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The Science of Hitting
The Science of Hitting
Articles (454) 

The 80/20 Rule - Disney & Microsoft

August 14, 2013 | About:

Less than two years ago, The Walt Disney Company (DIS) was trading in the $30 per share range; 24 months later, the stock has more than doubled from its lows. As someone with an interest in the name (the firm I work for has solid gains in DIS, which we continue to own), I was pretty baffled by what the analysts were focused on; I distinctly remember an interview from 2012 with Bill Nygren (from the Oakmark Funds), where he said the following about Disney (link):

“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:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.6/5 (31 votes)



Cdubey - 4 years ago    Report SPAM
Hadn't thought of that ! Thanks.
Nicktfranklin - 4 years ago    Report SPAM
I've looked at Microsoft earlier this year, even bought a little before recently selling it, and I don't know, I think its pretty fairly valued. They have a bad record of capital allocation decisions (write downs of poor product launches and acquisitions) so it doesn't make sense to me to look at free cash flow instead of GAAP earnings (they seem about right). If you add there net cash to their capitalized earnings, I get something in the $35-40 range. 10x pretax earnings puts it in the same range. I think to justify a higher price, you would need to assume a higher growth rate from... Bing? Office is a good product but what differentiates Server and tools from its competators? Do you understand that industry well enough to give a estimate of Microsoft's competitive positions? I don't. What do they do that IBM or RedHat, Accenture, etc. can't? Are those companies cheep? For Disney, the success of ESPN has nothing to do with theme park attendance, but that's not true for Microsoft where Windows penetration does effect their ability to sell Azure.
The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Glad you liked it - thanks for the comment!


Here's what I can tell you about their competitive position: they've continued to grow the top line high single digits in a period where customers are reluctant to invest due to macroeconomic concerns, with operating income growing at an even faster rate; in regards to your comment that Windows affects MBD and S&T, bookings and revenue growth in the most recent fiscal year suggests that is simply untrue. Whether or not that is true for a single product (in this case Azure, which is roughly 5% of those combined businesses total sales), I honestly don't know; as a whole, the numbers suggest that's not the case.

I would suggest that you watch Kevin Turner's presentation from WPC earlier this year, where he spells out many of the highlights for the specific products; he's not talking about what might happen in that video - he's talking about where Microsoft continues to win. I'd also point to this:


"Chief information officers have named Microsoft as their most indispensable “mega-vendor” during a recent survey by US investment bank Piper Jaffray this week.

The quarterly survey interviewed 135 CIOs, with 45% (61) choosing Microsoft as their most important vendor. Coming in with over double the mentions as second placed Oracle – SAP, Cisco, IBM, EMC, HP and Apple made up the list, in order of ranking. Microsoft has topped the American list previously, but this year saw its lead widen from 33% approval during 2012.

“CIOs state that ‘there are really no alternatives to Microsoft,’” Piper Jaffray said.

“[Others said] ‘MS services are getting better and will allow us to move more to the cloud,’ and ‘we are highly invested in their technologies and dependent on them extending their platforms.’"

You can take that for what it's worth; thanks for the comment Nick!

Link - http://www.digitalwpc.com/Videos/Pages/Videos.aspx#fbid=KGjakLp0amB

Go there and click "Load More" to see Mr. Turner's Speech
Acaciom - 4 years ago    Report SPAM
Good research made by Pipper Jaffray on MSFT, thanks.
The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM
Sure thinig Acaciom; thanks for the comment!
Nicktfranklin - 4 years ago    Report SPAM
RE: Nokia acquisition. Does this bother you? Do you get concerned that management is wasting money pursuing a growth strategy they are ill-equiped to manage successfully? More than anything else this has been my concern - poor capital allocation. Their strategy may work, but firing Balmer, the reorganization , the Nokia acquisition and the overall strategy of being a "Devices and Services" company is a different strategy that Microsoft and that represents a serious risk of failure - which would materially effect the value of the company (as in, it would burn a lot of the cash the company can make). I get that most of their cash comes from more stable lines of business but if they waste that cash on Bing, does it matter?

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Yes, it bothers me, for a couple of reasons. First, I think it outweighs the ValueAct news from Friday, which I considered one of the most important developments as an investor in Microsoft in a long time; now I think this will prove to be more business as usual than anything else, with ValueAct likely to be disappointed with the reception they receive (hopefully I'm proved wrong).

Secondly, it's a good amount of money; add in what Microsoft spends on R&D in any given year, and the company has averaged R&D/M&A spend in excess of $10 billion per annum over the last five years. Compare this to Google and Apple (who collectively spent less on R&D than Microsoft did in their most recent fiscal years), then think about the developments they've made in that period of time compared to what you can point to from Microsoft; it certainly doesn't make one too confident.

I'm very concerned by the fact that Microsoft continues to seemingly throw money away chasing missed opportunities; they need to find their next Bing - something they consider so critical that it cannot be passed up (which now appears to be mobile) - without giving the competition a 5+ year head start. The next CEO cannot laugh off competitors innovation, as Ballmer has done on several occasions - and been dead wrong.

On to the bigger question: If they waste all of their cash, naturally it becomes worthless; obviously reality is not that dire. MSFT has consistently spent ~50% of earnings on share repurchases and dividends over the past few years, with another good chunk going into CapEx ($4.2 billion in fiscal 2013); building the infrastructure to support Microsoft's cloud investments will only continue going forward, and is money well spent; I think ValueAct will push for an acceleration here.

We'll see who's picked as the next CEO (and what their track record and early actions as the new chief look like), and whether ValueAct is given a real opportunity to add their two cents; if both of those factors start heading in the wrong direction, I'll be much closer to abandoning MSFT, in large par due to the factor you've mentioned.

It's safe to say that Microsoft - my first foray into tech - could very well be my last; thanks for the comment!

Swnyc2 - 4 years ago    Report SPAM
I understand your concerns, but I predict Microsoft will succeed financially with its purchase of Nokia.

First, a comment on the Skype acquisition.... The $8.5B acquisition of Skype may have seemed to many at the time (including me) like a value destroying purchase. However, since Skype's purchase in 2011, sales have grown from $800M to almost $2B, in a rapidly growing internet telephony market which is expected to be worth .5B in 2014. Skype's earnings at the time of purchase were 5M. If Microsoft continues to get a substantial share of the growing internet telephony market, it is easy to see how its investment in Skype will be beneficial to shareholders.

Microsoft has a strong moat in the enterprise space with their Windows and Office franchises. They also have a wide range of other products including Skype, Xbox, and their own search business. The latest Nokia phones are getting good reviews at both the high end (Nokia 1020) and the low end (Nokia 520). According to many reviews, Windows Phone is excellent and is comparable in quality to iOS and Android. The most common reason given for low market share is fewer Apps, but this problem is decreasing with time.Although Windows Phone market share is low, it is growing at a faster rate than iOS or Android.

In the future, one should expect Microsoft windows phone to appeal especially to first-time phone buyers (no switching penalty), corporations (where IT departments will want an enterprise solution), and individuals who want a more integrated experience with other Microsoft products.

To be financially successful, Microsoft doesn't need to be the most innovative of tech companies. It just needs to make a quality product that sells in volume and at a profit. I think they can do that.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

The $265 million was not Skype's earnings - it was EBITDA; the deal certainly looks quite expensive on that metric, but I wouldn't judge the transaction on that factor alone. An update from management during the event on the 19th would be much appreciated by investors; I doubt we get one...

In terms of apps, I agree with you on the "top 100" type apps; of course, those can change over time - and Microsoft still hasn't been able to snag the newer ones (commonly cited - Candy Crush). Personally, I'm more concerned about the smaller / local type apps. In a lot of cases, regional banks, radio stations, retailers, and others are not making apps on the Windows Phone platform.

Is this a real problem from WP long term? I'm not sure, but I hope not. It really baffles me that Microsoft has not been able to get the top 100 apps in it's store; they could pay $100,000 a pop and spend less than $5 million to get the full slate in their store (many articles back in August suggested MSFT had 54 of the top 100). I don't understand how we can still be having this same conversation months later...

"To be financially successful, Microsoft doesn't need to be the most innovative of tech companies. It just needs to make a quality product that sells in volume and at a profit. I think they can do that."

I would agree with that, but that would assume they keep their costs in line. Over the last few years, Microsoft's spent more than $10 billion (on average) between R&D and M&A, with little to show for it; in most years, that is more than Google and Apple spent cumulatively.

W&WL numbers were weak this year for that reason alone (big investment in advertising behind Windows 8, Surface, and Windows Phone, plus write-down on RT); I would expect this spend to accelerate (as a percentage of sales) rather than slow with Ballmer at the helm. I hope the board and the next CEO seriously consider ValueAct's ideas; time will tell...

Swnyc2 - 4 years ago    Report SPAM
An anecdote I thought I'd share:

Yesterday, I just upgraded my iPhone4 to a Nokia 1020 with WP8. The phone and its camera are truly outstanding!

The salespeople at my neighborhood AT&T store were not so complimentary about Windows phones in general. They were touting Samsung's Galaxy 4 and the iPhone 5 because of the larger number of apps available.

I'm glad I didn't listen to them. I was apprehensive about switching, but after one day, I already prefer WP8 to iOS.

When I was in the store, I saw an entry level Nokia 620 selling for $150 less than a comparable Samsung android phone.

The concerns in the above discussion notwithstanding, my anecdotal experience suggests that MSFT will be a more prominent competitor in this market before long.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Fantastic - thanks for sharing; I've had similar experiences with sales associates at AT&T as well. It's not too clear to me why they can't (or wouldn't want to) incentive employees to make a third ecosystem viable; I'd have to assume that would be in their interest long term, especially if Apple continues to be more high end...

I'm not too optimistic, but hoping for some real growth (and soon) for WP8.

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