Cheap and Cheaper

I know, this is a broken record blog.  We all know financials are cheap and we all know there are plenty of reasons why they are cheap and why they might be right to be priced cheap.

However, I tend to still like the well-managed financials.

This is laughable and I don't mean to suggest financials should trade at over 3x tangible book value, but here's a valuation of historic deals in the investment banking sector I pulled out from the Merrill Lynch merger proxy (merger proxies are great sources of information; investment banks do a lot of valuation work to validate deal values and you get all that stuff for free in the filings):

OK, that came out pretty small but historic investment bank acquisitions have happened at an average of around 3x tangible book value with a median valuation of 3.4x.

Of course, this is pre-crisis so the world is quite a bit different now.

But I do think investment banks are certainly worth more than tangible book, if not a multiple of it.  Right now, people are worried about a complete European implosion and financial blowup that may be worse than what we saw in 2008/2009 in the U.S. 

Anyway, here's a list of price-to-tangible book values that was in the "Heard on the Street" page of the Wall Street Journal this morning:

                                   PTBV ratio
J.P. Morgan                95%
Goldman Sachs          76%
Jefferies Group            76%
Citigroup                    52%
Morgan Stanley          51%
Bank of America        44%

As I mentioned before, I really do like J.P. Morgan (JPM) and Goldman Sachs (GS).  I do think they are both very well managed.  JPM is a huge bank so will be subject to macro forces, but management has proven they can handle once in a hundred year events.

GS, too, has managed the crisis pretty well but they may be more flexible and agile than JPM since they are not a major bank.  Investment banks tend to be pretty nimble.  GS doesn't have a large physical presence (bank branches) or a large retail sales force (retail brokers) so don't have a large fixed cost base burden.  If things don't recover, you can be sure they will cut costs quickly and will move capital to where they can earn an adequate return.

At this point, according to the recent earnings conference call, GS is waiting for things to clear up a bit since things are in a sort of 'crisis' situation.  They do think that when things stabilize they will be able to deploy capital profitably.  If they thought this downturn is permanent, they would then use their excess capital to repurchase shares (and will probably cut more costs).

An interesting play here too is Jefferies Group (JEF).  I don't own JEF, but tend to really like it especially so cheap.  They are a small investment bank which has good sides and bad.  Right now, they are seeing the bad side of it.  JEF shares have tumbled alot after the MF Global blowup; people are now concerned about smaller firms that are too small to survive (versus too big to fail firms).

Some of my favorite value managers at Leucadia (LUK) bought into JEF stock on this decline as they are confident in the management of Richard Handler.  I think JEF will be able to pull through this as they do have a great reputation and Handler is known to be a conservative CEO (unlike the more risk-taking, reckless Corzine).

But in finance, you never know.  Good firms will go down in crisis situations, sometimes (although I don't think that happened in the 2008/2009 crisis; I think the firms that went down in that crisis weren't really good, well managed, conservative firms.  They were reckless, aggressive, overleveraged, horribly managed firms (BSC, LEH etc...)).

The good side of a smaller investment bank like JEF is that they may have more opportunities if they have a good niche (many smaller investment banks like Cowen haven't made money in years) and are well-managed.  The good thing is that they don't depend on mega-deals.  Bigger investment banks have to do bigger and bigger deals to increase revenues, just like larger and growing private equity funds have to do bigger and bigger deals to deploy bigger and bigger amounts of capital.

Anyway, all of these are financial companies and as I keep saying, one should be very careful how much exposure they have in any single sector (otherwise, I would be buying JEF too, but I have enough financial exposure now).

If Europe does really implode, financials can certainly go down more.  By their very nature, they are risky and another financial crisis of bigger than 2008 proportions is not a zero probability.

I do talk a lot about financials here now just because I do tend to think they are cheap, and because of my experience in the industry I tend to be more comfortable with some of them than most other investors and the general public (that seem to resent/hate financials!).

But that doesn't mean investors should pile into these things too much!

Olympus Continued

So the story continues to unfold and it doens't sound too good.  In my earlier post, I said that on the face of it there might be 459 billion yen or 1,700/yen per share in value at Olympus just by valuing the medical equipment business at 8.0x EBITDA, adding up the cash and securities and deducting long term debt (see here). 

I also did say, though, that financial statements are in question with such a fraud of massive scale.  Who knows what is going on there?  Since the scandal broke, they said that financial statements will have to be restated going back 20 years.

Still, if the loss was a billion dollars or so and if the phony payments and recent writedowns were related to the earlier losses and that was all there is, there was a chance that Olympus may have plenty of equity value for shareholders.

However, today's New York Times article about an investigator's memo raises questions about that.

From the article today (read here: NYT Olympus article, November 18, 2011)

"Olympus paid a total of 481 billion yen, or $6.25 billion, through questionable acquisition payments, investments and advisory fees from 2000 to 2009, according to the memo, but only 105 billion yen has been written down or otherwise accounted for in its financial statements.  That leaves 376 billion yen, or $4.9 billion, unaccounted for, according to the memo"

Well, if this is true, there goes the 459 billion in equity value that might have existed at Olympus.  Also, this memo only mentions the period 2000 to 2009.  If the losses occured in the early 1990s, there may be more from 1990 - 1999. 

Anyway, I guess this is a speculation that certain types of investors like, but with such a potential black hole, the wise thing to do might be to stay away. 

Wow.

Again, the scary thing is that I find it hard to believe that Olympus is a single, rogue company.  I think this is a systemic problem with many large corporations in Japan.  Of course it's silly to think this is going on at all Japanese corporations, but I find it hard to believe that this is the only company that has done this.

Harold!

That's the hint Warren Buffett offered to CNBC Monday morning when he said he will tell viewers which stock he has been buying this year.  None of the CNBC folks were able to guess (I had no idea) what stock it was. 

Harold's short name is Hal, of course, and Hal is the computer in the movie "Space Odyssey"; the letters following each of H-A-L are I-B-M.

This is a surprise on many fronts.  For many years, Buffett spoke of not wanting to invest in technology because it's hard to know what the industry will look like in five, ten, or twenty years.  Buffett really does continue to surprise. 

He always talked about how he doesn't like capital intensive businesses but then bought Mid-American, a capital intensive, regulated utility.  He also bought Burlington Northern more recently, both capital intensive and cyclical.  He has spoken about derivatives as weapons of mass destruction and then wrote $34 billion in notional amount of global stock index put options.  He speaks up against investment banks and then buys a large stake in Goldman Sachs (via preferred shares with warrants).

Now, after years of avoiding technology, he makes his largest public equity purchase ever and buys IBM.  What is great about Buffett is that he evolves.

Anyway, let's take a quick look at this.

Big Bet: Focus / Concentration
Buffett bought 64 million shares for $10.7 billion, starting in March of this year.  That's a huge buy.  To see how big it is, take a look at these figures.

as of September 2011:
Berkshire Hathaway Shareholder's Equity:   $160 billion
Stock holdings at Market:                              $67 billion

So he made a purchase that was 6.7% of the total net worth of Berkshire, and 16% of it's entire stock portfolio.  Now, that's focused investing.  How many people put 16% of their stocks into a single idea?

For reference, here is Berkshire's largest equity holdings as of December 2010:

If you look at the "cost" column here, you will see that this $10.7 billion purchase of IBM stock is the largest purchase ever for Berkshire.  After IBM, the next largest purchase is $8 billion in Wells Fargo and after that, nothing even comes close.  Kraft Foods comes in at $3.2 billion.

Of course, this table only includes stocks that BRK still owns, and not ones that were sold or were taken over completely (like GEICO, Burlington Northern, Gen Re etc...).

But still, there's no question this is a big purchase.   Only Coca-Cola would be worth more at this point than IBM.  Even the companies that he really likes, like Walmart, Procter & Gamble, Johnson and Johnson and others come in at only $2-3 billion.  Wow.

Reading Annual Reports
The other striking thing about this is that Buffett was triggered to move on IBM after reading the 2010 annual report in early March.  He said he read the report, did some work on it and then started buying in late March.

What is amazing is that he said he has been reading IBM annual reports every year for the past 50 years.  He said the same thing when he bought Annheuser-Busch too.  So even though Buffett wasn't interested in technology and thought he'd never buy tech company stocks, he kept reading IBM annual reports every single year anyway.  *This* is why he has such a strong understanding of business and good feel of the stock market.  This is why he is such a great investor.  Can you imagine the information stored in his head from reading tons of annual reports over the decades?  Even of stocks you never bought or thought of buying?  Incredible.

(Not to belabor the point, but next time you talk to someone who has lost money (or keeps losing money) in the stock market and blames the market, Wall Street or anything else, ask them how many annual reports they have read in the past month, year, lifetime?)

Due Diligence/ BRK Advantage
The other thing that struck me was yet again how BRK being a large conglomerate can be a big advantage.  I keep saying that Buffett may not be an economist and his predictions may be no better than anyone else, but with so many businesses reporting to him on a daily basis, he has a real time finger on the 'pulse' of the economy so he knows what's going on.  He doesn't have to wait for government statistics and he doesn't have to plug them into econometric models or comments/predictions from economists.  He knows what is going on every single day.

And here, for kicking the tires on IBM, he researched IBM's competitive position by asking all his companies about their IT.  He realized how sticky IBM really is and entrenched in corporate IT systems (and high cost of switching out), and how businesses will have to rely on IBM more over time as the need to process information increases.

He realized, apparently, that IBM is not your typical tech stocks subject to changing trends.  It would be very difficult to displace IBM with their strong position, much stronger than say a software company that writes limited applications and things like that.

Buying at the Highs
As usual, people focus on superficial things like the nominal stock price.  But IBM is trading at it's all time highs, they say.  It's not cheap.  These people would rather buy a crappy stock on their lows, like airline stocks in front of bankruptcy.  A good stock is a good stock because it's a great business trading at a decent valuation.  It doesn't matter if the stock is at an all-time high or low.

Of course, we value investors typically like to look for things on the new lows list to see if there are any babies in the bathwater, but Buffett has since been more interested in paying fair prices for great businesses rather than great prices for fair businesses (or something to that effect; I'll never get these things exactly right).

Some people analogize this to his Coca-Cola (KO) purchase too, which from a value investor standpoint wasn't a 'cheap' price nor was it on the new low list.  But it has done tremendously well.  I think people do tend to overemphasize this 'nominal' price.  This, by the way, extends to the overall market too.  Some only want to buy stocks during panic periods, like in early 2009 and think it's not a good time to buy stocks otherwise.  However, the KO purchase was not done at a depressed valuation for either KO or the stock market, and yet it is one of Buffett's biggest winners.

His Burlington Northern purchase also was at a high and the valuation was not even that attractive (I think 20x p/e or some such), and yet this holding (now completely owned by BRK so no market price) has been estimated to be worth 30 or 40% more than the acquisition price already (looking at earnings growth and using multiples of other listed railroad stocks).   A huge winner already.


IBM
So what's so great about IBM?  Buffett was impressed with the management even though he couldn't even pronounce the CEO's name (he said, "Palmi...", looked uncertainly at Quick who said "Palmisano").  He has been reading the annuals for years and was impressed with the change that they have undergone recently.  He said he was impressed by how they outlined exactly what they were going to do five years ago and achieved it. 

He said the 2010 annual report really details why he likes the company so much, and he can't think of any other management team that has laid out a roadmap with so much detail/specifics on exactly what they are going to do.  They did this before five years ago and achieved it so he feels they will continue to be able to meet their plans.

IBM 2010 Annual Report
OK, so what's the big deal about the 2010 annual report?  I took a quick look and here are some notes.

From the letter to shareholders:
Since 2002, IBM has:

• added $14 billion in pretax profit base to IBM
• Increased pretax income 3.4x and EPS 4.7x and free cash flow 2.8x
• had cumulative free cash flow of $96 billion
• Gross margins improved 9.4 points to 46.1%
• Pretax margin improvement to 19.7%
• 90% of profits in 2010 from software, services and financing

In 2010,

• Earned EPS of $11.52, up 15% for eight consecutive years of double digit growth (revenues were up +4%, pretax income +9%)
• Free cash flow was $16.3 billion
• Use of cash in 2010 was $6 billion in acquisitions, $4 billion in net capex, returned $18 billion to stockholders via $15.4 billion in share repurchases and $3.2 billion in dividends.

Over the past decade, IBM has returned $107 billion to shareholders through dividends and share repurchases after $70 billion in capex and $60 billion in R&D.   They also earned free cash flow of $109 billion, tripled software profits and increased share of revenues from growth markets to 21% from 11%.


In 2006, IBM introduced the Road Map 2010.  In this, one of the goals was for EPS of $10-11/share by 2010 (they achieved $11.52).

For the 2015 Road Map IBM expects $50 billion in share repurchases and $20 billion in dividends to be paid out.

Over the next five years through 2015, IBM will:

• earn at last $20/share in EPS
• generate $100 billion in free cash
• return $70 billion to shareholders
• grow revenues from growth markets to 30% (from 21% in 2010)

 Over the past ten years, free cash flow was $109 billion and $107 billion of that was returned to shareholders so we know that IBM is shareholder friendly.  Also, net income over those years were $95.6 billion so net income may be a conservative proxy for free cash flow so looking at the p/e ratio won't lead you too far off course here.  (In other words, they really do earn their EPS and they do convert that to distributable/returnable cash, and then they actually do return it to shareholders! This is very unlike other companies that put up positive accounting earnings but generate no cash, or even if they do, spend it unwisely and destroy shareholder value.)

So having said that, what is IBM worth?  What does Buffett see?  His average purchase price, he said, is $170/share.

That comes to 14.8x last year's earnings, 12.7x current year and 11.4x next year's earnings estimates.  That's pretty cheap for a company that plans to grow EPS by 11%/year (to at least $20/share by 2015), and that has grown 10%/year over the past ten years. 

(Yahoo finance earnings estimates for IBM were: 
  12/2011:  $13.38
  12/2012:  $14.85)

Even at the current price of $189/share, it is trading at  14.1x this year and 12.7x next year's estimate.

Buffett wouldn't have bought IBM if he thought IBM's competitive position would decay over the next few years.  If this is true, then IBM should manage at least a market multiple as their growth prospects are better than the average company. 

Given management's $20/share EPS target by 2015 (this is a low-end target as they say they will earn at least $20) and putting a 15 P/E multiple on that gives a target price of $300/share for IBM.

Buying it now at $189/share gives a return of 12% or so per year by 2015, not bad at all.

Should We Follow Buffett Into IBM?
In general, you can't really go wrong copying Buffett's stock buys.  He knows more about businesses and stocks than most others and his decisions will obviously be superior to others.

So for those looking for large, blue chip companies that they can own for a long time, I would recommend IBM and other BRK holdings for sure.

What's great about recent purchases is that the prices are still pretty close to where Buffett bought it, and the circumstances is going to be the same; fundamentals haven't changed much over the year.

This may not necessarily be true for Buffett's other holdings.  For example, people followed Buffett into Coca-Cola back in the late 90s calling it a Buffett stock, but they paid 40-50x P/E.  This did not turn out well for them (Buffett paid way lower prices back in the late 80s).

Buffett would not pay 40x P/E, even for Coke.   

Finding the right stock is only part of the equation.  A good price is the other side, and this is trickier to determine for Buffett's longtime holdings (again, since they may be overvalued at any given point in time).

Buffett put $10 billion+ of fresh BRK capital into IBM at these prices, so that's a different story than trying to figure out whether the other holdings are good buys now or not.

Having said that, for full-time investors and pros, IBM is not going to be the most attractive investment.  BRK can only buy stocks in the largest corporations in the world.  This reduces his universe dramatically from what is available to everyone else.  There are thousands of companies listed in the U.S. (actually, probably tens of thousands).

Joel Greenblatt, in a speech a while ago, recommended to investors, don't invest like you're managing $10 billion.  That means to go look for other opportunities where big players can't look (smaller cap stocks).

Anyway, I haven't even really dug into the IBM annual report for 2010 (10K etc...) so don't really have a good feel of the business.  I will take a look at it and may post an update if I find interesting things to say about it.

And a By the Way About Microsoft (and Intel)
Some people might have been surprised that Buffett bought IBM and not Microsoft (MSFT) given the cheapness of MSFT versus IBM and his close friendship and presumably good understanding of MSFT's business and future.

Buffett did say in the CNBC interview that he or anyone at BRK will never buy MSFT because he is just too close to Bill Gates.  If he or anyone at BRK (including the two new investment manager hires he told that MSFT was off limits) buys MSFT and then there is a positive development at the company, nobody would believe that Buffett didn't have inside knowledge of such development.  He also did say that it was an attractive stock.

Todd Combs, one of Buffett's two new investment management hires also bought a bunch of Intel stock (INTC) according to the latest filing.  This is also very interesting.

The argument against Microsoft and Intel is quite simply that the Wintel era is over and PC's are dead.  This is why we aren't supposed to like these companies even if they are cheap.  The suggestion is that these are value traps.

Perhaps they are.  I actually don't have a strong view on the future of PC's.  But I am inclined to think that maybe assuming the PC era is over and MSFT and INTC are not interesting investments may go into what Howard Marks calls "first level thinking" and not "second level thinking".  (Speaking of which, it wasn't too long ago that IBM was supposed to be dead because the PC was going to kill their mainframe business).

Anyway, Buffett's comment on the attractiveness of MSFT and Comb's purchase of INTC stock is a counterpoint to the "PC is dead so stay away from MSFT and INTC" argument.

Kraft Split-up Valuation?

OK, so Kraft announced that it will split into two; a slow growing U.S. grocery business and a fast growth global snack company. 

First of all, let me just say that Kraft is a decent looking company trading at a decent valuation so it's not a bad stock to own by itself.  Warren Buffett owns it and likes the business and has said that Irene Rosenfeld (Kraft CEO) is a terrific manager and that her operational skills are very good.  What Buffett didn't like is the use of an undervalued stock to pay up for Cadbury, and the fact that Kraft sold the frozen pizza business for a low valuation.  So Buffett doesn't like the financial skills of Rosenfeld and has reduced his stake in Kraft.

But anyway, back to the topic.   What kind of value can be realized by Kraft splitting up into two?  First of all, let me just say that a lot of information hasn't been released yet so an accurate valuation can't be done on the post-split pieces.  How the debt and corporate overhead will be split, etc...

An analyst on a conference call asked Rosenfeld how to look at a post-split valuation of the global snack business, and who the comparables were.  Well, she seemed pretty giddy and said that she will let us figure that out ourselves.  So I did scratch my head.  Is a comparable Hershey?  Cadbury is gone, but can we use the valuation of Cadbury at the time of Kraft's purchase?  That would be 37x the last year's EPS!  37x is too high, but there are lower, reasonable numbers.

Anyway, to keep it simple I will make a very simple assumption.  I will simply assume that whatever operating earnings split between the two segments is will remain the same for the EPS.  In other words, if both businesses account for 50%-50% of operating earnings, then I will just use that to figure out what the eps of each post-split company is.  This is not accurate as there are items below the operating earnings line that we don't know how will be allocated between the two companies.  I assume that a lot of the debt will be carried by the U.S. grocery business.  I think Rosenfeld did say that (but I'm not exactly sure).

I just took the segment revenues and operating earnings from the 2010 10K and divided up the segments myself into what I think roughly approximates the two split companies.  Here is the table:

This is not entirely accurate as there may be some segments that are within these big groups that might go to one or the other.  In their September 2011 presentation using full year 2010 figures, they said the U.S. grocery business had $16 billion in revenues and the global snacks business had $32 billion.  That compares to my above quick shifting around that gives $13 billion and $36 billion respectively, so it's a little off but I figure good enough for what we are trying to do here.

This is a free blog so that is close enough.  Perhaps if this was an $2,000/year newsletter, I would need to be more accurate.

OK.  So we notice that the operating earnings split is going to be 61% global snacks and 39% U.S. grocery.

Now we continue to make huge leaps for simplicity's sake and take the full year guidance of eps for 2011, which is $2.27. 

So using my rule that the eps split is the same as the operating earnings split, the U.S. grocery company will have an eps of $0.89, and the global snacks business will have an eps of $1.38.

 Let's not stop there. The year is almost over, so let's use next year's estimates. Analysts estimate Kraft EPS for the year to December 2012 to be $2.52.  So applying the same as above (which is not correct as the global snacks business is supposed to grow faster, but again, good enough for a rough estimate), we get a U.S. grocery business EPS of $0.98 and the global snacks business will earn $1.54.

OK, I like tables, so here are the EPS figures:

                                                   2011e             2012e
U.S. Grocery Company EPS:     $0.89             $0.98
Global Snacks Business EPS:    $1.38              $1.54

You can also use revenue growth assumptions to come up with different EPS estimates for 2012, but I'll keep it simple here.

Now comes the interesting part.  How do you value each side of the business?  For simplicity, I will just focus on p/e ratios here.  Here is a table of comparables.  I got the list of comparable businesses from the Wrigley's merger document from April 2008, but I added Tootsie Roll Industries as there wasn't enough snack businesses.  Tootsie Roll may be too small to be a relevant comp, though.  The valuations are from Yahoo Finance as of now (or a few minutes ago):

The average p/e ratio on a trailing twelve month basis (excluding Kraft) is 16.7x and 15.5x forward p/e (forward p/e is mostly for fiscal year ended December 2012).

On a forward basis, it seems like Kraft is selling for less than the average p/e.  Excluding Hershey and Tootsie Roll, 13-15x p/e looks to be a reasonable range for Kraft Foods.  Since many of the other companies are U.S. grocery type businesses and not global snack-like, maybe 13-15x p/e is a reasonable range for the U.S. grocery business.  To be safe, let's use the lower end of that: 13x.

From the above EPS, we can see that the U.S. grocery business (to be apples and apples, I will use the 2012 estimate),  $0.98/share.  At 13x p/e, the U.S. grocery business is worth $12.74.

Kraft is now trading at around $35/share.  So using a stub approach, the global snacks business is now being valued at $22.26/share.  Since it can earn $1.54/share next year, the market is valuing it at only 14.5x p/e.   I think this is the essence of the story.  The global snacks business will grow revenues and earnings at a double digit pace, which is not what the above comparables are doing performance-wise.  And yet, the market is only giving it the same sort of valuation, within the 13-15x valuation range in the table above.

Now, the question is what exactly is it worth?  One comparable may be Hershey.  And maybe Tootsie Roll Industries.  Hershey, though, has only grown sales at 3.3%/year for the past five years and EPS has only grown 2.3%/year over that time.  So despite Hershey's high valuation, it hasn't grown at all and I don't know that growth prospects is any better going forward.

Tootsie Roll Industries is highly valued too, even though it's a lot smaller.  But despite valuation of 25.2x p/e, Tootsie Roll has only grown sales +1%/year over the past four years and EPS has actually declined -3.6%/year over the same time period.

If these no growth snack companies can get a valuation of 20-25x p/e, why can't Kraft's global snack business? 

At 20x p/e, the global snack business is worth $30.80, and at 25x p/e, it's worth $38.50.

Combined with the U.S. grocery business which we valued at $12.74/share, that values Kraft Foods in total at between $43.54 - $51.24/share.

Is this what the activist agitators have been seeing?  Is this why Rosenfeld is smiling when she talks about the split?

In sum, here's the valuation assumptions for KFT.
                      
Value of U.S. grocery business:       $0.98/share eps x 13 p/e =  $12.74

plus
                           Value of global snacks                      TOTAL VALUE                                 
20x p/e:              $1.54 eps x 20 p/e = $30.80              $43.54/share
25x p/e:              $1.54 eps x 25 p/e = $38.50              $51.24/share
30x p/e:              $1.54 eps x 30 p/e = $46.20              $58.94/share

OK, I added the 30x p/e and that might be a bit aggressive.  Or is it? 

A Higher Target
Yes, 30x p/e in this day and age seems quite a bit aggressive.   I was looking at the Wrigley merger document from April 2008 for merger/acquisition valuation reference points.  Wrigley itself was bought out at 32.1x then current year expected EPS and 29.2x forward p/e.  Of course, Cadbury itself was acquired for what looks like 37x p/e by Kraft.

I do think a p/e ratio of 30x is highly unlikely to be achieved by the global snack business, but it does make sense to assume that it will be higher than 15x or so.  20x p/e may be a conservative valuation if they do have high growth potential.

Anyway, that's just a quick sanity check on what Kraft might be valued at post split.    Of course I left out a lot of stuff; how the debt and SGA is allocated etc... and assumptions of higher expenses due to reverse synergy (although I assume some of that will be offset by efficiency gains/cost cuts).

Olympus Kills Japanese Stock Market?

Olympus was down again the limit and I don't think any shares traded, having been offered down the limit all day at 484 yen/share.

Olympus, on it's own is not a big problem.  These things do happen.  The U.S. had it's Enron, Worldcom and others. 

But the problem is that Olympus is an old, stodgy blue-chip company, not some aggressive, MBA-led startup.  If you can't trust Olympus, who can you trust in Japan?  What other companies have similar problems?  If this sort of cover-up is culturally acceptable are any of the income statements and balance sheets in Japan reliable?  Is there something wrong with the auditing system in Japan?  The scary part is not what happened to Olympus itself, but the suspicion that this is not uncommon (as I said, sadly, I was not surprised by what happened).

This is a scary thought for investors.  This is especially true now with sentiment so fragile after the big, global financial blowup.

My fear is that this will turn people off to stocks in Japan for many years.  This is not like the financial crisis in the U.S. where the collapse is easy to understand.  It was a standard bubble and collapse.  People now trust banks quite a bit less and are afraid of leveraged balance sheets and risk-taking financial institutions.  But nobody is worried about Coca-Cola, Starbucks or Google.  Yes, stocks aren't that popular after such a long period of subpar performance. 

But that's different than what is going to happen in Japan going forward post-Olympus.  Olympus was not a subprime lender or bank.  What happened is not industry specific, so people won't just be able to avoid certain risky industries, they will have to avoid Japan overall.

The Japanese handling of the Fukushima crisis also doesn't inspire confidence.  If they can't tell the truth about that, how can we trust the regulators of Japanese corporations?  Would they not also lie and help cover things up for the sake of a bigger, social good?


Back in 2006 there was a Livedoor/Murakami scandal that rocked the Japanese financial markets and that really killed the Japanese OTC market, I think.

You will see that the market peaked in early 2006 just as the Livedoor scandal broke.  This really turned people off to the OTC market (even though Livedoor was Tokyo Stock Exchange listed).  I think it changed the perception of the market as a rigged thing with no chance for outside investors.


Why is this important?  You will say that lower valuations will be good for investors and they can make good returns.  This is true, but in the case of the Japanese OTC market, I think the problem is that with a bad market, low valuations and no liquidity, companies can't raise capital.  If companies can't raise capital at reasonable prices, the market won't develop.  I think the Japanese OTC market is stuck in the vicious cycle and can't get out of it, and it seems to me it is largely due to the Livedoor/ Murakami scandal.  At least it seems like that to me.

You can see that the JASDAQ market did top out earlier than the Nikkei 225 Index.  The Nikkei didn't top out until the financial crisis began to unfold.

The problem here is that any chance of people coming back to stocks in Japan may be set back for years due to this Olympus problem.  Who is next?  As for foreign investors, they will realize that they have no mechanism to resolve these Olympus-type problems as they do in the U.S.  This means that at the margin, foreign investors will be less likely to invest in Japan.

Of course, value investors need not worry about what other people do and whether stocks are popular or not.  But what it does tell you is that Japanese stocks will probably have to get a lot cheaper on a valuation basis before people get interested.

With this lack of transparency, shakey accounting/auditing, no recourse when trouble occurs, rational investors will demand a discount to invest in such a place.

For many years, Japanese stocks traded at a premium to U.S. and other global stocks.  This really made no sense to me as returns on capital, margins and other productivity measures were usually far lower than Western counterparts. 

The premium has disappeared in the past couple of years making people bullish on Japan again, but Olympus, I think, will change that somewhat.  Parity valuation will not be a reason to go to Japan anymore (unless there are other factors that make a specific investment interesting.  All of these things have to be evaluated on a case-by-case basis).

Couple that with the incompetence of the Japanese government in dealing with the economic situation and government finances, this is a recipe for a long, extended bear market far longer than has already occurred.

This is very unfortunate as I have been interested in Japan for many, many years and have been waiting for some sort of bottoming out over there.

It now looks like there won't be a true bottom for a long time.

I will continue to look for interesting situations over there, but things are not looking too good at all.

I do also understand that I may be putting in a low in the Japanese stock market by making such a negative post! 

Possible Downgrade of Nomura's Credit

Moody's announced that they may downgrade the long term credit rating of Nomura Holdings one notch to one notch above junk level.  This really could be lights out for Nomura (as an independent entity, at least).

I don't know if this means Nomura will end up bankrupt, but this is really bad news if the downgrade actually happens (a single downgrade won't bankrupt the company, but the jitteriness of markets will make it difficult).  As I said in my previous post (How Do You Solve a Problem Like Nomura),  one big issue with them is their big move into global markets and my concern was their history of losses and failure in previous attempts at globalization. 

Apparently, Moody's is very worried about this too.  On a balance sheet and capital ratio basis, Nomura seems pretty sturdy, with capital ratios close to 20%.  But I think the constant losses overseas and their big expansion, doubling down (or more) into an area that has been a source of big losses for them over the years is very scary.

Now, this credit downgrade wouldn't matter so much if Nomura was more a domestic business.  Japanese institutions are not so sensitive to the ratings of Moody's or S&P, nor are individual investor clients at their retail branches.

But since they are expanding rapidly globally in the wholesale markets, credit ratings are much, much more critical as clients are sophisticated institutional investors and they do tend to be highly sensitive to credit ratings.  This is even truer today after Lehman, Bear Stearns (and the problems of unwinding trades, getting prime brokerage account assets transferred) and of course the recent MF Global makes things much worse.

Here is a look at the long term credit ratings of the major global investment banks:

                                         Moody's               S&P           Fitch
Deutsche Bank                  Aa3                       A+             AA-
UBS                                  Aa3                       A+             A
Goldman Sachs                 A1                        A               A+
Morgan Stanley                A2                         A               A
J.P. Morgan                      Aa3                       A+             AA-
Merrill Lynch                   Baa1                     A                A+
Nomura                           Baa2                     BBB+

This is obviously problematic for many reasons.  Of course, the first issue is funding cost.  For investment banks, funding is everything.  If you don't have good funding in such a highly competitive, low margin business, you are not going to do too well.

Second of all, for derivatives, repos and other businesses that involve a counterparty, Nomura is not going to be an attractive counterparty.  Counterparties will demand more collateral or less favorable terms. 

Also, even clients that don't get into a counterparty situation with Nomura (such as repos or swaps and other derivatives) may not want to have too much assets in their accounts held there, whether it be in regular accounts, or especially in prime brokerage type accounts. 

This wouldn't have been as much of an issue a few years ago, but especially after the Lehman prime brokerage fiasco and the current MF Global mystery (of missing $600 million in customer funds), I think clients are much more sensitive to these things.


Nomura is going global to compete with the other global investment banks head-on.  But look at the above credit ratings.  Why would someone deal with Nomura when they can get Aa3 counterparties?  What can Nomura offer that the other banks can't that would make it attractive to deal with a lesser credit?  Investment banking is a highly competitive business where only the top players earn profits over time, and I would think this credit rating gap is a huge disadvantage in that situation.



In the end, things may turn out OK, but Nomura sure picked a tough time to go all out expanding globally.  The downgrade may not occur, but even if it doesn't, there doesn't seem to be much margin for error.  Any more surprises to the downside can really be the end of this company.

Having said that, bankruptcy probably won't happen; it will probably be merged with someone given how Japanese regulators have dealt with weak banks over the years. 

As I said in my other post, I really think the best solution is for Nomura to become the Japanese arm of a major global institution.  The domestic operation is a great business that could add a lot of value to a global major.

But of course, that will never happen.

Olympus

What is happening at Olympus is really sad.  The worst part of it is that I'm not even that surprised.  I have been looking to invest in Japan for a long, long time and have only found 'trades' to do there; buying stocks when they are very cheap due to short term worries about this or that.

But I haven't been able to find good, solid blue chips to invest in or interesting vehicles like Berkshire Hathaway, Leucadia or Loews type thing where you don't really care about the industry but trust the capital allocation skills of management.

This really illustrates one of the biggest problems in Japan; lack of transparency, total disregard for shareholders, outright dishonesty at the very top (which is not unusual in the U.S. either) which just seems culturally acceptable over there.  I guess part of it is due to the lack of due legal process.  In the U.S., people lie too, but they get sued or go to jail (OK, OK, I hear the protests about how few bankers have gone to jail...  Yes, yes, Fuld was a liar as were a bunch of others and they remain on the loose.  But still...).  I don't think that happens very often in Japan.

Anyway, let's take a quick look at this thing.  What is shocking to me is that despite the stock price being down 90% from their highs, the stock is not even super cheap.  It's cheap to be sure, but not ridiculously so.   Again, this goes to show how overvalued Japan has been even recently despite a 20 year bear market.

As the chart shows, as recently as 2007, the stock traded at 5,000 yen per share. Peak EPS was 214.44 in the year ended March 2008, which comes to a p/e ratio of 23x.   That might not be ridiculously expensive, but before that going back to 2001, Olympus never earned EPS of over 200 yen/share.

The EPS history goes like this:
year-end
March of:          EPS      
2001                    44.57
2002                    38.87
2003                    91.88
2004                  126.96
2005                   -44.98
2006                  105.99
2007                  176.79
2008                  214.44
2009                 -428.43
2010                  177.22
2011                    27.47

I haven't looked at the reports in 2007, 2008, but these were years at the height of the bubble so these earnings may or may not be repeatable.

Here is a close-up look at Olympus.  The stock crashed over the past few days from over 2,000 yen/share to the current 584 yen per share.

Is that cheap?  Since so many people talk about book value per share with respect to Japanese stocks, let's take a look at that.  According to the quarterly filing (in Japan), Olympus had 151 billion yen in shareholders' equity and 266.9 million shares outstanding (net of treasury stock), so that comes to a book value per share of 565 yen per share.  So even after this stunning drop in stock price, Olympus is now trading at only a slight discount to BPS.

Here are some fundamental figures for Olympus:

If Olympus earned decent returns on equity (ROE) over time, BPS would be a great buy.  But it looks like over time, the ROE of Olympus has been around 5.12%, not so exciting.  This does include the -44.4% loss in 2009, but since that is a real loss from a writedown, I would not exclude that.  The 25.8% ROE in 2010 is mostly due to a gain booked as a result of transferring a business so it's not operational.

Otherwise, Olympus only earned an ROE above 10% in five of the last twelve years.  A decent looking 15-16% ROE was only achieved at the height of the bubble back in 2007 and 2008.

I should point out that much of this book value is goodwill.  Even though there is 151 billion yen in shareholders' equity, there is goodwill of 168 billion yen.  So in the current world where tangible book value is popular, Olympus has a negative tangible book value.

Sales has been declining every year since 2008 and margins haven't been that exciting looking.

It is interesting to note that while Olympus is known for their cameras, the Imaging business accounts for only 15% of sales and hasn't made money recently at all.  The Medical Products business (70% market share of endoscopes etc...) has been the money earner here, accounting for more than 100% of the operating income at Olympus last year.

Since this is the crown jewel of Olympus, let's take a quick look at it:

Sales have been flattish over the past couple of years and operating margins seem to be trending down.    I don't have a lot of understanding of this industry and the outlook for this segment, but it does look like a decent business with decent margins, although it is trending down. 

Growth?  Management says that growth will come from Asia, and that may be so.  Who knows.  Many Japanese companies have been talking about Asia as their engine of growth for many years without too much to show for it so we'll see.

If Olympus does get back to historical earnings that it earned back in 2007, 2008, then Olympus stock is certainly cheap.   Peak EPS was 214 yen and the stock is now trading at 584 yen/share so that's only 2.7x peak earnings.  I am a bit skeptical that earnings can get back up there.

So let's take a look at the balance sheet.   As of the end of June, 2011 there was 151 billion yen in shareholders' equity and 59 billion yen in investment securities, much of it in equities.  Yet another problem with Japanese business is their continuing of cross-holding of stocks.  Twenty years later, a lot of corporate balance sheets are still stuffed with stocks.  This is very annoying, but is another topic altogether.

There is also 267 billion yen in cash and cash equivalents.  So one is tempted to add this up, the 267 billion in cash and 59 billion yen in stock and call that non-operating assets, deduct it from enterprise value and get a cheap valuation on the operating business.

Let's look at it that way, then.  Long term debt as of the end of June, 2011 was 631 billion yen.
With 267 million shares outstanding and a stock price of 584 yen/share, that's a market cap of 156 billion yen, plus 631 billion yen is total capitalization of 787 billion yen.

Deduct cash and cash equivalents from that and you get 520 billion yen enterprise value for Olympus.  If you consider the 59 billion yen as not operating assets and more like cash, then deduct that and you get 461 billion yen in enterprise value.

EBITDA of Olympus in the last three years were 108 billion, 130 billion and 96 billion yen for an average of 111 billion yen or so.

Using the enterprise value with cash and cash equivalents excluded would give a valuation of around 4.7x EV/EBITDA and excluding stockholdings, it would come to 4.2x EV/EBITDA.  Out of conservatism and the reality that these corporations may never sell their crossholdings, it's better to use 4.7x EV/EBITDA.

Is that cheap?

I don't know much about the medical systems business, but here's a quick look at some comparables (which admittedly don't look too comparable, actually).

Just as a quick sanity check, I picked some medical device-like companies:

                                                                           Operating
                                            EV/EBITDA          margin                       ROE
Johnson and Johnson                 8.6x                  25.4%                        18%
Medtronic                                  8.2x                  28.5%                        20%
Covidien                                    8.6x                  21.8%                        19%
Becton Dickinson                      7.5x                  22.5%                        23.6%

All of these are for the last 12 months and are pulled from Yahoo Finance.

Yes, 4.7x EV/EBITDA seems cheap.  But the ROE and operating margins are not even close.  Olympus earns nowhere near 20% ROE or 20% operating margins over time as a whole.

Maybe one should only look at the medical systems segment and see what it is worth since it does earn a 20-23% operating margin.  If that can be valued at 8.0x EV/EBITDA, then maybe we have a good sum-of-the-parts story here (even though betting on a corporate action in Japan is a loser's game; a value realizing transaction will never happen over there!!).

This is a really simplistic sum-of-the-parts, but here goes. 

Let's put a 8.0x EV/EBITDA multiple on the medical systems segment of Olympus, add the cash and stockholdings value, deduct the long term debt for the 'equity' value and divide by the number of shares to see what this thing is worth assuming the rest of the businesses are worth exactly ZERO.

In the year-ended March, 2011, the medical systems segment had the following EBITDA:

Sales:                                       355.5 billion
Operating income:                     69.3 billion
D&A:                                         16.9 billion
Amortization of goodwill:           9.3 billion
Total EBITDA:                          95.5 billion

The operating margin of this segment was a slightly less than 20%, so let's use an EV/EBITDA ratio of 8.0x to value this business and then add the rest of the stuff and deduct the long term debt:

Medical systems segment value:     764 billion  (95.5 billion x 8.0)
Cash and cash equivalents:              267 billion
Investments:                                       59 billion
Total:                                             1,090 billion
  less long term debt:                    -   631 billion
Equity value:                                     459 billion
Number of shares outstanding:          267 million
Equity value per share:                   1,719 per share

With the above assumptions, Olympus shares are worth at least 1,719 yen per share. 
However, this valuation may not necessarily be reached.  My opinion is that if the firm as a whole does not start to earn reasonable operating margins and returns on equity, then this hypothetical valuation may never happen (even though Olympus stock did seem to trade above this level for most of the recent past).

In order for this valuation to be forcibly realized, the medical systems group would have to be sold at this level of 8x EV/EBITDA or something like that, and as I said, in Japan these value realization events rarely happen as many foreign investors in Japan has learned over the past twenty years.

Also, it is not clear what the future of the other segments are.  Japanese companies tend to pump money into even losing segments out of inertia or pride.  This can be a very serious value destroying thing to do.  Japanese companies do  tend to overemphasize market share and sales growth more than return on capital. 

Of course, the biggest problem here is the big question mark of the current scandal.  What actually is going on?  Are the earnings/balance sheet figures even reliable?  What do they mean?  What is the future of Olympus?

These are very hard questions to be sure.

I don't own any Olympus and don't plan on buying any in the near future as I am skeptical that things will be 'righted' soon, but I will keep an eye on it and may post some updates if I see anything interesting.

Having said all that, this is not to say that the stock can't go up.   It is certainly possible that value investors see value here and jump in, pushing the price back up dramatically.    Just because I am not interested doesn't mean it won't go up (in fact, the fact that I'm not interested means it will probably go up).

But although I see some value on a look-through or sum-of-the-parts basis as described above, my experience watching Japanese companies makes me worry that future management will continue to destroy shareholder value, even with a nice, profitable jewel of a business.  I fear that instead of realizing value for shareholders via a spin-off or sale, or by shutting down unprofitable or low profit segments, they will continue to take money from the good business and dump it into the bad to preserve or increase sales, and more importantly, I think, maintain employment.  

Dumping good money into bad businesses seems to be at least partially motivated by Japanese management's aversion to right-sizing/layoffs.  They would rather spend money on a low profit factory to update it with subpar returns on investment rather than close it down and have to lay off workers.

Anyway, I don't know that this is what Olympus has been doing in the past, but their capital management in the past hasn't been very encouraging either way.  Also, even though there seems to be a lot of cash on the balance sheet, this may not go back to shareholders any time soon (it's not net cash anyway).  Just skimming the annual reports going back a few years, they seem to be hell bent on growth.

And one way they want to grow is through acquisitions.  And keep following that thought, Japanese corporations have historically been horrible in acquisitions.  That's partly because of their reputation to pay too high a price (which is no surprise given the history of managements' obsession with sales and disregard of returns on capital), and their reputation for not being able to manage the businesses they buy.

In any case, that's just a quick look at this thing for now.  I will keep thinking about this for a little bit.