, Valeant will have revenue of roughly $4.5 billion.

My takeaways from the above

1.  The model price math, in particular the management of theoretical earnings, from when J. Michael Pearson took over in 2008 to present has been masterful.  The market has recognized this by increasing the valuation for Valeant rewarding shareholders and in particular the CEO.

2.  When VRX announced the acquisition of Medicis Pharmaceutical on Labor Day, VRX jumped 15% because 1) the growth of VRX by acquisition is continuing after the company shares were consolidating over the last quarter or so. 2) Management has demonstrated it can manage TE and more importantly the spread between TE and estimated earnings – in other words I believe the market gave management and market participants the “thumbs up”.

3.  Rollups as a financing technique usually have a lifespan. Either the acquirer (consolidator) runs out of company’s to buy, to fuel future growth or through ego and/or hubris the acquirer’s management acquires companies that are too big thereby substantially increasing theoretical earnings and crushing theoretical earnings versus the forward looking earnings per share spread or ratio. Financial history tells us shareholders at the end of the acquirer’s strategy or a large management “ego buy” bears the ultimate financial losses.

4.  Since Valeant’s management team doesn’t have model price math it is interesting to speculate, at least on my part, is Mr. Pearson doing this instinctively after his 23-year experience at McKinsey or do they some working financial model of their own.

5.  I have spent a lot of time and effort on this blog for a number of reasons.

a) Great real life example of model price cause and the effect on a company’s valuation.

b) There have been thousands of rollups in the history of finance and to me it’s fun to analyze one in action.

c) History tells me I will be writing about this company sometime in the future.  Call this piece a primer for future blog posts.  d) Mr. Pearson went from mere millionaire to multimillionaire status being at the right time and the right company – is he lucky?  Model price math currently says no, however does he know this?

e) Finance is an interesting spectator sport when you know what to look for, hopefully I’m telling you what to look for.

f) Every public company has the ability of managing this ratio, resulting in much higher valuations.  The market pays for efficiency in a company’s use of capital.  Unfortunately in the world of finance today, a Mr. Pearson is rare.

g) As I have stated previously this blog site is about illuminating new financial concepts, which are not in any textbook.  Hope you agree I am doing exactly this.

Three Stocks I am Currently Watching – Yahoo, Micron, and Pitney Bowes

Let me say a couple of things up front before I get into the details about the three stocks mentioned in my title.  I am not recommending these stocks as investments, as you all know, but I am following them on a daily basis.  They fascinate me and in this blog I will tell you why.

Secondly I wanted to talk about other investment strategies other than “Coming Out of the Blue” that may interest my readers.  Don’t get me wrong, “Coming Out of the Blue” is one of my favourite investment strategies and I use it often.  However I do employ other investment strategies that fit my personality and the amount of time I can spend looking at a quote monitor.

Another very profitable investment strategy is looking for catalysts in a specific company or industry and using model price charts to pinpoint entry and exit points for profitable trading.  What kinds of catalysts do I look for?  A new CEO in a moribund or struggling company is one.  Maybe a new industry is being discovered like social media and marketing.  Or maybe technology is changing the dynamics of pricing and cost structure in an industry or company that will drive future profit growth where none existed in the past.  (The three companies selected each have a different catalyst at play.)

Again, I’m not looking for a quick buck here!  Sometimes catalysts can take many quarters or years to play out.  The critical point is how do you know you are on the right track with your investment?  Keeping an investment, often times for years, an investor or trader needs feedback – for me constant feedback – that the catalyst in play is still working for a positive rate of return expectation in your portfolio.

Model Price Theory (MPT) and charts allow you to observe the dance between improving fundamentals and stock price on a daily basis giving an investor/trader feedback you are on the right track – the money track.  This dance is what I call an “investment campaign”.

And believe me, I love campaigns!

To conclude, couple themes together like a major turnaround catalyst with a company or industry with a low valuation – low EBV level – brings together several ingredients necessary for major rates of positive return.  All an investor or trader needs is the patience to hold the position over a lengthy period of time.  By using Model Price Theory (MPT) and our model price charts during one of my campaigns gives me a comfort level that I’m on the right track with important, relevant feedback over a lengthy period of time.

So with this lengthy preamble let’s talk stocks!

Yahoo, Inc. (YHOO)

The Yahoo story is a corporate turnaround by a CEO who I believe gets “it”.  I have already written two blogs on Yahoo, here and here.  I have already professed in my first blog on Yahoo, back on August 21st, 2013 that I am a fan of Marissa Mayer and I have been watching our model price chart on Yahoo with keen interest for over the last year.

So let’s have a look at Yahoo’s current model price chart.

Yahoo, Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Yahoo, Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

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

What am I watching on our Yahoo chart through our Model Price app?

For the last seven weeks the stock price has been pounding away at EBV+4.  I like this!  It’s like coiling of a spring.  Energy is being captured and stored.  At some future date this energy will be released driving the stock price higher – I’m talking high probability NOT certainty.  This same current situation occurred back in July/August – see arrow annotated in the above chart – where the stock price spent eight weeks following along our calculated EBV+3 (Red Line). After this eight week period Yahoo shares spiked upward taking only three trading weeks to achieve EBV+4.

A good CEO leaves a fingerprint of Model Price math that propels a company’s stock price and valuation higher.  Marissa Meyer is doing exactly this.  My hypothesis is Yahoo, Inc. shares will be much higher a few years from now with Ms. Meyer at the helm.  The current interaction of Yahoo’s stock price and model price math is confirming my hypothesis over the last year and I am fascinated of what the future holds for both Ms. Meyers and Yahoo.

Micron Technology Inc. (MU)

First off, I know nothing about D-RAMS.  I know nothing of what a D-RAM is, nor nothing about D-RAM pricing.  Yes, Sargent Schultz!

But I do know supply and demand.  Micron is a cyclical like gold, materials and oil stocks.  What I see in our model price charts are analysts constantly increasing earning estimates for this company.  My suspicion is that after 13 years of struggle and hardship for shareholders, the company may have finally found a sweet spot of product pricing, costs and lack of competitive pressure.

Let’s have a look at Micron’s model price chart

Micron Technology, Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Micron Technology, Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

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

As you can observe Micron’s calculated model price has gone from around $4 in March to the current $32.  This meteoric rise in model price is as a result of the substantial increase in actual and future possible earnings estimates.  Again the last time something like this occurred was back in 2000, when Micron peaked out at EBV+7.  What is the share price value of EBV+7 with Micron’s last updated balance sheet?  We calculate EBV+7 at $83.62.  Again, I not saying Micron, the stock, is going to EBV+7!  However there is a probability.

I have also included a long-term model price chart of Micron Technology for your reference.

Micron Technology, Inc. with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

Micron Technology, Inc. with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

As you can observe our model price calculation has never been higher since 2006.

Pitney Bowes Inc. (PBI)

Let’s first observe the long-term model price chart of this company.

Pitney Bowes Inc. with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

Pitney Bowes Inc. with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

As you can see the EBV lines slope downward initially and then somewhat flatten out with jagged EBV lines.  Yes, they look crazy, compared with the typical smooth, upward sloping lines of a “normal” company in our model price database.

What is going on here?

The management team along with the board of the company decided to zero out or return the shareholders equity of the company to its shareholders back in 2008.  Slow growth/no growth companies do have this option, as long as their revenue stream is somewhat dependable, of returning the equity of the company to shareholders by way of share buybacks.  By shrinking the balance sheet of the company (equity), rates of return on capital jump materially.  Increasing rates of return on capital and our calculation of convexity – see Key Concepts – our model price calculation increases.

Looking at our short-term model price chart

Pitney Bowes Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Pitney Bowes Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

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

Observables for the above chart

1.  Yes, our calculation of model price is below the current stock price but our model price calculation is based on adding 4th quarter mean earnings estimates to the September balance sheet – the last updated balance sheet.  As you can observe this has an impact of an upward slopping EBV line from the end of September – see annotated up arrow on the above chart.  We cannot know how many common shares management will repurchase during the future quarter thereby flattening our EBV lines.  So I anticipate additional share buy-backs having a positive impact on our future calculated model price line.

2.  Valuation of PBI is at EBV+8 and I agree this is high.  As all my blog readers know I do prefer lower valuation companies.  But as I said previously, PBI has no shareholders equity in the company.  With a low or no shareholders equity this makes the valuation of the company very high.

3.  There are mathematical limits according to Model Price Theory (MPT) in terms of management reducing the size – assets and shareholders equity – of Pitney Bowes’s balance sheet.  Limits can also be reached in terms of the amount of debt the company can carry under normal business conditions.  Any internal company specific or external economic shocks could be fatal as the company’s resources and possible room to maneuver financially is very limited as the company presses on with this course of financial engineering.

Having said all the above you are watching financial engineering dynamic in its early stages.  Financial engineering performed correctly can be very profitable for investors over a period of time.

Conclusion

So I have these three stocks on my quote screen watching them intraday whenever possible.  Three stocks, three separate financial catalysts which model price math can trace through the feedback of the stock price on our model price charts and keep me on track holding these investments for the long-term.

Trading Strategies using Model Price Charts – Barrick Gold (ABX)

Great football quarterbacks not only can see the play unfolding in front of them but also the whole playing field.  When learning and using model price charts you can see the whole playing field through our Economic Book Value (EBV) lines.  You can ask yourself “What if” questions like “What if company ABC has a negative transit of an EBV line?  Looking back over the last 7 to 20 years you can ask yourself “Has this company ever traded at this lower EBV line before?”  The amount of questions – good questions – can be asked and answered with a high degree of accuracy with specific price levels with our model price charts.  Keep in mind that EBV+2 in 2001 is the same EBV+2 of today.  The constants are the same.  You are comparing apples with apples (EBV lines of the past with current and future EBV lines of any company.)  If this happens anywhere else in finance I am not aware of it!

By asking yourself these good specific questions, and you can now visualize the whole playing field where you can get a sense of probability of the price action of the individual company in question.  For example, if company ABC usually bottoms at EBV+2 over the last 10 years, and ABC just had a negative transit of EBV+3, what is the probability of ABC bottoming at EBV+2 again.  Very high, I would say.  Not 100%, but very high.  Would you buy ABC today, after the negative transit of EBV+3?  No, of course not.  You would wait for ABC to trade at EBV+2?  Of course you would.  You don’t know how long this will take, could take months, quarters but you are patient as you see ABC trade lower on a weekly or monthly basis. You see the probabilities of specific levels and specific prices where trading action can occur knowing the probabilities are on your side when investing your hard earned cash.

My first challenge in revealing this work was to convince you and others that these EBV lines and our Model Price calculations work and stock prices are influenced by these mathematical algorithms in real time.  For some of you, I have succeeded.  Knowing that our EBV lines have relevance we can take the next step together and strategize trading strategies on specific companies with a high degree of confidence of future price action.

Once you know or have a high probability of future price action, investment strategies can be worked out knowing your competence level with various investment instruments and the amount of capital in your investment account.  That said, I must reiterate that while I can review in detail various price points and probable future price action, I’m NOT recommending specific stocks to anyone.  Nor am I recommending buying or selling stocks at specific levels.  Model price work stands on its own and how you trade and or apply this work in your investment account is yours to decide.

So with that being said, let me strategize about Barrack Gold (ABX).  Why ABX?  Josh asked me to.  Thanks Josh for the question.

Barrick Gold (ABX)

Let’s start with our model price chart.

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

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

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

Let me know if the above chart looks too busy but I’m trying to point out all the relevant information for you to consider.  I will break down my thoughts on ABX with a review of ABX’s past price history from July, 2012 up to the market close on April 19,2013.  I will continue with my actual trading plan and strategize on an investment strategy for future price action of ABX.

Past Price Review of ABX

Back in July of 2012, ABX has its first negative transit of EBV+2. (Point A) Believe it or not my first thought was ABX was going to EBV or our green line.  This was my highest probability outcome.  Checking the long-term chart (monthly bars) ABX traded down to EBV (green line) in 2008, so in my mind this was likely future event.  However at the end of August ABX had a positive transit of EBV+2.  OK, I was proven wrong with my initial assumption but let’s see what happens.  Bingo, a second negative transit at the end of October (Point B).  Game on, EBV here we come!  Yes, 16 weeks later ABX has a negative transit of EBV+1 (Point C).  My high probability assumption is of course higher because of this event and it’s only a matter of time before ABX trades back to EBV and I will be ready.  Again, 6 weeks later ABX is at EBV (Point D).  Remember our multi colored EBV lines are more significant than our other EBV lines – grey – so I thought our EBV line (green line) would hold considerable price support for ABX.

Within a week ABX breaks EBV.  Yes, this is shocking but more importantly what is the most probabilistic EBV level in play after this negative transit?  The next colored line in our EBV spectrum is EBV-3 our blue EBV line.  This specific price level (EBV-3) is $15.62.  This EBV level has to be considered in your trading plan irrespective of the fundamentals of the company or its valuation history.  This is a key consideration in my mind.  What would your capital loss be if ABX trades to EBV-3?  This number is easy to calculate.  What would your trading account or RRSP (401K) look like after this hypothetical loss?  If your loss is too great, sell the position.  (You should sell the position anyway irrespective of the size of the loss because of the negative transit.)  Remember knowing when to sell your losing investments can save you more money than what you make on your winners over different periods or market cycles.  See blog here.

My Trading Plan

Once model price theory and our charts become familiar to you, you will realize there are many different trading strategies that you can employ.  I have my own trading strategy, which is personal to my temperament, personality and time – yes I do have a full time job and I cannot see market quotes for long periods of time throughout the day.  I must emphasize this personal trading strategy has nothing to do with Acker Finley Inc., Acker Finley Asset Management or any client(s) recommendations.  I also have a full time compliance officer scrutinizing every trade I make to ensure my trading is free from any conflict, real or perceived – which I have no problem with by the way.

So after all this, may I further add I’m a long position trader only and my universe is large market capitalized securities which are household names.  Very rarely do I short securities or use any exotics like call or put options.

If we are on the same page, here is how I traded ABX.  As I stated back in July, I thought ABX would trade down to EBV (green line) and this is what occurred many months later.  Once ABX traded at EBV I took a position in the company (Point D).  As ABX traded down through EBV, I tried to be patient and that was a mistake.  Yes, I do make mistakes.  ABX quickly fall to almost EBV-1, so I decided to again be patient with the position to see if any bounce would occur at this level.  The next day, ABX gapped down through EBV-1!  Great. So I traded out of the position realizing my losses.  This is very easy for me because I know, as I stated earlier, that EBV-3 is now a high probability.  No thanks.

The Future Price Action of ABX

I want to remind readers of this blog that our EBV lines are fundamental analysis.  Something is going on with ABX, fundamentally speaking, and the negative transits are reflecting this.  As I have said before our colored EBV lines have more significance than our grey EBV lines.  So the high probability future trade is for ABX to go to EBV-3 or $15.62.  If and when ABX reaches this EBV-3 level three possible outcomes are likely.  The first outcome is a tradable bounce in ABX’s stock price to EBV-2 or $18.18.  The second outcome could entail ABX trading along EBV-3 for a period of time.  How long?  I don’t know.  The third outcome is a negative transit of EBV-3 or “Going into the Blue” as we say in our shop.

So for fun, here is my guess.  I believe the most likely event of the three scenarios will be a negative transit of EBV-3.  If there is a negative transit of EBV-3 or $15.62 investors and traders should sell their positions outright.

My Future Trading Strategy

I want no part of any of these scenarios.  ABX has been trading like a hot knife through butter and I want no part of this price action or negative transits.  I will wait on the other side of EBV-3.  What does this mean?  Down the road when we the public have a full and somewhat complete understanding of what is going on with ABX and potential future corporate actions are reflected in the balance sheet of the company, ABX will have a positive transit of EBV-3 sometime in the future.  We call this “Coming out of the Blue” or EBV-3 (which I have blogged about many times) and this investment strategy is the simplest and most profitable strategy using our model price work and these two attributes fit my investment style and personality. So I will wait.

If you want to do something different go ahead.  If you think you are nimble enough for a possible tradable bounce off of EBV-3 be my guest.  This price action could be a distinct possibility.  Who knows?

Conclusion

Yes, our model price charts look so simplistic but there is more information contained in these simplistic charts than anything I have ever seen in conventional finance today.  You can see the whole playing field.  You can assess possible price support and resistance of any equity in our database for the foreseeable future.  You can ask intelligent questions about stock price movements with a high degree of accuracy.  More importantly you can match high probability market outcomes with your investable capital.

Want to know the most valuable feature?  Model Price tells you when to sell your investment.  I should have acted on the negative transit of EBV.  I should have been quicker in selling ABX.  Lesson learned (Again).

Why Apple’s Stock Price is Floundering!

“Apple’s valuation is a riddle wrapped in a mystery inside an enigma.”  I have revised Winston Churchill’s famous quote on Russia to make a point on investors, both professional and do-it-yourself types, that seem perplexed on Apple’s current valuation.  We have all watched while Apple’s stock price has inexplicably eroded from just over $700 per share to its current value of $452.08.  Why? This to my mind is what is wrong with the current state of finance. There is no definitive source or service available to have any discussion about valuation.  There is currently no math that exists today, in published textbooks or accredited courses that answer the question of valuation properly to the common man or investor.

New math has to be created.  New tools should be invented. The current orthodoxly is broken.  Isn’t there a Harvard MBA anywhere that can tell anybody the valuation puzzle that investors crave?  What is the key to unlock this valuation question?

Model Price Math to the Rescue!

First we calculate the model price or fair market value of Apple Inc. everyday – along with 2000 other companies.  As of last night the model price of Apple is $591.64.  Simple.

Here is our model price chart not only showing last night’s output but also a history of our model price calculation for our users benefit. (Purple dashed line)

Apple Inc. with weekly price bars and model price calculation (dashed line)

Apple Inc. with weekly price bars and model price calculation (dashed line)

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

How do we do this?

We created an algorithm that is so robust it works across all companies and industries.  Think of the differences in all these companies.  Think of the peculiarities of each company’s business model and balance sheet.  How is this possible?  By finding and inventing new mathematical equations that are relevant to the process of business.  By thinking about the process of solvency within the process of doing business, which every businessperson constantly thinks about not in an academic way but in a real world way.  By looking and examining balance sheets of all enterprises both private and public containing information that most if not all the investment community discards.

That’s how.

So in this blog I want to highlight just two concepts that reside in our calculation of model price that can go a long way to help in this valuation question on Apple Inc.

Theoretical Earnings (TE)

When I was introduced to the beginning mathematical concepts of model price work, some 15 years ago, one of the first concepts that peaked my interest was theoretical earnings or TE.  One of the big problems with analyzing any business, especially public companies, is that they are constantly in flux.  There is no constant or benchmark for analysis therefore all analysis is based on regression or relative measures with other businesses in the same industry.  If company X has a price/earnings ratio of 10 then company Y in the same industry with a P/E ratio of 8 must have some relative value.

The genius of theoretical earnings is the constant we are looking for is contained in the balance sheet of the company itself.   Using a company’s balance sheet, we can calculate a specific earnings number this same company needs in order to maintain state or constant in the future.   This constant or specific earnings number we call theoretical earnings.  It didn’t take us long to realize that the higher or greater the differential between theoretical earnings and estimated earnings per share the higher valuation the equity in question will achieve.  This is what the market, it seems to us, wants to value through a company’s share price among other concepts we have developed.

Apple Theoretical Earning’s

Here a chart of Apple’s TE relative to its’ 12-month forecast of earnings per share (EPS)

image0014

What is obvious from this chart is the parabolic growth of Apple’s earnings since 2007.  Remember the iPhone was launched in 2007 and the first iPad was released in April 2010.  One could argue Apple, with its brilliant founder – Steve Jobs – hit the perfect “three-peat”.  iPod with iTunes, iPhone and iPad launched Apple’s earnings into the stratosphere as you can clearly see.  What’s next?  Can these current levels of earnings be sustainable? Will there be a “reversion to the mean” with earnings in the company’s future?

Let’s go a step further.

Taking the data from the above chart, we can form a ratio of EPS/Theoretical Earnings – see chart below.

image0032

By looking at the chart you can see Apple went through three distinct periods.  The first period was between 1995 and 2005.  The period shows earnings relative to its TE fell to zero or Apple’s earnings were equal to its’ Theoretical Earnings and then rebounded.  The second period goes from 2005 to the beginning of 2010.  This second period highlights Apple’s EPS/Theoretical Earnings ratio of about 4 times.  The third period, when the iPad was launched saw earnings grow almost 8 times Apple’s TE.  Understandably the higher the EPS/Theoretical Earnings ratio the higher Apple’s valuation.

This brings us to the end of our chart.  Where is this ratio going in the future?  Will the EPS/Theoretical Earnings go back to a ratio of 4 times?  Will it go back to zero?  Or will the innovation keep happening, without Steve Jobs, and have this ratio turn around to achieve new highs?  What is your guess?

To date the market sees atrophy in this ratio and has acted on Apple’s share price accordingly.

Convexity

Convexity is one of our must difficult mathematical concepts to explain in relation to finance and the public markets however in some ways it’s an important part of our calculation of model price.  This mathematical construct is the feedback mechanism where the balance sheet of the company feeds into the stock price’s ultimate valuation in the public equity markets.  The higher convexity number computed the higher the company’s valuation.  However too high a convexity number will give a given company a higher valuation but will substantially increase variability (or volatility) in the company’s stock price as this feedback mechanism can become unstable.

Here is our chart on the calculation of convexity for Apple going back to 1995.

image005 copy

What is this chart saying?  Convexity will NOT be a driver for increased valuation until this chart or convexity starts turn up.  There is a consequence of Apple’s management decision to capture its’ excessive profits on its balance sheet in the form of cash reserves or other assets – a lower share price valuation because of very low convexity.  Assuming Apple’s EPS/Theoretical Earnings returns to a ratio of 4 times, Apple’s overall valuation will probably be lower if this convexity number is unchanged in future periods.

How would you increase this convexity input into our model price calculation?  Reduce the size of the balance sheet is one answer.  This can be easily achieved by reducing the cash on the balance sheet by either paying out dividends and/or buying back company shares.  Interestingly another way to increase convexity is by way of a stock split.  The math works!  Yes, this is counter-intuitive but anecdotally all market participants know that when a company announces a stock split this is viewed as a positive usually pushing the market value of the company up!  Increased convexity is the mathematical reason.

Apple’s convexity number is 0.12.  To give you some context, the S&P 500 has convexity of 1.40 which is market capitalized weighted like the S&P 500 itself.  As you can see Apple has a long way to go to catch up with other companies in the popular index.  (Apple obviously influences this convexity number with being a large weight in the index.)  Microsoft has convexity of 1.86 and Amazon 1.17 for comparison purposes.

Conclusion

Hopefully this blog gives you a whole different perspective on Apple and its fundamentals.  The good news is Apple is currently trading under its calculated model price calculation, which we calculate nightly.  Another piece of good news is the shareholder base is changing as we speak.  Growth, and the momentum crowd are clearly exiting being replaced by the value crowd, probably more patient and more happy clipping coupons than price appreciation and or volatility.

The bad news for Apple is where our EPS/Theoretical Earnings ratio will travel?  Innovation and new products was the key to Apple’s enormous success, which translated into record profits and valuation highs.  Is this Apple’s future?  Was this a product of Steve Jobs unique vision that obviously will not be around in the future?

The numbers suggest to me, especially convexity, that Apple’s current management is happy to consolidate their position – giving out fresh iterations of their current product line (iPhone 15 anyone) – sitting on this enormous cash pile, waiting.  Wait for what you ask? Waiting for the next big product to launch.  Yes, this could be years down the road but no matter.  What is probably more important to Apple right now is to preserve the Job’s legacy and not screwing up then going back to its roots as an iconoclast think differently company that everyone finally came to admire.

Procter & Gamble (PG) – Bill Ackman goes after P&G, What Does ModelPrice Guy see?

Fresh off his success at Canadian Pacific, which I blogged about (here, here), Bill Ackman has purchased just over 1% ownership stake in Procter & Gamble.  Mr. Ackman seems to have a nose for underperforming companies and likes to hand pick executive teams and board members for a possible turnaround. So what does he see in P&G?

Mr. Robert McDonald, P&G’s CEO – through a spokesperson – welcomed Ackman’s investment in the company and further stated “We are focused on creating shareholder value by executing on our plan to deliver top-and bottom-line growth through our $10-billion cost savings program, renewing our focus on innovation, pricing initiatives and improved execution, and reallocating resources to invest in the highest return opportunities”

Do you think this will help save Mr. McDonald?

So let’s have some fun!  Yes, fun.  This is what I do for fun.  Let’s look at P&G through the model price math to see what is going on with P&G’s financial numbers.    For comparison purposes let us compare P&G against one of its’ competitors say Colgate – Palmolive (CL).

Solvency Ratio

The first thing we can review is the Solvency Ratio of P&G and Colgate.  I have reproduced the Solvency Ratio equation from our “Key Concepts” tab as a reminder.

Computations yield a Solvency Ratio of 1.85 for P&G and 1.14 for Colgate.  I have plotted each Solvency ratio on our Solvency curve for comparison purposes.  What this is saying is that Colgate’s balance sheet in terms of assets and liabilities is more efficiently structured then P&G’s.

Does This Matter?

Equity markets give valuation for effective use of the company’s resources in relation to what the company earns.  Debt, if used correctly, can make the company’s balance sheet more efficient, thereby yielding more market valuation, however there are limits to what debt can do.  As indicated on our Solvency Curve, the peak efficacy is 0.689.  Once past the point the company is venerable to any internal or external shock, which may happen from time to time.

P&G could use more leverage, to move up our Solvency Curve.  More debt is obviously a simplistic solution, which the equity markets, may recognize with increased valuation.  The more important question is what should the increased debt be used for?

Enter Theoretical Earnings

Another one of our “Key Concepts” comes into play as well and that is Theoretical Earnings.  I have reproduced these comments, from the “Key Concepts”, Theoretical Earnings section of my blog.

“The calculation of theoretical earnings and its evaluation can give investors useful information of the production performance of the company.  TE can give insights not only on past investment returns but also a strong predictor of future performance.”

So let’s look at a long-term graph of the calculated theoretical earnings (TE) versus the EPS (12-month Forecast) contained in our database.  Note the big increase in TE after 2005, so what occurred for this to happen?

The Purchase of Gillette

P&G announced the purchase of Gillette for $57 billion on January 28, 2005.  Interesting on the day the acquisition was announced, P&G stock fell 3% on the announcement.  The usual platitudes are pronounced at the announcement of these mega deals – “Creating a Juggernaut”, “I’m a great believer in scale.” said the Vice Chairman at the time – however what does our model price math say?

Nearly one year later after the announcement, after approvals, transacting the deal, and finally seeing what the balance sheet looks like we see P&G’s theoretical earnings skyrocketed from $0.78 cents to $1.85.  A whopping 137% increase, without a similar increase in earnings.  You can see why P&G shares traded downward on the announcement.  As the graph illustrates theoretical earnings settles in at $1.36 in the middle of 2006, and slowly builds to $1.68 as of the March 30, 2012 balance sheet.

Ratio of EPS versus Theoretical Earnings

Maybe this graph is more relevant.  We look at the ratio of earnings per share (EPS) divided by Theoretical earnings per share.  As you can see, the acquisition of Gillette “crushed” this ratio and in the subsequent periods after this mega purchase this ratio hasn’t come close to where it was prior to this acquisition.

As I state under “Key Concepts”, Theoretical Earnings

By observing theoretical earnings over time we can infer how management manages its balance sheet.  For instance, if management transacts a large acquisition, theoretical earnings can increase significantly as the size of the balance sheet (R+P) increases depending on the size of the acquisition and the way its financed (R/P).  If the multiple of earnings, differential between theoretical earnings and the new consensus earnings post acquisition, hasn’t at least stayed the same (multiple) or has deteriorated, the acquirer’s stock price usually declines on the announcement reflecting the compression differential between theoretical earnings and pro forma earnings post acquisition.

For fun (remember we are having fun here), let us have a look at Colgate – Palmolive (CL).

First, here is the graph showing Theoretical Earnings and EPS (12-month Forecast) separately.

Then, showing the two variables as a ratio to each other.

More importantly, how have the two companies faired since 2000 in terms of market performance.  No surprise that CL has out performed P&G not only in the last 12 years but also when Mr. Robert McDonald became CEO of P&G some 4 years ago.

So what is Mr. McDonald to do?

1.  His $10 billion in cost savings is a good start.  This will increase earnings per share, over time, and help restore our EPS/Theoretical Ratio marginally.  If this is all he focuses on, I believe he will still lose his job.

2.  In order to save his job, Mr. McDonald needs a two-prong strategy.  Along with his $10 billion in cost savings program, Mr. McDonald needs to focus on P&G’s balance sheet.   (The R+P if you will)

3.  Goodwill on P&G’s balance sheet represents a whopping 67% of total assets.  Goodwill is recorded at $90 billion.  (Obviously P&G has been purchasing companies other than Gillette)  Can Mr. McDonald write-off any of this?  At least in the old days of purchase accounting goodwill was amortized over a twenty-year period.  Unfortunately under today’s rules, goodwill is means tested, and if deemed to have value can stay on the balance sheet forever.

4.  Start selling off underperforming companies and/or divisions.  This will help, hopefully, reduce goodwill and P&G can use this cash to pass along to shareholders.

5.  P&G can initiate a giant share buyback program with increased debt levels.  This can help two fold.  First, the increase debt level will move P&G’s Solvency Ratio to a more optimum level – say to Colgate’s.  This increased debt level should be used to repurchase P&G’s shares, to shrink the amount of capital within P&G’s business, thereby reducing TE.

There are multiple small alternatives and strategies, however the big challenge is to lower Theoretical Earnings (TE) in a meaningful way to make a material difference in the market value of Procter & Gamble.  I guess the other big negative is that management of P&G, has had nearly a decade to manage their Theoretical Earnings lower (increasing the EPS/Theoretical EPS higher) by managing their balance sheet in a more efficient way.  Has time run out?

Can Mr. McDonald pull this off?

Radical change usually happens from the outside.  As you can see from my graphs, especially comparing model price numbers for P&G to Colgate’s, P&G will have to undergo a major cost cutting exercise as well shrinking their Theoretical Earnings/balance sheet.  Obviously, a company the size of P&G is like watching an oil tanker in the middle of the ocean turn around – in other words this will take time.  Will Ackman/shareholders give McDonald time?  I think not!

NFLX – Two Big Problems for the Bulls on NFLX!

The 1st quarter results are out and the market has reacted.  Analysts on both sides -buy side/sell side – seem to be screaming at each other over the results.  As we said in our last NFLX blog, “We are sure quarterly reporting of NFLX will be a nail-biter over the next year”.

Old NFLX chart from our January 30, 2012 blog:

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

New NFLX chart for April 26, 2012 (with 1st quarter financials)

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.

We made this prediction in our January 30, 2012 blog.

“The more interesting question is what happens when NFLX transits downward through EBV+7.  If and when this happens we think NFLX will find a more comfortable home at EBV+5.”

We have not changed our minds on this prediction; we think eventually NFLX will go to EBV+5 or $49.66.  Then assess at EBV+5, whether NFLX should go lower.

We cannot add much to the loud conversation, on both sides, about subscription adds and churns but we can look at our unique metrics and offer two troubling trends when we look at the balance sheet.

Theoretical Earnings (TE)

As we noted in our last blog when the company raised $400 million of additional capital, this raised TE from $1.43 based on NFLX’s September balance sheet to $2.06 at year-end.  With the 1st quarter report TE has risen again to $2.35, a 14 percent increase.

What does this mean?

NFLX will have to produce more in earnings in order to create valuation.  As we said in our last blog on NFLX, we like the use of an analogy of the marathon runner.  It’s easy to run a marathon at 143 pounds (based on TE of $1.43).  However at 206 pounds (TE of $2.06), 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!  NFLX now weights 235 pounds (TE of $2.35).  NFLX needs at least $2.35 per share of earnings and above to generate a positive sloping model price.  (Currently, the mean estimate for NFLX is $2.82 for 2013.  Over the coming quarters it will be interesting to see this estimate and further changes to NFLX’s balance sheet.)

Longer Term we can look at the relationship between earnings pre share and theoretical earnings.

As you can see the spread between forecast earnings per share and theoretical earnings were widening positively.  The market, in particular, momentum stocks, trades on this relationship and will pay any valuation for this expanding differential.

The first step needed for NFLX to get its’ mojo back!

The first step needed would be for current, forecast earnings to surpass its’ theoretical earnings.  With theoretical earnings trending upward, the more earnings NFLX needs to at least reverse the slide in the stock.

Convexity

Convexity is friction.  Higher convexity means less friction.  When convexity moves lower in a meaningful way, valuation becomes harder to achieve because of, you guessed it, more friction.

Here is the history on calculated convexity for NFLX going back to 2004.  Convexity is now lower than any other time in NFLX’s recent history.

What does this mean?

NFLX will find it hard, if not impossible, to not only return to the valuation of 2010 -11, (EBV+10) but also the current valuation of EBV+6 is hard to justify with these changing fundamentals. (Higher theoretical earnings and lower convexity)

How do you find theoretical earnings and convexity on model price charts?

These calculations are included in model price.  So users don’t have to worry about individual variables in our model price calculation.  However, it’s fun for us to deconstruct what is going on “under the hood of the car”.

ATDB – Alimentation Couche-Tard having fun and making money with acquisition math.

Unfortunately circumstances are rare that an announced acquisition for the acquirer that shareholders are rewarded.  Usually the acquirer gets slaughtered while the shareholders of the acquired company celebrate with high fives.  So what makes Couche-Tard acquisition different?

First, let’s look at the chart

Alimentation Couche-Tard (ATDB) with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

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

Our key take-a-ways without reiterating any of the details outlined in the newspapers are:

1.  Before the deal was announced the company had a 20.4% upside to model price.  The deal help close the value gap because of the underlying future growth of the business.

2.  The company will finance the acquisition with debt.  ATDB has a “Solvency Ratio” (see Key Concepts) of 1.33 before the deal was announced.  This acquisition with debt will move ATDB “up” the “Solvency Curve” making them more efficient in terms of solvency or the use of debt on their balance sheet.

3.  Though we haven’t seen any numbers yet, and probably won’t until the acquisition is closed.  We are willing to guess that what the company took on in terms of theoretical earnings (increase) they more than offset with additional earnings.  We will report back on this when the deal closes and the numbers are released.

Very well done!

FSLR – First Solar Falling into the Blue!

We tweeted yesterday, a warning to investors of First Solar (FSLR) that FSLR had fallen below EBV-3.  This is significant because the market is communicating (Yes, the market is talking to you) there is something wrong with the balance sheet of FSLR or is it something more serious?

First, let’s look at the chart.

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

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

Here are 4 reasons why stocks may fall below EBV-3.  Which we call “falling into the blue”.

  1. If the company is an operating business with a big amount of goodwill on the balance sheet. (Goodwill (excess purchase price over FMV of physical assets) is recorded usually after one or more acquisitions performed by the company).  The market is telling the investor that the “good” goodwill on the company’s balance sheet has turned to “bad” goodwill.  Usually this “bad’ goodwill will be written off in a subsequent quarter or year-end.
  2. If the company in question is a financial, the recorded assets are NOT worth what is stated on the balance sheet.  Market value is worth less than book value.  If the financial is big, say a money center bank, write offs usually do not occur.
  3. If the company has little or no goodwill, the market is saying the company’s whole is worth less than the sum of its’ parts.  (This is rare).  Also the company’s business model might be in peril.  Don’t see this much in public companies unless it’s a “concept” company with only one line of business.
  4. The company maybe insolvent.  Model Price ™ has a solvency ratio calculation that we use (see “Key Concepts” tab above).  We identify 3 forms of insolvency.  If the security has any form of insolvency, this warning sign (trading below EBV-3) will likely mean the equity price will go to zero unless the company can recapitalize in a timely fashion.

So let’s look at this list, point by point, to see if any of these points is applicable to FSLR.

  1. Reviewing the financial statements, FSLR took a Goodwill impairment charge during 2011 of $393 million dollars.  The company stills has $65 million dollars in recorded Goodwill on the balance sheet.  Even if the company reduced this amount to zero, it wouldn’t be material to the company, and not a reason for the company to fall into the “blue”.
  2. FSLR is not a financial so point 2 does not apply.
  3. Reviewing the 10K we found these comments
    “The solar industry experienced a challenging environment in 2011. The year was categorized by intense pricing competition, bankruptcies of several solar companies, many solar companies with little or no operating income, and toward the end of the year, announcements of manufacturing shut-downs or slow-downs. At December 31, 2011, the global PV industry consisted of more than 150 manufacturers of solar modules and cells. In the aggregate, these manufactuers have installed production capacity that significantly exceeded global demand in 2011. As a result, industry average module pricing declined significantly as competitors reduced prices to sell-through inventories in Europe and elsewhere. We believe this structural imbalance between supply and demand (i.e., where production capacity significantly exceeds current global demand) may continue for the foreseeable future, and we expect it will continue to put pressure on pricing and our results of operations in 2012.”

    Bingo, we think we found the reason for FSLR “falling into the blue”.  The market has not only priced in this structural imbalance but also has determined this imbalance is getting worse.

  4. To complete our list above,  FSLR has a Solvency Ratio of 1.96.  This is healthy and in no danger of having solvency issues in the near future.  (See “Key Concepts” tab above)

So what are we saying?

We believe the market must be making a comment on the business itself.  The market is discounting “bad” news ahead for this company.  We will watch with interest what the future holds however the market is talking, are shareholders listening?   Also, once FSLR stock price falls below EBV-3, the company’s stock price will become more volatile.  WHY?  The company’s stock no longer has the structure of the EBV lines.  EBV-3 is our last line.

What would change our minds?

If and perhaps when FSLR transits above EBV-3.  A transit above EBV-3, you guessed it, would be “Coming out of the Blue”!

Suncor – Finally Getting Its’ Mojo Back!

With “Dirty Oil” and Keystone politics making its’ way through this very political year, like a pig passing through a python, Suncor is finally coming back to life after being placed in the penalty box last August.  Let’s have a look at the model price chart.

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

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

The calculated model price on Suncor, as at February 24, 2012 is $65.13.  A whopping 76% above the close on the above noted date.  Sometimes on television I’m asked what the difference is between model price and target price.   I seem to interchange these terms at will.  Suncor is an excellent example of the difference in using these terms.  Even though the model price is substantially above the current price, I would use EBV+3 as my target price for Suncor.  That target price would be $52.12, a gain of 40%.  Once reaching EBV+3, we would estimate that further gains would only accrue by the growth in EBV+3, which would be 11.5% annually, still not bad when treasury bills are zero.

Another chart we will present, for the first time in this blog, is one we use for perspective on valuation over long periods of time.

Suncor charting the difference (delta) between Model Price and the market price going back to 1995

This chart goes back to 1995.  We set model price as a constant, at 1.0, which is represented as the dashed line on the chart.  As the differential between model price and the then current market price goes above 1.0, or visually above the dashed line, this would indicate Suncor’s market price would be overvalued in comparison to model price.  Obviously, anything below the dashed line represents an undervalued situation.  The red lines signify one standard deviation, in either direction, of the differential in model price and the then current market price.  The blue line represents the average differential over the whole period represented on the chart.  Over the last 17 or so years Suncor has, on average, traded below its’ model price.  Notice the discount between the dashed line and the blue line.  Therefore, our prediction on “target” price of EBV+3 versus “model price” price objective.  This prediction obviously assumes a “going concern” basis and not a “buy out” situation.  On a buy out we would hold to model price as our price objective.

As one can see, this is the lowest, in terms of valuation differential the Suncor has traded in the last 17 years.  We do not recommended stocks in this blog, however we want to use our database to show statistical relevant items that investors may miss in achieving good returns for their portfolios.  On the statistical valuation front Suncor stands out.