Microsoft Valuation

While it seems clear that Windows 8 is not going to be the immediate home run that many investors were looking for, I still haven't given up on Microsoft. The stock is down over 11% in the past two weeks. Microsoft is already a substantial position in my portfolio, but if it really goes into free fall I will look to add to the position. For those who might be interested, I present my analysis of the company and stock below.

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Company: Microsoft
Ticker Symbol: MSFT
Exchange: NASDAQ
Industry: Software
Sector: Technology
Headquarters: Redmond, Washington
Fiscal Year End: June 30th
Date of Valuation: 11/18/2012
Name of Analyst: Pat Larkin
Market Cap: $223.351 billion
Current Price: $26.52
Estimated Value: $45.38

Thesis:

Microsoft common stock represents an excellent value at its current price of $26.52/share. The stock has been shunned by many investors because of its poor price performance since the tech bubble of the late 1990's and because investors fear that changing trends in the PC market will make the company's products obsolete. The stock's poor price performance since 2000 is almost entirely due to its extreme overvaluation at the beginning of the period and to the poor performance of the overall market over that time frame. While the business of selling windows operating systems for PCs likely faces a slow decline, it will continue to be a cash cow for the foreseeable future. But the area where Microsoft is strongest is in the enterprise. The company offers a very competitive product in almost every enterprise computing niche, including a very strong cloud computing platform in Azure. The switching costs faced by Microsoft's enterprise customers give the company a very strong competitive advantage. This makes for a very safe projected future cash flow stream that gives Microsoft investors a margin of safety at the current price.

Business Description:

Microsoft was founded by Bill Gates and Paul Allen in 1975 and went public in 1986. The company produces a variety of software and hardware for both the enterprise and consumer markets.

In August of 2007, Microsoft paid approximately $6 billion to purchase aQuantitative, a digital marketing and advertising company. In the fourth quarter of fiscal 2012, Microsoft took a special charge of approximately $6.2 billion to write-down the value of aQuantitative and other assets in its online services segment. In February of 2008, Microsoft offered to buy Yahoo for approximately $44.6 billion in cash and stock, but the offer was turned down by Yahoo's board. In October of 2011, Microsoft acquired Skype for $8.6 billion. 

Microsoft is organized in five segments: Windows and Windows Live, Server and Tools, Online Services, Microsoft Business, and Entertainment and Devices. Table 1 provides a breakdown of revenues, operating income, and operating margins for each segment and for the entire company from 2010-2012. The Microsoft business division, which includes the popular Office software, accounts for the largest portion of the firm's revenues and operating income, followed by the Windows division and the Server and Tools division. Entertainment and devices, which includes the Xbox game console, is marginally profitable, while online services has been a money loser to date. Operating income for both online services and for the overall company were greatly depressed by the large write-off of the aQuantitative assets in 2012. Without the write-off, overall operating margins for 2012 would come in at about 37.8%, roughly in line with prior years and with the 37.9% margin achieved by competitor Oracle (ORCL) in fiscal 2012.

Table 1 - Microsoft Sales and Operating Income, 2010-2012
Growth Growth
Windows & Windows Live 2012 Rate 2011 Rate 2010
Revenue $18,818 0.17% $18,787 -0.01% $18,789
Operating Income $11,908 -0.53% $11,971 -1.82% $12,193
Operating Margin 63.28%
63.72%
64.89%
Server and Tools
Revenue $18,696 12.01% $16,691 10.38% $15,121
Operating Income $7,459 17.80% $6,332 17.74% $5,378
Operating Margin 39.90%
37.94%
35.57%
Online Services
Revenue $2,934 9.48% $2,680 14.29% $2,345
Operating Income ($8,122) 206.61% ($2,649) 10.61% ($2,395)
Operating Margin -276.82%
-98.84%
-102.13%
Microsoft Business
Revenue $23,963 7.39% $22,314 14.28% $19,525
Operating Income $15,688 8.54% $14,453 19.36% $12,109
Operating Margin 65.47%
64.77%
62.02%
Entertainment and Devices
Revenue $9,585 7.75% $8,896 45.00% $6,135
Operating Income $365 -71.79% $1,294 146.48% $525
Operating Margin 3.81%
14.55%
8.56%
Unallocated
Revenue ($273) $575 $569
Operating Income (5,535) (4,240) (3,712)
Operating Margin
Total Revenue $73,723 5.40% $69,943 11.94% $62,484
Total Oper. Income $21,763 -19.87% $27,161 12.71% $24,098
Operating Margin 29.52%
38.83%
38.57%
source: Microsoft 2012 10-K

All segments experienced healthy revenue growth in 2012 except for the Windows and Windows Live segment. The lack of growth in this segment can be attributed to changes in consumer preferences away from PCs and laptops and toward tablets, to the weak global economy, particularly in Europe, and possibly also to customers putting off purchases in anticipation of the launch of Windows 8 in October of 2012.

Microsoft makes money on both a transactional model and a licensing model. The transactional model involves selling software licenses and other products in volume to enterprises and one at a time to individual customers. The licensing model involves the sale of multi-year licensing agreements to enterprises. A large portion of license revenue, including about 80% of the business division revenue, is based on the number of information employees in the organization and not on the number of installed PCs. Licensing revenue has increased relative to transactions revenue in recent years. Licensing revenue results in a great deal of up front revenue to the company that must be deferred for financial reporting purposes.

Microsoft gets slightly more than half of its sales from the United States. No other single country makes up more than 10% of the company's sales.

Competitive Position:

Microsoft benefits from customer captivity due to network effects and switching costs, which allows them to charge more for their products than they could in a more competitive environment. A simple example of both network effects and switching costs is the existence of millions of Microsoft Word, Excel, and PowerPoint files that are viewed as substantial assets by the individuals and businesses that created them. It is costly and risky to attempt to switch these files to a different format, even when it is possible to do so. The fact that so many established professionals and companies are committed to these programs creates a network that is worth paying to enter or to stay in. For example, students and young professionals will want to be able to read the files sent to them by instructors and managers, so they will find it worthwhile to invest in the Microsoft Office suite.

Microsoft's moat is strongest in the enterprise. This strength consists of much more than Office. Microsoft Server and the Exchange e-mail platform are well entrenched market leaders and the company has strong offerings in most other critical enterprise applications. For many large enterprises, IT is a potential vulnerability, not a profit center. An IT director is in some ways like an Umpire in baseball: unlikely to attract much attention unless he commits a major gaff. Taking risks has little upside for the IT manager, so he is likely to stick with established providers like Microsoft for a range of enterprise solutions, even if the cost is high relative to other options.

The server and tools division continues to grow rapidly and achieve high profitability. Microsoft was an early mover in cloud computing with Azure. Azure has the potential to provide the same degree of customer captivity that Microsoft has enjoyed with Windows. No one can be certain how public cloud computing is going to develop. In the event that the cloud never reaches its full potential for security, privacy, or other reasons, few if any large technology companies are as well positioned as Microsoft to pivot back to on-site solutions as deftly as Microsoft. Microsoft is beginning to recognize the potential in creating private clouds and integrating them with Azure. This makes the company the best choice for enterprises that are cautious about making a full commitment to the public cloud.

Microsoft faces formidable competition in its Server and Tools, Online Services, and Entertainment and Devices Divisions. In server and tools, in addition to open source, IBM and Oracle provide strong competition. However, the switching costs involved and the very large size of the market make it possible for several highly profitable firms to coexist in this space.

In Online Services, Google is dominant. While Microsoft has a comparable technology in Bing, this is a business where the network effect dominates. One strategy that the firm has contemplated to improve results in this area is partnering with Facebook (FB). While it remains questionable whether this segment will ever yield high returns on the capital invested in it, shareholders can at least hope that fact that the company has already incurred the enormous startup costs to establish a foothold in online services will dampen future losses.
  
In entertainment and devices, Microsoft's Xbox had a 49% market share in the first quarter of fiscal 2013 in a very competitive and difficult business. It's Kinect motion sensing device gives Xbox an edge on competing consoles. The technology that Kinect is based on might also enhance Microsoft's drive to dominate the "smart house" of the future.

Apple and Google are both formidable competitors in smart phones and tablets. Microsoft pursues a dual strategy of licensing its operating system to other manufactures of phones and tablets and producing its own devices. In October of 2012, the company released the Surface tablet along with its new Windows 8 operating system. The Surface comes with a keyboard and can be folded up and used like a tablet or unfolded and used like a laptop. The first version runs on the Windows RT operating system that is compatible with the energy saving ARM chip architecture, while a new version to be released later in 2012 will run on an Intel Chip. Microsoft hopes to find a niche for the surface among customers who need a productivity tool that can run Office and other applications and want the fun and portability of a tablet. Some reviewers of the Surface are concerned that the two different versions will confuse customers, and initial sales seem to be modest. However, Microsoft appears to be attempting to create an environment where developers can create software and apps that will work on PCs, laptops, tablets, phones, and potentially other devices with differing hardware. If successful, this strategy could become a self-reinforcing success, much like Microsoft has long enjoyed in PC operating systems.

The biggest strategic threat faced by Microsoft is an acceleration in the decline of PCs and its Windows franchise. As mentioned earlier, the decline in PC sales in the first quarter of 2013 was driven by the weak European and global economy and also probably by the coming launch of Windows 8. Many of Microsoft's partners are set to launch an array of attractive new Windows based products such as Ultra books. Still, the possibility of a continued steep decline in sales of Windows computers to consumers is real. On the enterprise side however, the main threat to Windows and Office seems to be a quick movement to the cloud, where Microsoft has already established itself as one of the leading players.

Valuation:

Microsoft has the proverbial "fortress balance sheet," with $66.644 billion in cash and investments versus $11.950 billion in negotiated debt at the end of fiscal quarter one, 2013. The firm has astronomical coverage ratios and a rare AAA bond rating. The fact that the company has any debt at all is probably due to the fact that a large fraction of Microsoft's cash is parked overseas and would be subject to higher tax rates if brought back into the United States to pay dividends or repurchase stock. With interest rates at record low levels, the company prefers to borrow to fund some cash needs while waiting for the possibility of a tax holiday that would allow them to repatriate their foreign cash without a tax penalty. According to data from Standard and Poor's, the five-year cumulative probability of default for a AAA rated issuer is 0.44%. Due to their proverbial "enormous cash hoard" and very healthy cash flows, I estimate that the probability of the company facing financial distress in the next five years is essentially zero.

I will present two scenarios for a discounted cash flow valuation of Microsoft stock. The first scenario is reasonable but not aggressive while the second scenario is extremely conservative. In both scenarios I work with real estimated cash flows and a real discount rate. I add the current 10-year inflation protected U.S. treasury bond yield of -0.73% to the estimated market implied equity risk premium of 6.01% obtained from professor Aswath Damodaran's website to arrive at an estimated real discount rate of 5.28%. However, being a conservative investor I have a policy of always using a real discount rate of at least 7%, which is just above the long-run average real return earned by the U.S. market.

In my "reasonable" scenario I will value Microsoft's stock using a two-stage free cash flow to equity (FCFE) model with zero real growth in the second stage:

(1) FCFE = Owner Earnings - (1- D/I)*(GCAPX + ΔNC NWC)

Equation (1) says that the cash available to pay out to equity holders in a given period is equal to what the company earns minus what it invests in new fixed and current assets minus the portion of new investment that is financed with new debt. Owner Earnings represents the amount of cash that could be taken out of the company without impairing its competitive position or reducing unit volume. The owner earnings calculation involves making a number of adjustments, including adding back depreciation and subtracting MCAPX, or maintenance capital expenditures, the capital expenditures required to maintain owner earnings. D/I is the portion of new investment that will be financed with debt. GCAPX is capital expenditures for growth, which is equal to total CAPX minus MCAPX. I include acquisitions with GCAPX. ΔNC NWC is the change in spontaneous non-cash net working capital. Short-term debt is not included because it is interest bearing and is classified as negotiated debt. In addition to these variables, the two-stage FCFE model requires estimates of the real growth rate in the first stage, the length of the first stage, and the equity investment rate. The equity investment rate is equal to equity investment, the second term in equation (1) above, divided by owner earnings, the first term.

There are a variety of approaches to estimating a company's normalized owner earnings. In my judgment, it is reasonable and conservative to estimate Microsoft's normal owner earnings using data from the trailing four quarters. Microsoft bulls might argue that the preceding year was a slow year for the global economy, but it clearly wasn't a recession year. I begin with Microsoft's trailing twelve month (ttm) cash flow from operations and make the following adjustments (all dollar figures are in millions):


Cash flow from Operations.........................................$31,617
(-) Maintenance CAPX..............................................$2,472
(+) NC NWC Investment...........................................$537
(-) Interest and Other Income from Investments..........$748
(-) Stock-Based Compensation..................................$2,289
Estimated Owner Earnings..........................................$25,571
     
Note that I ignore that large charge-off in the fourth quarter of 2012 because I am interested in estimating normal owner earnings going forward. Beginning with cash flow from operations also counts deferred revenues, but not revenues from sales made in prior years and recognized in the current year, in owner earnings. I don't have any problem with this because the early receipt of licensing revenues should be a benefit enjoyed by Microsoft in perpetuity. Income from investments is removed because I follow the common practice of valuing cash and investments separately. I use the conservative assumption that all CAPX for the year is MCAPX. While I focus on cash, I use the accounting estimate of stock-based compensation because dilution associated with stock-based compensation is likely to remain a real cost to shareholders in the future and I don't know of a superior way to account for it. Other factors that one might consider in estimating owner earnings in this way that are not relevant to the current valuation include preferred dividends, minority interests, extraordinary items, and discontinued operations. Some of these depend on what measure of net income is reconciled to cash flow from operations in the cash flow statement.

From year end 2007 through year-end 2012 Microsoft invested 24.5% of its estimated owner earnings in future growth. This includes CAPX, Acquisitions, and investment in non-cash net working capital. As I believe that Microsoft's use of debt is driven by record low-interest rates and tax factors related to its foreign cash holdings, I assume that the company's target debt to capital ratio is 0% and that all future investment will be funded by equity holders. Counting GCAPX in investment is technically double counting when all GCAPX has already been subtracted from owner earnings. This doesn't bother me too much, as I am more concerned with underestimating the amount of investment that will be required to sustain future growth than I am with overestimating it.

Microsoft's real sales growth over the trailing five recession plagued years has been a bit above 5%. I conservatively assume that Microsoft will be able to grow at a real rate of 3% over the next 10 years. These assumptions result in the free cash flows and present values presented in Table 2 below.

Table 2: Free Cash Flow Valuation of Microsoft Operations

Year
Owner Earnings
Investment
FCFE
PV FCFE
1
$26,990.191
$6,612.695
$20,377.495
$19,044.388
2
$27,799.896
$6,811.076
$20,988.820
$18,332.448
3
$28,633.893
$7,015.408
$21,618.485
$17,647.123
4
$29,492.910
$7,225.871
$22,267.039
$16,987.418
5
$30,377.697
$7,442.647
$22,935.050
$16,352.374
6
$31,289.028
$7,665.926
$23,623.102
$15,741.070
7
$32,227.699
$7,895.904
$24,331.795
$15,152.619
8
$33,194.530
$8,132.781
$25,061.749
$14,586.166
9
$34,190.366
$8,376.765
$25,813.601
$14,040.889
10
$35,216.077
$8,628.067
$26,588.009
$13,515.996
11 and After
$36,272.559
$0.000
$36,272.559
$263,416.139

Summing the present values results in a value of $424.817 billion for Microsoft's operations. If we divide the first year's owner earnings by our 7% real discount rate we find that $385.574 billion of this value comes from the firm's earning power value (EPV). The remaining $39.243 billion represents the net present value of growth opportunities.  

Approximately $58 billion of Microsoft's cash and investments were held abroad as of year-end 2012. I give this amount a 20% haircut to reflect the difference between the U.S. statutory corporate tax rate and the substantially lower rates that prevail in Ireland and other domiciles where the cash is held. This leaves $55.044 billion in cash and investments. Microsoft has no defined benefit pension plan, and I am unable to identify any other significant balance sheet adjustments that need to be made to the valuation. Adding the adjusted cash and investments to the value of operations then brings the total estimated value of the common equity to $479.861 billion.

Microsoft had 8.422 billion shares of common stock outstanding at the end of the first quarter of fiscal 2013. The company also had 248 million shares of unvested restricted stock and 22 million stock options outstanding. I add these additional potential shares to the existing share count to arrive at a fully diluted common share count of 8.692 billion shares. I should note that this is not considered a sound practice in terms of valuation theory. The textbook solution is to attempt to value the options and restricted shares using an asset pricing model. However, given the information that is commonly available to outside investors, all available approaches to dealing with options and other contingent claims have serious drawbacks. As I am looking for a conservative valuation and I am comfortable with simply adding the additional potential shares to the share count in most valuations. Dividing the estimated equity value by the adjusted share count gives an estimated going concern value of $55.21 per share for Microsoft.

Since my conservative scenario assumes zero real growth, FCFE will be equal to owner earnings. One of the subtle challenges in many valuations is separating outlays that are truly intended to grow the business from outlays that are necessary to merely maintain the business in its current condition. In my conservative valuation I assume that essentially all outlays are expenses and not investment. To arrive at my conservative estimate of FCFE, I begin with my "reasonable" estimate and make the following adjustments:


Estimated "Reasonable" Owner Earnings.......................$25,571
(+) Interest and Other Income from Investments............$748
(-)  Adjustment to Bring Cash Tax Rate to 35%............$2,974
(-)  5-Year Average Spending on Acquisitions..............$2,242
Estimated "Conservative" Owner Earnings.....................$21,103

I add interest and other income from investments here because in this conservative valuation I do not attribute any value to Microsoft's existing cash and investments. While I personally believe that at the proper time management will be open to making large distributions of excess cash, the opposite case can also be plausibly argued. It could also be argued that the company is too large and ownership is too concentrated for activists or other outside shareholders to force a change in capital allocation policy.

I estimate Microsoft's cash tax rate for the prior year to be just over 20%, so I adjust for the possibility that cash tax rates could resemble the current U.S. statutory rate of 35% going forward. I estimate that the company had even higher cash tax rates in some years in the late 1990's and early 2000's. While I think that it is much more likely that the either the firm will continue to be able to keep its tax bill lower or the U.S. corporate tax rate itself will be lowered, it seems appropriate to use the statutory rate in a very conservative valuation of the stock.

I subtract the average amount spent on acquisitions by Microsoft in the past five years to reflect the possibility that the company will continue to make money-losing acquisitions. Some of these acquisitions might serve the purpose of protecting some of the firm's existing franchises, but in that case they are more like MCAPX than investments for growth.

Since owner earnings are equal to FCFE in a zero growth model, we can capitalize the conservative owner earnings at the real discount rate of 7% and divide by the adjusted share count to obtain an estimated intrinsic value of $35.54 per share. If we put equal weight on the reasonable and conservative valuations, we get an estimated value of $45.38, which is my point estimate of the current intrinsic value of MSFT common stock.

Adjusting for write-offs, Microsoft currently has a trailing P/E ratio of about 10.19, not too far above is all-time year-end low of 9.70. Competitors Oracle (ORCL) and Google (GOOG) have P/Es of 14.90 and 20.28, respectively. Going back to 1998, I estimate Microsoft's median P/E at 21.50. At my estimated fair value of $45.38, Microsoft's P/E would be 17.45. The firm's price to sales and price to book ratios are also significantly below their long-term medians. 

Given it's size, profitability, and emphasis on software and the enterprise, in my judgment Oracle is the closest comparable firm to Microsoft. Applying Oracle's current P/E of 14.90 to my estimated owner earnings per share of $2.94  in my "reasonable" FCFE valuation ($25.571/8.692) yields an estimated value of $43.81 per share. Using the extremely conservative FCFE valuation suggest a value of about $37.33 per share. Overall, these rough estimates support the discounted cash flow (DCF) valuation presented above.

Capital Allocation and Governance:

Microsoft pays a quarterly dividend of $0.23 a share, which translates into a yield of 3.46% at the current stock price. The company has a long track record of repurchasing stock, though repurchases were substantially lower in fiscal 2012 than in prior years. Microsoft has shown a tendency to make large "strategic" acquisitions that haven't always paid off, though one could argue that the jury is still out on last year's Skype acquisition.

Microsoft has one class of common stock. To their credit, they only grant stock options for use in acquisitions. Incentive compensation typically consists of restricted stock. As of the end of fiscal 2012, co-founder and Chairman Bill Gates owned 5.47% of the company and CEO Steve Ballmer owned 3.95%. Stock holdings for all board members and executives totals 9.46%. Gates, for many years the world's richest private citizen, sells large blocks of stock on a regularly scheduled basis for the purpose of diversifying his portfolio. With his MSFT stock holdings down to about 21% of his $66 billion net worth (according to Forbes) perhaps he will slow down the pace of selling in the near future.

There's not much to say about Ballmer's management that hasn't been said already. He has been accused of being closed minded. According to rumors, he doesn't let his children use Google search or own Apple products. The company recently pushed out Steven Sinofsky, the long-time head of the Windows division who many observers thought might be the heir apparent to Ballmer. According to rumors, Ballmer wants to speed up the product development cycle at Microsoft and Sinofsky was viewed as an obstacle to achieving that objective.

Ballmer is incredibly driven and committed to returning Microsoft to its former glory. I tend to think that with access to Gate's counsel Ballmer will do a better job at running this complex company going forward than any likely replacement (other than possibly Gates himself) would do. My biggest concern is that it only takes one huge mistake in capital allocation to undo several years of strong operating performance. 

Risks:

-As mentioned above, the decline in PC sales and Windows could happen more quickly than anticipated. In my view the firm has a coherent strategy to deal with this eventuality, though it is unlikely that all lost cash flows from a Windows collapse could be replaced.

-The firm could make one or more ill-advised large acquisitions. A Facebook (FB) acquisition, for example, could be a shareholder killer.

Catalysts:

-The company's strategy of linking multiple platforms and devices to Windows 8 could succeed and pave the way for sustainable competitive advantages and large economic profits in a range of markets.

-More developing countries could start to pay for Microsoft software as they integrate into the global economy.

-A tax repatriation holiday or reduction in the corporate tax rate could free up cash for large scale share repurchases.

-Microsoft spent almost $10 billion dollars on research and development in the last year and some of the smartest people in the world work at its campus in Redmond. Something good could come of this.

Disclosure: I am long Microsoft common stock. Positions may change at any time without notice.



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I am an individual investor who occasionally shares opinions about investments and other matters on the internet. I am not a registered investment adviser or investment adviser representative. I did pass the series 65 exam in 2011, but I have never been registered as an investment adviser or investment adviser representative in any jurisdiction. I will not respond to any inquiries about investment management services. Nothing posted on this blog should be interpreted as actionable investment advice, financial planning advice, tax advice, or legal advice. I do not derive or seek to derive any income from my blogging activities. This blog is intended solely for the entertainment of the reader, and the author.

IRE ADR Price Now Back in Line with London Shares

Back in early September, I pointed out how IRE, the NYSE traded ADR for the Bank of Ireland, was grossly misvalued relative to the price that the bank's shares were trading for in Dublin and London (BKIR.L). At that time, the ADR represented four ordinary shares and traded at $1.24 per ADR, while the ordinary shares traded at about 0.088 Euros. At the time the Euro was worth about 1.43 U.S. dollars, so the ADR should have been trading at about 0.088*1.43*4 = $0.5034, or about fifty American cents. This situation persisted for some time because it was impossible to short the ADR or to convert ordinary shares into ADRs. At the time I pointed out that unless the ordinary shares really take off, the ADR was bound to plunge dramatically. This predication turned out to be accurate, but IRE's fall was masked by a one-for-ten reverse stock split. The reverse split didn't alleviate the pain experienced by the ADR holders, but it might have helped the bank to avoid some bad publicity. Fast forwarding to this morning, the bank was trading at 0.089 Euros in London, and the Euro was at 1.3238 per dollar. After the one-for-ten split, the ADR now represents 40 of the ordinary shares, so a fair price for IRE would have been  0.089*1.3238*40 = $4.7127 per share. As I was able to purchase a small number of shares of IRE for $4.73 this morning, it seems that the price of the ADR is once again aligned with the price of the ordinary shares. If you plan on buying the ADR, it is easy to check that prices are still aligned by looking up the price of BKIR.L and the exchange rate for the Euro on Yahoo Finance (assuming you don't have a Bloomberg). Are the shares worth buying in the first place? I still hold to my original case, but the shares represent only a tiny portion of my portfolio. I expect much more bad news and several more bad earnings reports before prosperity returns to Ireland, but I expect it to return and for shareholders in this bank to be well rewarded when it does.

Disclosure: long IRE and IRLBF.PK (Bank of Ireland Shares traded on the pink sheets). Positions can change at any time without notice.



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I am an individual investor who occasionally shares opinions about investments and other matters on the internet. I am not a registered investment adviser or investment adviser representative. I did pass the series 65 exam in 2011, but I have never been registered as an investment adviser or investment adviser representative in any jurisdiction. I will not respond to any inquiries about investment management services. Nothing posted on this blog should be interpreted as actionable investment advice, financial planning advice, tax advice, or legal advice. I do not derive or seek to derive any income from my blogging activities. This blog is intended solely for the entertainment of the reader, and the author.

LoJack Corporation (LOJN)

Thesis
LoJack Corp. (LOJN) is a  cheap, cash generating business with a strong competitive advantage that has become substantially cheaper due primarily to a series of solvable business disruptions and being removed from the S&P 600 index. The stock price plunged from an all time high of $28.84 on December 2nd, 2005 to $2.86 at the close of trading on November 14th, 2011. The price then fell a further 14.33% to close at $2.45 on November 18th on news that LoJack will be delisted from S&P 600 small cap index and replaced by Marriott Vacations Worldwide Corp at the close of trading on Monday November 21st, 2011. I believe that the stock is dramatically undervalued and that renewed strong profitability and cash flow will cause the stock price to rise substantially as business conditions normalize, new car sales continue to improve, and new management talent applies itself to the firm's problems and opportunities.

Business Description
LoJack is best known as the leading global provider of systems for recovery of stolen vehicles. The firm has been in operation since 1978 and their technology has resulted in the recovery of over 300,000 vehicles worth over $5 billion. The recovery rate of stolen vehicles equipped with the LoJack system is over 90%. The firm operates in three segments: North America (28 states and the District of Columbia) International (32 nations), and all other. The all other segment includes LoJack SafetyNet, which provides technology for rescuing people with disorders such as Alzheimer's and autism who wander off, and SC-Integrity, which provides technology for the recovery of cargo and other valuable business assets. The firm has a 100% ownership in all business lines except for SC-Integrity, in which it has a 60% interest.

The company reported revenues of  $34.5 million in the third quarter ended September 30th, 2011, and $138.3 million in the trailing twelve months. In the third quarter, the North American segment accounted for 70.25% of revenues, International for 27.65%, and All Other for 2.1%. About 87% of North American revenues come through sales of LoJack units by new and used car dealers. While the firm receives some revenues from licensing fees and subscription services in the international segment, the bulk of international revenue (about 95% in fiscal 2010) is also derived from the sale of LoJack units. Overall, management estimates that only about $10 million per year in revenue is recurring. The only international market that LoJack operates directly, instead of through licensees, is Italy, which experienced a 43% year over year revenue increase in the third quarter and is expected to reach profitability in the fourth quarter. SCI and LoJack SafetyNet generate revenue from a mixture of device sales and service fees. The company contracts for the manufacturing of most components but assembles some products in house.

Lojack was firing on all cylinders from 2005-2007, with sales peaking at $222.7 million in 2007. The company was hit hard by the great recession and the accompanying steep drop in auto sales. The firm's sales are cyclical and unit volumes tend to track trends in auto sales. The business is also seasonal, with the first quarter the slowest and the fourth quarter the busiest, due partly to year-end deadlines imposed by insurance companies in foreign markets for drivers to get LoJack units installed. So far this year, LoJack has failed to show signs of turning around with the gradually improving auto market. Management cites three reasons for the firm's difficulties in the first three quarters of 2011. First, there has been an unfavorable change in the model mix of vehicle sales in the U.S., driven partly by shortages resulting from the Japanese earthquake. The models most affected by the earthquake are also the models where buyers are most likely to purchase the LoJack system. The chairman states in the third quarter conference call that experts expect these shortages to ease in the fourth quarter. The second problem relates to uneven timing of orders by quarter from international licensees. Part of this was reportedly due to protracted negotiations with the licensees. Management believes that most, though not all of the drop-off in sales in the second and third quarters from prior year figures will be made up in the fourth quarter of 2011. Third, costly and distracting litigation has hampered performance. The firm incurred $2.3 million in legal fees in the third quarter. Though legal actions are ongoing, the firm has reached a tentative agreement to settle a long running California federal employee claims case for $1.6 million, which is part of the $2.3 million in legal fees mentioned above.

Cyclicality aside, LoJack is strong cash generator. Going back to 1997 and including the trailing twelve months, the firm has only had two years, 2002 and 2009, of negative free cash flow, defined as cash flow from operating activities minus net capital expenditures and cash spent on acquisitions. Free cash flow was -$0.4 million in 2002 and -$11.4 million in 2009. Cash flow from operations was positive every year except 2009, when the firm paid an $18 million legal settlement. Average free cash flow over any period beginning between 1997 and 2007 and ending at the end of the third quarter of 2011 is at least $9.4 million per year, without adjusting for inflation.

Management
It is difficult to judge whether some recent setbacks were more due to bad luck or management missteps. Management and directors get stock options and share awards but collectively hold little stock in the company. In 2009 LoJack paid an $18 million settlement in a dispute with a licensee. Changes in the cellular infrastructure in Canada from analog to digital caught the company off guard, leading to write-offs of $3.3 million, $38.1 million, and $14.4 million in 2007, 2008, and 2009, respectively. The company has now completed the build out in infrastructure that is necessary to integrate LoJack units into their Canadian vehicle recovery system.

On October 17th, the company brought Randy Ortiz on board as CEO. He has 28 years of experience in the auto industry, mostly with Ford and related entities. He brings a "deep working knowledge of dealership operations" to the company. Also on October 17th, LoJack named Donald Peck as the new CFO. Mr. Peck is also a former corporate attorney. To the extent that poor management was responsible for recent underperformance, the addition of these experienced individuals could provide a catalyst for improvement.

Competitive Position
LoJack has a proprietary technology that works on a radio frequency (RF) network. LoJack, in connection with the FBI, operates a single radio frequency that the FCC has set aside for the purpose of tracking and recovering property and people. The LoJack system consists of a registration system controlled by LoJack, a sector activation system and vehicle tracking units operated by law enforcement, and a LoJack unit installed in the vehicle. LoJack supplies the sector activation system and tracking units to law enforcement for free and maintains them. Tracking units are present in law enforcement cars and aircraft. When a car is stolen, the victim calls the local police, and a signal is automatically sent out to the tracking units. In most cases, a unit will be near the location of the stolen vehicle and the vehicle is recovered quickly before significant damage is done.

LoJack is clearly superior to GPS for the purpose of tracking stolen vehicles. Crucially, LoJack is able to locate vehicles that are hidden behind buildings or other obstacles that often frustrate GPS. Second, with GPS, multiple calls have to be made after the theft to fully mobilize law enforcement. Third, the LoJack unit is not visible, making it extremely difficult to remove, while GPS units are typically more conspicuous.

It is hard to envision a rational competitor entering the market to compete with LoJack, at least in markets where LoJack is already established. Since LoJack provides equipment to law enforcement for free, a competitor would probably have to offer to pay law enforcement to convince them to switch over. It would also be difficult to duplicate LoJack's relationship with car dealers. LoJack's performance record is so impressive that potential customers would have to offer a comparable product at a lower price point to compete. But it is difficult to envision a comparable product that doesn't rely on close cooperation from law enforcement that can be sold at a high enough margin to recoup the cost of unseating LoJack's position with law enforcement and auto dealers.

In a 1998 paper, Steve Levitt and Ian Ayres study the economics of LoJack. The economists find that LoJack creates a great deal of social value that the company is unable to capture. Car thefts fall dramatically in areas where LoJack is known to operate. This implies that much of the benefit of the existence of LoJack goes to car owners that do not have LoJack installed, and to insurance companies, especially those that do not offer substantial premium reductions to customers who have LoJack installed. If thieves knew which vehicles were protected by LoJack then LoJack sales would likely increase dramatically as non-LoJack users would be unable to "free-ride." While it seems unlikely that this will happen given that it hasn't happened yet, the consolation to LoJack shareholders is that at least they are investing in a firm that provides social value and is likely to be at least left unmolested, if not encouraged, by government.

The LoJack SafetyNet product for rescuing lost Alzheimer's and autism patients hasn't become a material part of the business yet and is currently only offered in three states (Florida, Pennsylvania, and Massachusetts). However, management reports that the business is making slow progress. In my opinion, this could be a very large market. From LoJack's 2010 10K:

"It is estimated that 5.3 million Americans suffer from Alzheimer’s disease and that there will be between 11 and 16 million Americans affected by 2050. Wandering, the most life-threatening behavior associated with Alzheimer’s disease, affects 59% of such patients, and 45% of the cases where the person is not located within 24 hours end in death. Additionally, Autism afflicts one in every 110 children in the United States and children with Autism are prone to wandering."

Once a product like LoJack SafetyNet becomes widespread it could quickly gain momentum and come to be considered a necessity for Alzheimer's and autism patients. Law enforcement, which is responsible for conducting frequently high-cost searches for missing patients, could be an ally in advocating the adoption of SafetyNet. SafetyNet has the same technical advantage over GPS that LoJack has in stolen vehicle recovery.

Balance Sheet
LoJack has a solid balance sheet, with $53.1 million in cash and short-term investments versus 9.5 million of negotiated debt at the end of the third quarter of 2011. Almost all of the negotiated debt is long-term. The firm has a current ratio of 2.2 and a quick ratio of 2.0. Almost $20 billion of the $38.7 million in current liabilities consists of deferred revenues. The firm recognizes revenues on certain services associated with its supplemental early warning product over the estimated life of the vehicle. If you take out cash, the firm operates with negative working capital. Tangible book value of common equity (less minority interest of $0.232 million) is $31.1 million, resulting in a price to tangible book ratio of about 1.5.

Off-balance sheet, LoJack has 2,347,961 stock options vested or expected to vest with a weighted average exercise price of $7.33 and an average life of 4.1 years, and 1,423,822 exercisable options with a weighted average exercise price of $8.70 and an average life of 3.21 years. There is no defined benefit pension plan and no other legacy liabilities.

Overall, the firm is solid financially and has the resources to weather most crises and quickly seize opportunities without relying on outside funding. Excess cash has actually reached a level that management might consider increasing its buyback if business stabilizes and the stock remains undervalued.

Valuation 
I value LoJack's common stock by estimating normalized earnings power value and then adjusting for items such as excess cash, minority holdings, and stock options. This method is similar to the method taught by Bruce Greenwald at Columbia, except I discount owner earnings at the cost of equity instead of discounting NOPLAT at the weighted average cost of capital. I estimate real "owner earnings" and use a real discount rate to avoid the necessity of estimating the future inflation rate. I consider three scenarios for normal operating income. In the conservative scenario, normal real sales and the EBITDA margin are set equal to the corresponding values for the trailing twelve months, yielding normal EBITDA of $7.2 million. In a steady state depreciation should be equal to maintenance capital expenditures (MCAPX), which I assume to be equal to the average of estimated MCAPX over the past five years in the conservative scenario. I classify almost all of the CAPX over the trailing five year period as MCAPX. This yields an estimated normal real operating income of $1.639 million for the conservative scenario.

In the quarter 3 conference call, management endorses an estimate for normalized annual EBIDA of $14-$15 million over the cycle, less occasional non-recurring legal costs. Using the lower $14 million figure and subtracting $2 million for legal (this year's roughly $4 million every two years) gives EBITDA of $12 million per year for my "realistic" scenario. This could be arrived at by posting normal real sales of $150 million per year and an EBITDA margin of 8%. The $3 million value for depreciation/MCAPX in the realistic scenario represents estimated 2011 CAPX less investment in the firm's new headquarters building. Estimated normal real operating income in the realistic scenario is $9 million per year. Estimated normal real operating income in the optimistic scenario is arrived at by using 10-year averages for real sales and EBITDA margin and comes to $18.385 million.

(First column is "conservative" scenario, second is "realistic," third is "optimistic." $ figures in millions except for per share data)

                                                                                                                                 
Normal Real Sales:$138.30 $150.00 $185.61
EBITDA Margin: 5.21% 8.00% 11.52%
Normal EBITDA: $7.20 $12.00 $21.39
Normal MCAPX/Depreciation: $5.56 $3.00 $3.00
Normal Operating Income: $1.64 $9.00 $18.39
Normal Other Income&Expenses: $0 $0 $0
Estimated Interest Expense: $0.80 $0.80 $0.80
Owner Earnings Before Taxes: $0.84 $8.20 $17.59
Estimated Cash Tax Rate: 30% 30% 30%
Estimated Cash Taxes: $0.25 $2.46 $5.28
Owner Earnings: $0.59 $5.74 $12.31
Real Discount Rate: 9% 9% 9%
Earnings Power Value: $6.52 $63.78 $136.77
Add Cash and Securities: $50.10 $50.10 $50.10
Subtract Minority Interest: $0.23 $0.23 $0.23
Subtract Moving Costs: $2.35 $2.35 $2.35
Value of Common Stock: $54.51 $111.76 $184.75
Shares Before Option Exercises: 18.417 18.417 18.417
Share Value Before Options: $2.96 $6.07 $10.03




PV of Option Proceeds: $5.57 $5.57 $5.57
Value of Common After Options: $60.07 $117.33 $190.39
Shares After Option Exercises: 20.792 20.792 20.792
Share Value After Options: $2.89 $5.64 $9.15
Share Value: $2.89 $5.64 $9.15
Estimated Probability: 30% 50% 20%

All values below normal operating income are the same in all three scenarios. Miscellaneous income and expenses are expected to average to zero. Estimated interest income is not added because cash and short-term securities are added back to earnings power value. Interest expense is assumed to stay constant at the trailing twelve month value of $0.8 million. I conservatively assume a 30% cash tax rate in perpetuity. To estimate the real discount rate, I add the roughly 1% real yield on the 30-year treasury to the roughly 6.5% current implied equity risk-premium for the S&P 500. I then tack on a 1.5% small-cap premium. Keep in mind that this is a real discount rate and would translate into a rate of about 12% if we allowed for a 3% expected inflation premium.

All of the firm's cash and short-term investments are interest-bearing, but I subtract $3 million from the amount of cash added back to account for the estimated additional taxes that would be due if the firm repatriated the cash it holds in foreign accounts. The firm anticipates incurring $2 million of capital spending and $0.5 million in incremental operating expenses associated with moving to its new headquarters building in the current quarter (as an aside, the firm expects to realize savings by consolidating all operations in one location). As these are not recurring expenditures, I take a one-time deduction of $2.350 million for the incremental CAPX and the after-tax incremental expenses. Lojack had 17.7 million shares outstanding at the end of quarter 3 2011, to which I conservatively add 0.717 million in unvested restricted stock to get a total share count of 18.417 million. Before accounting for stock options, this results in an estimated intrinsic value of $2.89/share in the conservative scenario, $6.07/share in the realistic scenario, and $10.03/share in the optimistic scenario.

The firm has 2.375 million stock options outstanding with an average exercise price of $4.10 and an average time to expiration of 4.12 years. I assume that all options will be exercised at expiration, resulting in an increase in the share count to 20.792 million shares. In this scenario, Lojack would receive proceeds of $9,737,692.70 in 4.12 years.  I use a very conservative nominal discount rate of 15% to discount this value back to the present, resulting in an addition to value of $5.568 million. Adding that $5.568 million to the value of common equity before the adjustment and dividing by the new share count results in an estimated per share value of $2.89/share in the conservative scenario, $5.64/share in the realistic scenario, and $9.15/share in the optimistic scenario. Since each of these estimates are below the corresponding estimates before accounting for the stock options, these are my final estimates of per-share value. I'm not sure that there is a great deal of value in formulating a point estimate of value in addition to a range, but if pressed to do so I would estimate the intrinsic value of the stock at $5.50/share.

Note that this valuation does not attribute any value to growth. The option to leverage current assets to take advantage of valuable growth opportunities like LoJack SafetyNet surely has some value, but it is difficult to estimate.

Risks
-The stock is relatively illiquid. Average volume was about 37,000 shares per day before the delisting announcement.

-Pending legal claims seem unlikely to lead to large losses but one can never be sure.

-Management fails to execute.

-More bad luck.

Catalysts
-Forced or speculative selling resulting from delisting from the S&P 600 small cap index has pushed the stock price down over 14% since November 15th.

-Stock is revalued to reflect normalized EBITDA and free-cash flow over the cycle instead of the current depressed levels of these variables.

-The buyback is increased. Management indicated that they are open to this option in the third quarter conference call. Management also indicated that they might be open to a buyout on favorable terms.

-New management is able to execute on opportunities and avoid unnecessary legal and business problems.

-LoJack SafetyNet gathers momentum and the market recognizes the potential of this growth opportunity.

Disclosure: I am long LoJack Corporation (LOJN) common stock. Positions can change at any time without notice.


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I am an individual investor who occasionally shares opinions about investments and other matters on the internet. I am not a registered investment adviser or investment adviser representative. I did pass the series 65 exam in 2011, but I have never been registered as an investment adviser or investment adviser representative in any jurisdiction. I will not respond to any inquiries about investment management services. Nothing posted on this blog should be interpreted as actionable investment advice, financial planning advice, tax advice, or legal advice. I do not derive or seek to derive any income from my blogging activities. This blog is intended solely for the entertainment of the reader, and the author.