Category: Equity

Quick review of some large cap technology stocks

I am continuing to look at the US large cap sector, just for personal review rather than serious consideration. I am continued to be surprised by relatively good valuations, around the 10% yield levels. Most of these are in the first-generation “old-school” technology sector. Very well-known companies include the following, with some very anecdotal remarks on my behalf:

Microsoft (MSFT) – Trading at 9.3x FY2012 projected earnings, with $30B net cash on balance sheet, Windows/Office empire continued to be chipped away at with competition;
Intel (INTC) – Trading at 9.5x FY2012 projected earnings, $20B net cash on balance sheet, likely to be around for a long time, competition in mobile processors, but nothing in really ‘large scale’ CPUs except AMD;
Dell (DELL) – Trading at 8.6x FY2012 projected earnings, $8B net cash, well-known customer support/service issues, but otherwise entrenched in computer/IT market;
Hewlett-Packard (HPQ) – Trading at 7.3x FY2012 projected earnings, $10B net debt, along with Dell, entrenched in computer/IT market;
Lexmark (LMK) – Trading at 7.7x FY2012 projected earnings, $600M net cash, major supplier in printer/imaging market;
Xerox (XRX) – Trading at 8.3x FY2012 projected earnings, $8B net debt, in a similar domain as Lexmark;
Seagate (STX) – Trading at 7.2x FY2012 projected earnings, $0 net cash/debt, hard drive/storage manufacturer;
Western Digital (WDC) – Trading at 9.3x FY2012 projected earnings, $3B net cash, in a similar domain as Seagate;
Micron Technology (MU) – Trading at 8.4x FY2012 projected earnings, $600M net cash, memory manufacturer;

One would think that diversifying a position into these nine companies and calling it the “Old-school technology fund” would probably be considered a relatively safe alternative over the next 10 years, compared to the 3.4% you would achieve with a 10-year US treasury bond.

My gut instinct would suggest that these companies would still be around in 10 years, especially Intel, which has the biggest competitive advantage out of the nine listed above.

I am also assuming that smarter eyeballs than my own have looked at these companies, which is why I suspect there isn’t much extraordinary value here other than receiving a nominal 10% return on equity, which is pretty good for zero research.

Petrobakken – Value trap

(Update, June 23, 2011: Readers may be interested in further coverage of Petrobakken by clicking here.)

Petrobakken (TSX: PBN) has been on the top of my radar screens for oil and gas companies for quite some time. The reason is fairly simple – it appears to be a high-yielding security that has a large amount of reserves and land rights. During my extensive investigations of this company during the autumn of 2010 (when the common equity was at around $23/share) I rejected PBN as an investment candidate.

The past three years of trading have had investors seen their better days in earlier times:

The drop in late 2008/early 2009 can be attributed to the economic crisis and the decrease in oil prices, but the price drop lately can be solely attributed to financial management. In 2009 and 2010 the company engaged in a series of significant purchases with companies with large holdings in the Bakken oil fields (southeastern Saskatchewan). It also has significant holdings in the Cardium (roughly northwest of Calgary and south of Edmonton). These acquisitions were very costly and ended up hurting shareholders.

The company is paying off about $180M/year in dividends to its shareholders when it is spending far above its operational cash flow to drill for more wells in order to keep its production levels steady.

The large dividend yield probably serves as a psychological crutch for investors, in addition to providing its parent company, Petrobank (TSX: PBG), with a cash stream. Petrobank owns roughly 60% of Petrobakken. This appears to be a classic example of knowing the risks of investing in companies that are majority-held or controlled – a retail investor’s interest may not be in alignment with the parent company, and when this is the case, you may receive an adverse outcome.

The big operational issue in the Cardium and Bakken fields is that your production falls off steeply after the initial drilling (as opposed to your typical Steam-assisted gravity drainage project that a company like Cenovus does):

Although the capital expenditure can be justified, the economics are not as pleasant as what most people may anticipate by looking at the “trend” of oil production based on first year results. Most of the growth in revenues has to be looked at with the knowledge that the first year of wells will be extraordinarily high, while the second and subsequent years will have slower, but steadier production.

In 2010, PBN took in about $562M in operational cash flow, but they also spent $36M repurchasing their common shares (questionable given their balance sheet), $812M in capital expenditures, $483M in corporate acquisitions (mainly for land rights discussed previously). When you net everything together, the company had to borrow $750M in cheap financing (6-year notes, 3.125% coupon) and also maintain a line of credit with a bank ($825M outstanding of $1.2B available) in order to finance all of this spending and payouts.

Although the company is producing a lot of operational cash flow (in particular, they like quoting the statistic funds flow from operations, which was $3.51/share in 2010), in order to maintain this cash flow they need to continue spending significant sums of money on capital expenditures.

The valuation then becomes a matter of determining the decay rate of the various wells drilled on the Bakken/Cardium fields and the prevailing price of oil – and there are smarter people than myself that can model the decay rate better.

Most retail investors, however, would just look at the dividend yield at the current $19.60/share and say “Wow, look, 4.9%!” and buy in, not realizing that the company has probably hit the point where it can’t borrow money as cheaply as it has in the past. If you look at the GAAP net income, 26 cents per share does not look that impressive compared to the share price. One does have to model for a significant amount of depreciation (which is a non-cash expense that represents money already paid for drilling) in order to receive a more relevant free cash-flow figure.

This is not to say that Petrobakken is not a legitimate oil company – just that to my knowledge, its equity valuation does not represent an under-valuation at present, even factoring in the existing price of oil.

CN Rail or CP Rail – A look at the Railways

People trying to get on board the Warren Buffett bandwagon and are too cheap to purchase a Class A share of Berkshire Hathaway (currently $129,538/share) to participating in Burlington Northern are looking at other publicly traded rail options.

These include the following American names:
CSX (NYSE: CSX) – Eastern USA, competes with NSC
Kansas City Southern (NYSE: KSU) – Mid-Southern USA and both sides of Mexico
Norfolk Southern (NYSE: NSC) – Eastern USA, competes with CSX
Union Pacific (NYSE: UNP) – Primarily competes with Burlington Northern

In Canada, there are two majors:
CN Rail (TSX: CNR) – Very large network from Prince Rupert and Vancouver on the Pacific to the St. Lawrence River and Halifax to the Atlantic and New Orleans to the Gulf of Mexico.
CP Rail (TSX: CP) – From Vancouver to the St. Lawrence River.

The railways trade at roughly the same valuations – very roughly, around 16-20 times earnings, depending on the company. There are reasons for these earnings differentials, mainly balance sheet factors.

Comparing CNR and CP, CP rail appears to be a tad cheaper right now, but both are relatively expensive for what you are purchasing – a utility-type company that will continue to be very profitable in the future as energy prices increase. They will once again decrease in valuation when the physical amount of goods in the economy slows down, like things did in the second half of 2008.

Although both companies are well run and profitable, they are classic examples of such companies that you would not want to invest in unless if you wanted to invest a huge amount of money in them for the purposes of stability. Even then, one would think that waiting for the next recession would give you a better entry point.

Start of a correction or just a pause?

The uptrend in the market indexes over the past 7 months has been noted by many, but due to geopolitical instability and the rising price of crude, the uptrend has taken a break. I note before when this also happened:

I do not know whether this is the “top” or whether this is a head-fake on the way to an S&P 500 at 1400. Time will tell.

Although one day does not make for the market’s direction, crude equities fell significantly today. The long commodity trade is very crowded and whenever this condition occurs, the risk of being long becomes progressively higher – momentum can only take you so far. Prudent investors will take money off the table and be patient, and let the greedy ones get burnt.

I wish I had something more to write other than that I have been continuing to take money off the table, and also putting capital into one other obscure US-based equity position that is not listed on any index, and appears to be relatively under-valued at the moment.

Large caps appear cheaper than small caps

Just from my cursory examinations of the markets, it appears that large cap stocks are representing a better value than smaller capitalization issues. I am guessing the market is discounting some form of zero-growth projection in the future for a lot of these firms. One factor to remove from the analysis is government revenues – the theory would be that companies with higher exposure to government business will face pressure as deficits will force spending cutbacks.

Because of the currency differential, US stocks appear to be a better value at the moment – dividend-bearing companies can also be put in the RRSP to avoid withholding tax.

Just as the most basic example, Walmart (NYSE: WMT) is projected to earn about 8.5% of its capitalization this year – much better than sticking it in a 10-year government bond yielding 3.41%. You would think that the company would be able to scale its business appropriately if there was a recession – indeed, by looking at the stock chart you would be hard-pressed to see even a hint of an economic crisis in 2008-2009. You don’t even have to do any research – there is virtually no chance of Walmart not being able to produce profitable retail business in the medium-term future. This is contrasted with Amazon, which has to justify its valuation with huge amounts of growth over the next decade.

You will never see your investment in WMT rise by 30% in a year, but then again, you will not see it sink 30% either. It almost trades like a bond. It is a typical good “grandmother” stock.

There are many better (and smaller) examples of large cap companies that are trading at very attractive valuations, have a “moat”, and unlike Walmart, you could envision scenarios where they will warrant higher valuations.