PRIMECAP Management Buys Charles Schwab and Ltd. Brands, Adds RIM

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Aug 12, 2011
PRIMECAP Management Company manages the Vanguard PRIMECAP Fund, the Vanguard Capital Opportunity Fund, the Vanguard PRIMECAP Core Fund, and the PRIMECAP Odyssey funds as well. PRIMECAP Management utilizes fundamental analysis to understand companies and develop opinions independent of market consensus. They look for stocks where the underlying fundamentals will evolve significantly better than their valuation suggests. The company then targets stocks that will outperform the market over a three- to five-year time horizon, often selecting companies and industries that are currently out of favor among investors. The company emphasizes individuals having conviction in decision making, believing that this will generate the best investment ideas.

Over the past ten years, the Vanguard PRIMECAP Fund has generated a cumulative return of 48.5%, outperforming the S&P 500's ten-year cumulative of 16.4%. According to its second quarter portfolio update, PRIMECAP Management bought Charles Schwab (SCHW) and Limited Brands (LTD) and added to its position in Research in Motion (RIMM).

Charles Schwab Corp. (SCHW, Financial)

In the second quarter, PRIMECAP Management purchased 30,406,100 shares of Charles Schwab at an average price of $17.41, impacting its portfolio by 0.72%. The price of the stock has since fallen 31%. The Charles Schwab Corporation provides securities brokerage, banking, and related financial services to individuals and institutional clients. The company offers various brokerage products and services and various banking products and services. The company also provides trust services and mutual funds to broker-dealers as well as research and analysis.

According to Charles Schwab's second quarter report, despite low interest rates and volatile equity markets, net revenues increased 10% over last year, from $1.08 billion to $1.19 billion. Asset management and administration fees have increased 15% as clients have remained "solidly engaged with their investments," with cash holdings at Schwab declining to pre-financial crisis levels. Net interest revenue also increased 18% over last year. Revenue from trading decreased 12% as trading activity has been "relatively soft," though the company reported that clients have increasingly opted to enroll in their advisory solutions. Overall, the company reported net income of $238 million for the quarter, up 16% over last year's $205 in net income thought down 2% sequentially. For the six-month period ended on June 30, net income was $481 million, up 43% over last year's $337 million, with return on stockholder equity up from 8% to 15%.

Client assets under Schwab retail advisory offerings increased 20% over last year to $113 billion at quarter-end. Adding in assets under guidance of an independent fee-based advisor brings total advised assets to $811 billion at quarter-end, a 17% increase. Net new assets totaled $15.4 billion, up 10% over last year, and total client assets reached $1.66 trillion at quarter-end, up 22% over last year.

During the quarter, Schwab introduced an array of mobile investing, banking, and deposit capabilities to clients as part of the intergraded brokerage and banking services available to smartphone users. According to CEO Walt Bettinger, the company continues to work on "recently announced global investing capabilities, a new online portal for prospective clients, new retirement income planning tools and content, an ETF education center, enhanced fixed income services, and our acquisition of optionsXpress." The company also launched a new consultative program, "Managing Client Profitability," designed to help advisors manage profitable and scalable businesses through client segmentation.

Charles Schwab has a market cap of $14 billion. The stock trades with a P/E ratio of 19.3, on the lower end of its ten-year average. Its P/S ratio is 3.3, near its ten-year low.. Its P/B ratio is 2.1, also near its ten-year low. Book value per share has been rising steadily over the past three years, currently at a high of $5.38. The company's debt-to-equity ratio is a healthy 0.298.

Limited Brands Inc. (LTD, Financial)

In the second quarter, PRIMECAP Management purchased 6,441,098 shares of Limited Brands at an average price of $38.45, impacting its portfolio by 0.36%. The price of the stock has since fallen 15%. Limited Brands, Inc. is an international company that sells its products through Victoria's Secret, Pink, Bath & Body Works, La Senza, C.O. Bigelow, White Barn Candle Co. and Henri Bendel. The company operates specialty stores in the United States and its brands are sold in company-operated and franchised additional locations worldwide.

According to the company's first quarter report for the period ended April 30, net sales for the quarter were $2.22 billion, a 15% increase over last year's $1.93 billion. This included a 15% increase in comparable store sales. Operating income was $216.8 million, up 17% over last year's $185.0 million, and net income was $165.2 million, up over last year's $112.5 million. However, excluding a pre-tax gain of $86.4 million related to the sale of Express stock, a pre-tax expense of $50 million related to the multi-year funding of the company's charitable foundation, and an income tax benefit of $11 million, adjusted operating income was $266.8 million, up 44% over last year's adjusted operating income of $85.0 million. Adjusted net income was $129.8 million, up over last year's adjusted net income of $82.9 million.

According to the company's monthly reports, in May, the company reported a comparable store sales increase of 6% year-over-year. Net sales increased from $657.3 million to $717.4 million. In June, comparable store sales increased 12%. Net sales increased from $965.4 million to $1.080 billion. In July, comparable store sales increased 6%. Net sales increased from $619.7 million to $660.4 million.

Limited Brands has a market cap of $9.8 billion. Its stock currently trades with a P/E ratio of 14.4, in line with its ten-year average. Its P/S ratio is 1.1, above its ten-year average. Its P/B ratio is 9.0, a new high. Its debt-to-equity ratio has increased over the past five years, currently at a high of 3.11. GuruFocus has awarded Limited Brands a predictability rating of three stars.

Research In Motion Ltd. (RIMM, Financial)

PRIMECAP Management has held Research In Motion since 2006, when it owned more than 16.3 million shares of RIM when the average price was $23.66. As the price of the stock climbed in 2007 to an average of $52.20, PRIMECAP sold off more than half of its shares. In 2008, the stock peaked in price to as high as $140, but PRIMECAP only sold 645,000 shares during the peak. When prices tumbled back down, PRIMECAP once again began to amass shares of the company to more than 12.8 million. In the second quarter of 2011, PRIMECAP greatly increased its holdings of RIM, adding to its position by 63.9% at an average price of $43.84. This impacted its portfolio by 0.34%. The price of the stock has since dropped by 50%.

Research In Motion is a world leader in the mobile communications market. Its portfolio of products, services and embedded technologies include the BlackBerry wireless platform, the RIM Wireless Handheld product line, software development tools, radio-modems and software/hardware licensing agreements.

According to RIM's first quarter report for the period ended May 28, revenue in the quarter was $4.9 billion, down 12% from last quarter's $5.6 billion though up from last year's $4.2 billion. The year-over-year increase included a 14.1% increase in hardware revenue, reflecting higher sales of BlackBerry handheld devices, as well as new sales of the BlackBerry PlayBook tablet in North America in April, contributing to hardware revenues with approximately 500,000 tablet sales during the quarter. Service revenue increased by $280 million to $973 million as a result of increased net new Blackberry subscriber accounts. Net income for the quarter was $695 million, down from last year's $769 million and last quarter's $934 million, as a result of increased SGA expenditures and R&D expenditures, partially offset by an increase in the company's gross margin.

The company announced a cost optimization program on June 16, 2011 that would streamline operations across the organization, including reductions in employment. The realignment will focus on "taking out redundancies and a reallocation of resources to enable the Company to focus on areas that offer the highest growth opportunities and align with RIM strategic objectives, such as accelerating new product introductions." The company expects to implement the program beginning in the second quarter of fiscal 2012.

RIM also announced that it approved a share repurchase program to purchase up to 5% of RIM's outstanding common shares, dependent on future market conditions and potential alternative uses for cash resources.

According to smartphone sales data in, RIM's market share at this time in 2010 was 3.2% with 11.63 million units. In 2011, RIM's units numbered 12.65 million, but its market share decreased to 3.0%.

On 6/10/2011, RIM announced its plans to launch the BlackBerry PlayBook tablet in an additional 16 markets around the world over the next month.

On 8/3/2011, RIM announced that it planned to launch 5 new BlackBerry smartphones based on the BlackBerry 7 operating system.

Research In Motion has a market cap of $11.5 billion. The stock trades with a P/E ratio of 3.4, a five-year low. Its P/S ratio is 0.6, also a five-year low. Its P/B ratio is 1.2, below its five-year average. Quarterly net income has trended exponentially upward, however this quarter represented the first sequential decrease in net income since second quarter 2009. Quarterly revenue had trended exponentially upward as well over the past ten years, though this quarter was again the first time it decreased sequentially since first quarter 2009. Free cash flow was a gain of $798 million, down from last year's $897 million, though the company has had strong free cash flow generation over the past two years.

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