“A situation we like is when we think investors are applying the 80-20 rule inaccurately; 80% of their attention is on 20% of the business value. And that was a situation that we saw at Disney where theme park attendance had been down a little bit, and almost everything that was written about the company was about the outlook for theme parks and how that was likely to change over upcoming years.
When we looked at business value, the cable networks that the company owned - ESPN and the Disney Channel along with some other lesser networks - we thought they were at least 80% of the value of the company. We believe the price we were paying was less than the cable networks alone, and with that focus we didn’t have to spend that much time worrying about whether next year’s traffic at the theme parks was going to be up or down a little bit.”
Let’s run the numbers: At $30 per share, and approximately 1.9 billion shares outstanding, the entire company was on sale for less than $60 billion in mid-2011. In 2010, the last full year of results an investor would be looking at in the middle of calendar 2011, Disney’s Media Networks division reported more than $5.1 billion in operating income, an increase of 7.7% from the prior year - and a compounded annual growth rate of nearly 10% in the previous five-year period. If we attribute the Cable Networks their fair share of corporate/unallocated and interest expenses, we can estimate the segment earned $4.5 billion pre-tax in fiscal 2010.
An investor buying Disney at $30 per share was paying roughly 12.5x pre-tax earnings for what is likely the most valuable media property in the world, in addition to other gems like The Disney Channel; the company’s Consumer Products, Parks & Resorts (cruise ships, theme parks, hotels, etc.), Interactive Media and Studio Entertainment divisions - which collectively reported about $2.5 billion in operating income in that same year – were just icing on the cake.
One question seems obvious: why would the market pay attention to 20% of the business and ignore the vast majority of the company’s intrinsic value / earnings generation? I think the answer undoubtedly lies with the analysts, who in so many cases drive the conversation with the management team (on conference calls, at events, etc), and lay the groundwork for the financial media’s talking points / discussions. Analysts, as clearly spelled out in the disclosure of their published reports, are trying to guess where a stock will go in the next twelve months; business value, in the sense that Mr. Nygren is referring to, is a secondary focus, if at all. They are blinded by the allure of Mr. Market, and constantly defer to his expertise to decide what the reality is at this point in time; by the definition spelled out in their disclosures, one must assume that they’re paychecks are dependent upon their ability to guess (and it really is just a guessing) what a stock will do in the arbitrary period of time before the Earth’s next revolution around the sun.
In the words of Upton Sinclair, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”
We saw another example of this phenomenon recently with Microsoft (NASDAQ:MSFT); here’s the reporting from Barron’s, pointing to the following note from an analyst:
“While Windows gets much of the air time when discussing MSFT, the reality is Windows is now MSFT’s third largest business and Microsoft’s enterprise businesses (MBD and S&T) account for the vast majority of the company’s earnings power. In fact, even when assuming some GM hit due to the shift to Cloud and using fairly conservative assumptions for the consumer-related MBD revenue (~15% of MBD), we believe that on a stand-alone basis, MBD and S&T could be worth $24-$26 per share (~$2.15 in combined CY14 EPS x P/E of 11-12x). When also accounting for ~$6/share in net cash (assume 30% tax hit on offshore), we see the downside risk as being fairly low (~$30) given that S&T and MBD are now largely annuity based and FY13 billings trends were solid – S&T (+9%) and MBD (+3%), especially when factoring in the OEM (S&T) and consumer (MBD) overhangs on each of the businesses. Further, our assumptions allocate corporate-level expense on a revenue- weighted basis. If we were to allocate more of the legal, retail store and IP costs to Windows and E&D, we believe the earnings power of S&T and MBD would be even higher than what we are currently assuming.”
Again, let’s look at some numbers: collectively, the Microsoft Business Division and Server & Tools segment reported $45 billion in revenue in fiscal 2013; this is up from $32 billion five years ago, good for a compounded annual growth rate of 7% (Microsoft’s fiscal year 2008, the starting period for this measure, was largely complete before the financial crisis began; this is a five year period that’s about as tough as any in recent memory). Over that same period, the combined operating income of the segments increased from $16.9 billion to $24.3 billion, or just ahead of the 7% CAGR reported for revenues.
Both of these segments are incredibly sticky, with the vast majority of revenue coming from enterprise customers, an increasing percentage of whom are making long term commitments to Microsoft products through multi-year enterprise agreements; in addition, both segments generate substantial free cash flow, and have clear paths to continued growth for years to come (with Office 365 being the most recent example of just how dominant this business really is).
Looking at those factors, I’d be salivating at the opportunity to gain control of the business for just 12X trailing earnings; as an example, 15X would value MBD and S&T at $32/share by the same measures shown above. But let’s take the 11-12X figure as given, for $24-26/share. Adding in the $6/share of cash (after tax), we’ve already reached the current market price. Even an absurd value for the remainder of the businesses easily gets you to the $40 per share level (one rudimentary example – Xbox Live has nearly 50 million paid subscribers, or about 40% more than Netflix; NFLX has a market capitalization north of $15 billion).
In order to argue with the current valuation, you’d have to make the case against the assumptions presented above (unless you think the Windows division, which earned nearly $10 billion last year, is worth nothing); I’ve yet to hear anyone seriously make that case, likely because there’s no basis for it. Analysts choose to avoid that conversation and focus on Windows because their job description entails guessing short term stock price movements, moves that can diverge from intrinsic value for long periods of time. For those of us who realize the futility in this approach, there’s solace in Ben Graham’s words: “In the short run, the market is a voting machine; but in the long run, the market is a weighing machine.”
About the author:
I hope to own a collection of great businesses; to ever sell one, I 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.