Big Thoughts About Big Caps; Tech and Otherwise, and the Myriad Benefits of Leverage

April 21, 2013

Another weekend, another ironic, superlative laden Barron’s feature to spur some thoughts about the direction of both a number of big cap technology stocks that reported last week, as well as the direction of overall market indices.  And while the Barron’s cover story this weekend predicting a rise in the DJIA to 16,000 within a year amid record bullish sentiment might not be as absurd as predicting a sustained turnaround in ST Micro (Terrapin Sector News Post 4/8/13- note STM is down 10% in the interim while ALU is flat), it could well be close.  Clearly a key factor underlying such a prediction is the global levering of central bank/sovereign balance sheets, and we also saw another indication of the great benefits of massive leverage this week as Intelsat priced its IPO.  As we have noted recently another irony we continue to find is the premium valuations accorded the most highly levered names across various aspects of the TMT space, from FSL (the subject of a similar blog post upon its IPO – Freescale Limps Out of the Gate 5/25/11) to the proposed DISH/S combination to CHTR to another recent IPO WSTC.  As with a lot of what we are seeing these days across both the TMT sector and broader markets, the positive correlation between increased leverage and increased valuation metrics doesn’t make much sense to us.

We move back to the blog given some of the high level musings in this analysis, but also include some comments on relevant large cap tech reports late last week later on in our discussion.  We have been sidling up to MSFT in recent months and move to long 2 post the company’s report late last week, coincident with increasing our INTC short position to maximum levels.  We also note another strong report for GOOG (long 2) as well as strong results from TSMC which feeds most of the world’s fabless players including BRCM (long 3) which has been under pressure of late along with AAPL.

The main irony in the Barron’s DJIA story is that it appears after the worst week for the index in several months, one that could and likely should have been a lot worse given the earnings driven weakness in IBM (the second most favored name in the Barron’s survey) , GE and MCD on Friday which together speak to a non trivial portion of the US and global economies.  Which brings us to another irony, resulting from an analysis that we actually started to put together prior to seeing the Barron’s piece but is even more interesting in context.  And while the Dow gets a lot of heat for being outmoded and not terribly representative, we do note that there is $4.3 trillion in market cap accounted for below.  The index remains a key focus from a retail perspective, is straightforward to analyze from a component perspective and in truth usually in pretty well in sync with the S&P outside of days like Friday when warnings from several of the world’s biggest companies was apparently not news for the S&P 500.

The analysis below follows the general format of some of our recent earnings analyses for companies in the tech space (Let’s Look at Some Charts 6/11/12, Let’s Look at Some More Charts 2/4/13) with a focus on comparing movements in forward looking estimates with movements in share prices.  What we find is the typical of the contradictions we have seen throughout the market in recent months.  Over the last twelve months, the average revision in earnings estimates has been down 6%, with the average change in share price up 12%. 80% of Dow components have seen negative earnings revisions over the period, while 76% have seen increasing share prices.  Only three names have seen meaningful upward revisions (eg greater than 5%), while 13 have seen meaningful downward revisions.  The most effective strategy appears to be to manage a slight (1-4%) decline in earnings estimates and let the liquidity tsunami do its trick, with the 11 companies in that category posting an average 18% annual gain in share price.  At a high level, for an index coming off all time high’s one would think the earnings picture would be a bit better.

Table 1: Prices Up, Estimates Down in the DJIA

2013 EPS

Price

4/13

4/12

chg

4/13

4/12

chg

P/E

Div

Yld

Mkt Cap

AA

$0.57

$0.94

-39.4%

$8.08

$9.73

-17.0%

14.2

$0.12

1.5%

9

CAT

$7.68

$11.45

-32.9%

$80.52

$102.77

-21.7%

10.5

$2.08

2.6%

53

INTC

$1.88

$2.68

-29.9%

$22.40

$28.40

-21.1%

11.9

$0.90

4.0%

111

HPQ

$3.51

$4.42

-20.6%

$19.56

$24.76

-21.0%

5.6

$0.53

2.7%

38

DD

$3.89

$4.79

-18.8%

$49.19

$53.46

-8.0%

12.6

$1.72

3.5%

46

XOM

$7.99

$8.88

-10.0%

$87.45

$86.36

1.3%

10.9

$2.28

2.6%

391

UTX

$6.10

$6.73

-9.4%

$93.22

$81.64

14.2%

15.3

$2.14

2.3%

85

CVX

$12.33

$13.55

-9.0%

$115.90

$106.56

8.8%

9.4

$3.60

3.1%

225

MCD

$5.78

$6.29

-8.1%

$99.95

$97.19

2.8%

17.3

$3.08

3.1%

100

BAC

$0.98

$1.05

-6.7%

$11.66

$8.11

43.8%

11.9

$0.04

0.3%

126

MSFT

$2.84

$3.04

-6.6%

$29.90

$32.05

-6.7%

10.5

$0.92

3.1%

249

GE

$1.65

$1.76

-6.3%

$21.75

$19.58

11.1%

13.2

$0.76

3.5%

226

KO

$2.14

$2.25

-4.9%

$42.66

$38.16

11.8%

19.9

$1.12

2.6%

190

PG

$4.05

$4.20

-3.6%

$81.43

$63.64

28.0%

20.1

$2.41

3.0%

222

PFE

$2.28

$2.35

-3.0%

$31.06

$22.90

35.6%

13.6

$0.96

3.1%

223

MMM

$6.82

$7.02

-2.8%

$105.71

$89.36

18.3%

15.5

$2.54

2.4%

73

JPM

$5.48

$5.60

-2.1%

$47.23

$42.98

9.9%

8.6

$1.52

3.2%

178

MRK

$3.63

$3.70

-1.9%

$47.29

$39.24

20.5%

13.0

$1.72

3.6%

143

T

$2.52

$2.56

-1.6%

$38.28

$32.41

18.1%

15.2

$1.80

4.7%

210

UNH

$5.51

$5.56

-0.9%

$60.04

$56.15

6.9%

10.9

$0.85

1.4%

61

AXP

$4.75

$4.79

-0.8%

$67.24

$60.21

11.7%

14.2

$0.80

1.2%

74

VZ

$2.76

$2.78

-0.7%

$52.25

$40.38

29.4%

18.9

$2.06

3.9%

149

JNJ

$5.41

$5.44

-0.6%

$84.49

$65.10

29.8%

15.6

$2.44

2.9%

236

IBM

$16.61

$16.70

-0.5%

$190.00

$207.08

-8.2%

11.4

$3.40

1.8%

212

CSCO

$1.99

$1.98

0.5%

$20.46

$20.16

1.5%

10.3

$0.68

3.3%

109

WMT

$5.34

$5.28

1.1%

$78.28

$58.91

32.9%

14.7

$1.88

2.4%

258

DIS

$3.45

$3.40

1.5%

$61.56

$43.11

42.8%

17.8

$0.75

1.2%

111

HD

$3.51

$3.26

7.7%

$74.00

$51.79

42.9%

21.1

$1.10

1.5%

156

BA

$6.38

$5.70

11.9%

$85.00

$76.50

11.1%

13.3

$1.94

2.3%

67

TRV

$7.17

$6.32

13.4%

$84.81

$64.32

31.9%

11.8

$1.84

2.2%

32

Median

-2.9%

11.4%

13.3

2.7%

Mean

-6.1%

12.0%

13.6

2.6%

Perhaps the point of the Barron’s piece further significant downward revisions are expected in earnings estimates for the Dow and hence further boffo share price performance. Though in reality rising corporate earnings is cited as the key factor in driving future gains in indices, though given recent performance it’s hard to see that as a lock.  Even for downwardly revised 2013 EPS estimates there is a bit of a hockey stick in place for the second half of the year, with those Dow components with December fiscal year ends booking about 22% of their annual profit expectations in Q1.  IBM, for example, is still expected to show revenue growth in fiscal 2013 despite a 5% top line decline in Q1.

The generally weak earnings data we have seen so far this quarter correlates well with weak overall macroeconomic reports of late.  However, as is also made plain in the Barron’s piece, the TINA narrative (there is no alternative [to equities]) remains firmly in place, driven by low interest rates, relatively attractive dividend yields and continued liquidity from massive central bank money printing and fiscal stimulus.  We do however see one major risk to this narrative, namely that stocks can never go down.  Which is to say, a 2.6% dividend yield doesn’t do a whole lot of good if stocks are in a double digit correction. All of this monetary and fiscal intervention needs to lead to actual growth in corporate revenues and earnings for these index moves to be sustainable, and based on this analysis there is not much evidence of that happening.  In fact, there appears to be more evidence supporting deterioration than improvement in fundamentals at this point.

Moving further in our discussion of the apparent myriad benefits of huge amounts of leverage from the macro to the company specific level, last week’s IPO of Intelsat may set a new high (low?) in terms of public market investors apparent willingness to bail out highly levered private equity backed companies.  As outlined in the table below, Intelsat, in addition to going for the single letter ticker, comes to market with a huge debt load to compliment a satellite communications network under increasing competitive pressure from terrestrial fiber and exhibiting little to no growth.  The  IPO priced well below the original $21-25 range, pricing at $18 only to open below $17 and subsequently rally over $20.  With the world’s largest and far better positioned communications service provides trading at around 6X EBITDA, it’s hard to argue for a 25% premium for I on any basis other than it needs one to have a positive market cap.   An absolutely amazing quote from the FT after the deal priced cites an unnamed private equity source which pretty much says it all:  “The reason we decided not to pull [the IPO] was that at the end of the day, the natural home for the business was on the public markets,” one person familiar with the process said.

This deal follow a similarly noxious PE backed IPO from call center and E911 service and technology provider West Corp.  As the description would indicate, there is not a lot of organic growth here either in what has mostly been a roll up story, and like I the WSTC IPO was not well received.  Even so however the company still has a positive market cap despite leverage that is typically unheard of in technology circles (outside of FSL of course, which continues to set records along those lines at least temporarily) and trades at a premium to other far less levered and faster growing names in the space

Table 2: What Could Possibly Go Wrong?

I

WSTC

FSL

CHTR

DISH/S

Price

$20.25

$20.46

$12.73

$103.04

$39.00

Mkt Cap

2066

1698

3195

10407

25857

Net Debt

15385

3457

5689

12880

40600

EV

17451

5155

8884

23287

66457

EBITDA

2100

750

750

2787

8500

EV/EBITDA

8.3

6.9

11.8

8.4

7.8

ND/EBITDA

7.3

4.6

7.6

4.6

4.8

 

While public market investors may have forgotten that the downside scenario with so much leverage can mean a complete eradication of equity value, this is certainly not the case in the private market as LBOs both large and small, Conexant and TXU, have filed for Chapter 11 bankruptcy over the last week or two.  And thus while the prescribed course for a CTL (long 2) or PCS (long 3) would appear to be to add twice as much debt to current 2.5-3.0 to 1 debt ratios and hence dramatically increase lagging EBITDA multiples, we will hold to our apparently controversial views that Debt to EBTIDA ratios in the 5-7 range,  for service providers in an increasingly competitive (eg non monopoly, cable operators used to carry there ratios when they had zero competition) market and certainly for actual technology companies should result in discounted not premium multiples.

The catalyst for the Dow analysis was a focus on the big cap tech elements of the index and our work on INTC and MSFT in particular, as we continue to focus on TMT fundamentals from a bottoms up standpoint despite being buffeted by a lot of the tops down aspects previously discussed.  In our comments on the Intel report we had indicated plans to look at the WinTel alliance more broadly post the MSFT report.  As the analysis below indicates, Microsoft exhibited solid growth in its report on Thursday, outgrowing its Wintel partner in both the data center and more PC centric markets with far higher margins while continuing to trade at a solid valuation discount.  Thus should the solid 2H recovery in PC and enterprise markets that INTC is forecasting occur, we feel confident the MSFT will benefit as well if not to a greater extent, and we believe MSFT is better positioned in the mobile OS market relative to INTC’s positioning in the mobile semiconductor market.  We remain constructive on the prospects for WinPhone8 as evidenced by both our recent re-addition of NOK to the long list as well as our current addition of MSFT.

Table 3:  The Win in the Wintel Alliance

MSFT

INTC

Revenue

PC

$5.7

$8.0

Data Center

$5.0

$2.6

Enterprise

$6.3

Other

$3.4

$1.0

Total

$20.4

$12.6

Growth

PC

0.0%

-6.0%

Data Center

11.0%

7.5%

Enterprise

8.0%

Other

28.8%

-9.0%

Total

7.6%

-2.3%

OM pct

35.6%

19.8%

EPS

$0.72

$0.40

growth

8.0%

-27.3%

Price

$29.70

$22.44

Shares

8.429

4.95

Mkt Cap

$250.3

$111.1

Debt

$14.2

$13.2

Cash

$74.4

$14.7

EV

$190.1

$109.6

2013E EPS

$3.01

$1.90

P/E

9.9

11.8

GOOG (long 2) continued to validate our view that they are unlikely to do much wrong in their Q1 report on Thursday, with continued strong revenue and earnings growth in the high teens and very strong execution across desktop, mobile and video markets.  Having recently moved back to long 2 in our Q1 Review and Outlook, we continue to be unabashed fans of both the company’s near term execution and long term innovation and see a company far more worthy of the benefit of the doubt trading just over a market multiple than the market itself or many of its highly valued peers (AMZN short 3) or highly levered denizens.