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Widening the Moat

September 29, 2012 | About:
The Science of Hitting

The Science of Hitting

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I’ve seen a few interviews lately with value investors like Tom Russo and Pat Dorsey that made me realize I was overlooking a critical piece of company analysis; I’ve put together some historic data for Coca-Cola (KO) and Microsoft (MSFT) to show this. Here’s what Microsoft’s capital expenditures and M&A spend looked like over the past five years:

Fiscal Year CapEx M&A Total for Year
2012 2,305 10,112 12,417
2011 2,355 71 2,426
2010 1,977 245 2,222
2009 3,119 868 3,987
2008 3,182 8,053 11,235


And here’s what cash flow from operations looked like over the same time period:

Fiscal Year Cash Flow from Operations
2012 31,626
2011 26,994
2010 24,073
2009 19,037
2008 21,612
2008 – 2012 CAGR: 10%


Now let’s compare this with Coca-Cola over the same period:

Fiscal Year CapEx M&A Total for Year
2011 2,920 977 3,897
2010 2,215 2,511 4,726
2009 1,993 300 2,293
2008 1,968 759 2,727
2007 1,648 5,653 7,301


And here’s what cash flow from operations looked like over the same time period:

Fiscal Year Cash Flow from Operations
2011 9,474
2010 9,532
2009 8,186
2008 7,571
2007 7,150
2008 – 2012 CAGR: 7.3%


Now let’s compare these figures:

Company Five Year CapEx + PP&E Increase in CFO Investment per 1$ of Incremental CFO
Microsoft 32,287 10,014 $3.22
Coca-Cola 20,944 2,324 $9.01


There’s one big issue with this comparison – GAAP accounting requires research & development to be expensed (except for software that has reached technical feasibility); while this isn’t a big expense for Coca-Cola, it is a huge cost for Microsoft:

Fiscal Year R&D
2012 9,811
2011 9,043
2010 8,714
2009 9,010
2008 8,164
Five Year Total 44,742


Now let’s relook at those numbers, with Microsoft’s R&D added into the investment account:

Company Five Year Investment Increase in CFO Investment per 1$ of Incremental CFO
Microsoft 77,029 10,014 $7.70
Coca-Cola 20,944 2,324 $9.01


When we add in the R&D spend, Microsoft and Coca-Cola don’t look at that different. Looking at Microsoft’s results over this period, we see that Server & Tools and the Microsoft Business Division are responsible for the majority (60%+) of the change from 2008 to 2012:

Division MBD Server & Tools
2008 Operating Income 12,358 4,593
2012 Operating Income 15,719 7,431
Change 3,361 2,838


On the other hand, the Online Services Division has been a perpetual drag on operating results; from 2008 to 2012, the segment has lost more than $1 billion (and usually more than $2 billion) each and every year. This is concerning for a couple of reasons, the most important one being that there is no clear indication how this business in any way relates to strengthening the company’s moat; at best, it appears like a foray into a business with huge barriers to entry, which may one day be a profitable addition to the company’s collection of businesses.

The goodwill balance attributed to OSB shows how Microsoft has continued to throw money at this business (it has decreased back to a couple hundred million after the recent impairment charge):

OSB Goodwill Balance
June 30, 2007 $552M
June 30, 2011 $6,373M


Again, as I noted above, it’s unclear how Microsoft’s diversification into businesses such as search tie back to the moat which surrounds the key business segments. Compare this to Coca-Cola, where the company is spending billions in key emerging markets over the coming years in an attempt to rebuild the dominant position the company holds in most of the developed world (looking at the market share data, it appears they’ve done a fantastic job so far). This, in my opinion, is Microsoft’s biggest problem: Windows and Office throw off billions year after year – yet only need a fraction of that amount to make the incremental investment required to maintain the businesses moat. The question is, would you rather own a business that generates fantastic returns on invested capital with limited opportunities to redeploy that cash, or a more capital intensive business, but one that still generates highly attractive rates of return and offers the compounding that comes from reinvesting capital back into a good business?

With Microsoft (although this can’t be quantified with 100% accuracy since we don’t have visibility into CapEx like we do with M&A), I would be willing to bet that a disproportionate amount of investment is going into OSB and Entertainment & Devices, two businesses that don’t appear to be particularly attractive (E&D’s big 2011 was followed up with a 71% drop in operating income); my contention is that even though return on incremental invested capital looks strong, the result is skewed higher by the businesses like Server & Tools and MBD – which only can sustain so much reinvestment.

Again, I can’t confirm all of this from looking at the annual reports; my beliefs may be incorrect, and this particular example could be flawed. The point still remains: for the benefits of compounding to work their magic over time, a company must have a way to reinvest free cash flow in a competitively advantaged business (usually, it will simply be an extension of their current example, like KO is doing in new geographies and product categories); without a way to reinvest excess capital back in the business, the benefits of a moat are greatly diminished – and value creation can quickly turn to destruction when management chooses to focus on empire building, rather than on widening the moat and distributing excess cash back to the owners of the business.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 3.9/5 (33 votes)

Comments

rdj1234
Rdj1234 - 1 year ago
Mr. TSOH,

Your article points out why Mr. Buffett's favorite moat is a company whose products are subject to very little change. With KO, you have the benefits that Inventory doesn't become obsolete, you have lower r+d, capex and the cost to fund them, and less chance of being out-innovated or a new product failing. MSFT has all these advantages KO has, working against them. It's funny how every article I've read about moats, none consider products with a long, predictable life that benefit from an absence of change a moat.

Roger
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Rdj1234,

And frequent consumption - no doubt KO's moat is one of a kind (PepsiCo salty snacks business gives them a good run for their money though).

Thanks for the comment Roger!
fkattan
Fkattan premium member - 1 year ago
The science of hitting, thanks for the article!

However, don't you think that if you add to MSFT Capex R&D costs, you should add to KO Capex advertising costs? If not, what do you think is the difference?

Regards,

fkattan
Fkattan premium member - 1 year ago
The science of hitting, thanks for the article!

However, don't you think that if you add to MSFT capex R&D costs, you should add to KO capex advertising costs? If not, what do you think is the difference?

Regards,
fkattan
Fkattan premium member - 1 year ago
TSOH, thanks for the article!

However, don't you think that if you add to MSFT capex R&D, you have to add to KO capex the advertising costs? If not, what do you think is the difference?

Regards,
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Fkattan,

I don't think adding advertising cost would be applicable, but R&D certainly would be; the reason I left it out is because I don't have that data for KO (they don't break it out in their annual reports), but there's no question it is nowhere near as big an expense as it is for Microsoft.

Even companies like Unilever, Procter & Gamble, and Colgate spend about 2-3% of sales, compared to 13% of sales for MSFT each of the past two years, and 14% the year before that; I would be willing to bet that KO's spend is even lower as a percentage of sales than the CPG companies listed above, and is a couple hundred million dollars a year.

Thanks for the comment!
fkattan
Fkattan premium member - 1 year ago
TSOH, thanks for the answer. But I still don't see the point in adding R&D in the case of MSFT and not advertising cost in the case of KO. They are both expenses. MSFT spends more in R&D and KO spends more in advertising and marketing than MSFT does.

Regards and thanks again.

varunfriend
Varunfriend premium member - 1 year ago
TSOH .. Thought provoking article as usual. I could be wrong but Since R & D is already expensed, it's already backed out of NI and as a result CFO. If so, are we dbl counting?
silviocast
Silviocast premium member - 1 year ago
Varunfriend is correct. It's double counting. Also, why do you compare capex + m&a to "incremental" CFO (increase in CFO)? Yearly CFO is already an incremental measure, a "flow". I don't understand the meaning of comparing a flow (Capex) to a "flow of a flow". Maybe I'm wrong. Just my two-cent comment.
marcolanaro
Marcolanaro - 1 year ago
TSOH,

Fkattan has a point. Different companies in different industries have different needs to maintain their competitive advantage, in your examples KO and MSFT, KO needs more advertising while MSFT needs constant innovation. Anyway, how any company can increase its CFO is an important question to ask.
The Science of Hitting
The Science of Hitting premium member - 1 year ago
That's a good point Fkattan, I wasn't thinking about it that way; I still wonder about that break-up in R&D spend (what business segments to be specific), but you're right - I should have included that.

Varunfriend - you are right as well; I was thinking about the impact capitalizing that cost has on net income, and inappropriately applied that to this article.

Silviocast,

What do you mean that CFO is already an incremental measure? While some accounts are tied to the previous year (particularly the change in working capital), surely net income isn't - am I misunderstanding that?

Thanks for the comments - sorry for the errors!
fkattan
Fkattan premium member - 1 year ago
TSOH, thanks for the answer.

Regards
silviocast
Silviocast premium member - 1 year ago
TSOH,

CFO, regardless of whether it's derived from P&L accounts (which are already, by definition, a flow) or the difference between two "static" Balance Sheet measures (such as NWC accounts), represents a flow, i.e. how much cash has been generated over a particular period of time. Therefore, in my opinion, Capex (in and of itself a "flow", i.e. how much money has been spent for investments over a certain period of time) should always be compared to the CFO measure over the same period of time. In other words, how much of such CFO has been spent in Capex is the relevant thing to know. Comparing Capex to the "change in CFO" doesn't make any sense to me.

Hope this is clear.

Thanks for answering.

Regards.
lolla
Lolla - 1 year ago


which all seems to point back to the owner earnings flow

http://en.wikipedia.org/wiki/Owner_earnings

which all seems to point back to the owner earnings flow

http://en.wikipedia.org/wiki/Owner_earnings



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