William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

At Smead Capital Management we believe that thinking like a private equity firm is a good exercise when examining companies which we intend to hold for long-term investment purposes. As we look at companies which fit our eight proprietary criteria, we stop ourselves and ask two questions. First, how would we feel if we owned the entire corporation and, second, how comfortable would we be if stocks didn’t open for trading for ten years? In other words, we think like an owner or think like an effective private equity buyer.

Today we’d like to hone in on two of our companies, Microsoft (MSFT) and EBay (EBAY). Our decision to look at them in this way was triggered by a fabulous rundown on MSFT in the October/2010 issue of Institutional Investor (II) magazine written by Stephen Davis. He covered almost everything anyone would want to think about MSFT; including a breakup of the company. By looking at these companies from a “sum of the parts” standpoint and from the view of a private equity buyer, we believe that an investor can get a sense of how truly undervalued these companies are.

Sum of the Parts—MSFT

Estimated PE Buyout Price–$32/share or $284 billion
Insider Ownership Percentage—12.8% or $36.45 billion
Cash on Balance Sheet—approximately $40 billion

PE Investment–$30 billion
Borrowing Needed for Buyout at $32/share–$168 billion
Annual Interest Expense at 7%–$11.76 billion
Cost Savings from Closing Money Losing Divisions, reduced Headcount and lower R&D expense–$3-6 billion annually

With estimated cash flow in the current fiscal year estimated at around $20 billion, this transaction would be very feasible.

Sum of the Parts—EBAY

Estimated PE Price to Buy–$32/share or $42 billion
Insider Ownership Percentage—12.6% or $5.8 billion
Cash on the Balance Sheet–$5 billion
Saleable Parts–$3 billion (Skype, Online Classifieds, Craigslist, etc.)
PE Investment–$6 billion
Borrowing Needed–$22 billion
Interest Expense at 7%–$1.554 billion

With estimated cash flow in excess of $2.2 billion, this transaction is very feasible.

In both cases, it would be very advantageous for a PE buyer of either company to include the insider owners as participants in the leveraged buyout of the company. Lender comfort and interest rates would be directly tied to beginning equity or “down payment” levels. In the case of EBAY, you could get the founders without employing the CEO, John Donahoe. In the case of Microsoft, it is unlikely that you’d get Steve Ballmer and Bill Gates as private equity owners without them being involved in running the company. The transaction is very doable without them participating because of the massive free cash flow and room for expense reduction.

In both cases, existing free cash flow levels would leave plenty of room for debt retirement. Motivated private equity owners would push for cost savings, reduced bureaucracy and make tough choices on R&D and capital allocation. Will the open market close these valuation gaps in the next couple of years or is it time to break these companies up to realize shareholder value?

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version
Subscribe to the Missives Podcast
Click here to listen to this Missive

Dear Fellow Investors:

At Smead Capital Management (SCM) we have eight criteria for selecting common stocks. Our first five criteria must be met at all times, while one of the remaining three may be temporarily overlooked. We only ignore weakness in one criteria if we believe the strength of the remaining criteria gives the company the time needed to qualify across the board. At SCM, we give grace in these instances because they typically coincide with a price discount which gives us an attractive entry point for initiating a position in our portfolio.

Shareholder friendliness is one of our criteria and can be waved temporarily. We prefer to have leadership with a great vision of the future, a willingness to keep costs down and the wisdom to allocate free cash flow well. One of our top ten holdings is Microsoft (MSFT). We believe Microsoft trades at a significant discount to fair market value because stock market participants view the company as shareholder unfriendly. Below, we have outlined SCM’s quick take on Microsoft shares regarding what we think is the inherent discount due to shareholder unfriendliness. Additionally, we’ve given a few approaches that could be taken by Microsoft to unlock value going forward.

Thomson-Reuters estimates that the S&P 500 Index trades at 15.1 times trailing earnings. For the sake of our discussion let’s assume that a 15 P/E ratio is pretty normal in this environment. This means that if you are perceived to have above average future prospects you trade above 15 times earnings. Your stock would trade below 15 times earnings if your future isn’t as bright as the average large public company.

First, we’ll take a cold hard look and examine Microsoft. Microsoft had nearly $36 billion in cash and near cash net of debt at the end of its last quarter (over $4 per share). Cash earns almost nothing after taxes for Mr. Softie. Therefore, almost the entire $2.05 per share consensus estimate analysts have for this year is created by operational profits and not interest. If you put a 15 multiple on $2 per share and add back the cash you get a $34 share price. With the stock trading at $26 per share, it means that MSFT trades at about a 25% discount to the average stock. The discount is even heavier if you would be so outlandish as to say that Microsoft has many of the characteristics of an above-average company and deserves a 20 multiple. In that instance, the current price of $26 per share sets up a huge discount to the $44 value per share.

We believe Microsoft is a superior company in a variety of ways. They write great software that is needed. They have been enormously profitable on a consistent basis and have such a good moat that the government sued them for it. Their profit margins are to die for and their balance sheet is impeccable. Thanks to the upcoming refresh cycle in business technology, most analysts look for them to have very strong earnings growth over the next 2 to 4 years. US Corporations have very high levels of cash on their balance sheets and as the economy recovers will use some of it to become more competitive through technology upgrades. So where does the intense dislike of once proud Microsoft and its market multiple discount originate?

Many investors hate MSFT because its stock has fallen over 50% from its tech bubble peak in the last ten years. Some dislike the corporate arrogance and others dislike the fact that they didn’t create the “New, New Thing”. We at SCM believe the core of the discount has to do with shareholder friendliness. Microsoft tries to act like the puny dividend and the $2 billion of stock they bought back in the first quarter defines them as shareholder friendly. When you sit on $40 billion of cash and near cash, generate $17 billion of free cash flow and pay a stingy $.50 of annual dividend, you anger investors like us who prefer to champion the company.

We’ve watched the current management squander billions of dollars on the weakest areas of the company (Media and Entertainment Division/Online Division) like a drunken sailor on leave. The problem is that the drunken sailor has been on leave for ten years! We saw a chart last week that showed that Microsoft spends about 14% of revenues in Research and Development, while Apple (AAPL) spends about 2%. In the most recent quarter, MSFT lost $713 million in the online division. If it were a stand-alone company, that would be one of the worst corporate performances in the S&P 500 Index. Hasn’t anyone at Microsoft or on the board of directors read Jim Collins book, “Good to Great”? The book says that great companies build themselves around their strengths. There is zero evidence that there exists any venture capital or private equity talent at Microsoft.

Thank God that time is the ally of the patient investor. We believe there are two scenarios for MSFT. The first goes back to the $34 fair value estimate. If the current management stays in place, Microsoft has $8 upside in the next year and upside going forward equal to growth in earnings/free cash flow at the average stock multiples. Nobody wants to pay up for a company squandering it’s free cash flow. The second scenario would occur if management closed or spun off all non-core divisions and dramatically increased the stock buyback and annual dividends. Since that is a very low probability event, the only way we get the second scenario is to change management. I’m glad there is upside without it, but it could be a huge stock if someone near the top would speak up.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version
Subscribe to the Missives Podcast
Click here to listen to this Missive

Dear Fellow Investors:

Why do most people make money owning their home? Why do folks make money on company stock and ten-year options? The answer is they hold these investments for a long time. If you hold a sound investment for ten to twenty years you typically get rewarded quite well. However, most human beings never participate in an investment for twenty years in anything other than their home or a piece of investment property. Why do investors hold most investments for short time periods when all the evidence is that you get the greatest rewards for long holding periods?

Historically, homes have appreciated at around 5% in the U.S. and common stocks have gained around 10% from a combination of appreciation and dividends. Why do US households have most of their capital tied up in real estate? We believe the biggest factor is liquidity. The only investments folks hold for twenty years are relatively illiquid. The cost and hassle of buying and selling property causes people to hang on. The hassle of moving your residence and the added monthly payments of buying a new one preclude activity. The fact that the price is not printed in the newspaper every day and there isn’t a willing buyer every day causes longer holding periods. We at Smead Capital Management think people are better off for having invested in real estate for long holding periods.

This brings us to our theme for this year-Hall of Fame Companies. Hall of Fame Companies have unusual success, great consistency and long duration. Why haven’t more investors participated on an uninterrupted basis in the common stock of McDonald’s (MCD) or Disney (DIS) or Merck (MRK) the last twenty years? Why do investors put their investable assets with money managers, financial advisors or financial institutions which make no attempt to own the same good quality common stocks for a long time? We believe one of the main reasons is that these terrific companies and their common shares are liquid every business day of the year. Someone offers to buy your shares every day. The temptation to time the cycles or shorten the reward period is overwhelming.

The New York Stock Exchange reported in 2009 that the average holding period for common stocks dropped below a year for the first time since the late 1920′s. Since investors invest in their rear-view mirror and good quality common stocks have had one of their worst ten-year stretches in history, investors don’t believe that they can get a long-term reward from the very thing that they are the most likely to get it from. One of our main jobs as portfolio managers is to help these very liquid investments become illiquid. Most investors and money managers take their cue from stock market trends, economic growth expectations or views of the current political leadership. We want to shepherd folks through long holding periods with companies that fit our Eight Criteria. In the process, we believe we will be able to look back in twenty years and realize that our client’s wealth has been determined by the companies we own which end up making the Hall of Fame.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.