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Blue Chip Blues!

February 15, 2010 | About:
Reily

Reily

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A growing consensus among fund managers is blue chip companies are cheaper than the market. Since many of these stocks continue to lag despite the emerging consensus I am encouraged. While these stocks may lag in the short-term their 10- year performance is going to be exceptional. I believe these stocks are performing poorly for macro reasons rather than micro performance. In fact, many of these companies have extraordinary levels of cash and record earnings like IBM. Others, like Exxon Mobil are suffering from temporary issues like weak crack spreads. A company like Microsoft has roughly 30 billion in net cash and an emerging product cycle. What I find interesting about this group is their 10-year financial performance versus their stock market performance. While oil is up multiples from the year 2000, Exxon’s market capitalization is flat over the last 10 years. When evaluating Exxon remember they buyback significant amounts of shares, so while the share price has increased from $40 to $65 the market capitalization is essentially flat at 300 billion as shares outstanding declined from 7 to 4.8 billion as of 12/31/09. While it seems Exxon is coming to the natural gas party late, XTO is likely a top performer in the next decade as they continue to increase output and prices normalize. Exxon’s current weakness is attributed to poor margins in refining as crack spreads narrowed sharply in the economic downturn. In past downturns, oil prices fell along with refined products but international demand has propelled oil prices leaving domestic refined products in the dust. While this downturn seems extreme it is unlikely to persist because several independent refiners are in a poor financial state and output is likely to fall, which causes prices to rise or possibly soar if demand returns. Another possibility is the economy recovers demand normalizes and everything turns out fine for the group. The margin of safety isn’t a falling dollar and rising prices, but Exxon’s ability to scrap refineries and sell the scrap on the open market.

Another promising blue chip is IBM. In full disclosure, my father has worked for IBM for many years (30) and we both have plenty of our net worth in the stock. The current CEO Samuel Palmisano is another longtime IBM’er. While I was very young in the early 1990’s, extraordinary turmoil was taking place at my father’s employer. IBM wasn’t managing costs as growth slowed over the 1970’s and 1980’s. IBM was very generous with their employees during this period because of unsustainable promises. IBM had the problem Google will have in 5 or 10 years as growth slows and costs continue to soar because of promises from early growth; a dangerous trap. As a result, Samuel Palmisano sought a business model for the 2000’s that decreased volatility in earnings with a heightened focus on a favorable business mix. Focusing on services in software and hardware has produced extraordinary financial results for IBM in the last decade. However, their stock market performance has been poor because they started the decade significantly overvalued. Financial performance like IBM’s makes it difficult to argue the stock market is overvalued because they continue to increase profits with fewer shares outstanding and increased margins. Roughly 60% of their revenue is similar to annuity payments, which has reduced volatility in their earnings. Eliminating poor performing product lines like personal computers which generated strong revenues and poor profits is deceiving to an investor who sees IBM’s revenue is up only 10% from the year 2000. While their revenue has only increased 10% over this period, their gross profit is up 33% from 32 billion in 2000 to 43 billion for fiscal 2009. Samuel Palmisano learned a valuable lesson from the 1990’s; a disciplined focus on costs has produced significantly improved financial performance and eventually the market capitalization will catch up. For IBM, I believe their financial performance caught up with their valuation in 2005, so IBM’s share buybacks after this period were more valuable because they were at a discount to fair value. My favorite metric for valuing IBM is cash flow from operations because their numbers aren’t contrived and reflect the reality of their business. I believe depreciation is accurate and their profits reflective of their financial performance, which is critical. For 1999-2001, their average cash flow from operations was 11 billion and the last three-year average is 18 billion with 20.7 billion for fiscal 2009. IBM’s cash flow has increased and their share count has decreased over the last 10 years while their market capitalization is roughly flat at 160 billion.

It’s fun to analyze blue chips because they usually have a long history of operating performance and the macro economy can produce opportunities to buy or sell the stocks. Another blue chip with a long operating history is Coca-Cola. Coca-Cola has plenty of data and analysts following the stock. Famously, Warren Buffett began purchasing large amounts of KO when Wall Street was negative on the stock, but the Oracle of Omaha won with the world’s most valuable brand. Each year BusinessWeek creates a dollar estimate for brand value and for 2009 Coke was valued at 68 billion. For Coca-Cola, 2000 was a volatile year for their stock performance and another steady Eddie for financial performance. KO’s free cash flow has doubled from $3 billion to $6 billion over the last 10 years while their stock price and market capitalization remained flat, KO focuses on dividends rather than buybacks. Coca-Cola’s free cash flow yield has increased from 2.5% to 5.2% over this period, while the business value has increased and their growth prospects in emerging markets remain unchanged. Interestingly, BusinessWeek’s brand value estimate for KO in 2001 was $68.9 billion and their 2009 estimate remained unchanged at $68.7 billion.

Separating hindsight from foresight is a challenge for investors because price movements often lack rationality or any correlation to financial performance. However, its fun to evaluate the difference between financial performance and market performance to prepare for future opportunities with the caveat hindsight analysis never provides foresight knowledge. I think it’s highly likely the companies I mentioned financial performance continues to excel although it’s not certain.

I own shares in each company mentioned.


Rating: 2.7/5 (6 votes)

Comments

MadamePJBailey
MadamePJBailey - 4 years ago
Your views of IBM may change after the upcoming Stockholder meeting.

Details and analysis -- www.ibmTheWidowMaker.com

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