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The Role of Relative Valuation

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1 The Role of Relative Valuation
3/25/ :35 AM The Role of Relative Valuation Stu Linde November 1, 2006

2 Topics The Broad Fundamental Analysis View
Financial Statement Overview Relative Equity Valuations CBS: A Case Study Appendix 1

3 Knowing How to Apply is Deadly!
3/25/ :35 AM Topics Information is Dangerous…. Knowing How to Apply is Deadly! 2

4 3/25/ :35 AM The Broad View 3

5 The Broad View Revenues
3/25/ :35 AM The Broad View Common Analyses Elements Revenues Drivers Of Business Model / Stress Test Against Industry Model Expectation Often Predicated On Recent History Rather Than Realism Industry Growth, Management Strategies And Comparisons Are Key Profitability Where Rubber Hits The Road….Is Revenue Growth Creating At Least Incremental Profitability Easiest To Play With – “One Time” Vs. Recurring Q To Q Volatility Cash Flow Measure Of Earnings Quality Measure Of Growth Capabilities Risk Of Over-Investment 4

6 The Broad View Valuation
3/25/ :35 AM The Broad View Common Analyses Elements (cont’d) Valuation P/E Most Commonly Used To Benchmark Against Market, Other Industries And Peers Cash Flow (EV: EBITDA); Enterprise Value (Debt, Book And Equity Measures) Dividend Yield Sales The List Goes On! Expectations Greatest Opportunity To Enhance Risk Taking Broadly Is To Anticipate Expectation Embedded In Stock. 5

7 3/25/ :35 AM The Narrow View Uncommon Analyses Elements: How Do They Affect the Model Levers? Key Questions to Set Stage for Valuation: What are the Key Drivers of Growth? What is the Category Growth ? What Macro Variables Affect the Sector? Are There Sector and Company Specific Risks? What is the Geographic Scope? Does Scale Come into Play? 6

8 Financial Statement Overview
3/25/ :35 AM Financial Statement Overview 7

9 Financial Statement Overview
3/25/ :35 AM Financial Statement Overview Income Statement Analysis Revenues – Examine Growth Drivers Different for Every Industry Recurring vs Non Recurring Macro Drivers Example Cable Networks: Subscribers, Subscriber Fees and Advertising Example Hotels: Occupancy Rate, Price, RevPAR Gross Margin = Revenues – COGS Impacted by Material & Labor Costs Operating Margin/EBIT = GM – SG&A – D&A Impacted by All Operating Expenses/Run the Business EBITDA = EBIT + D&A 8

10 Financial Statement Overview
3/25/ :35 AM Financial Statement Overview Income Statement Continued Below Line Items Interest Expense/Income Minority Interests Non Consolidated Investments One Time, Non Recurring Items Taxes EPS Basic Fully Diluted – Options Included Operating EPS 9

11 Financial Statement Overview
3/25/ :35 AM Financial Statement Overview Watch for Earnings Inflation Quality of Operating Earnings is Critical! Analyze Earnings Release Carefully Remove Cheerleader Behavior Watch for: Depreciation and Amortization Corporate Expense Interest Expense Minority Interests Lower Share Count Unexpected Tax Rates Changes 10

12 Financial Statement Overview
3/25/ :35 AM Financial Statement Overview Balance Sheet – Understand Leverage Drivers Liquidity = Current Assets – Current Liabilities Inventories, Receivables, Payables, ST Debt Burn Rates LT Debt Analysis – Be Cognizant of Maturity Schedules Credit Crunch Could Impact Bank Rates Floating vs Fixed Cost of Debt Could Be Impacted By Ratios, Operations and Mkt Conditions Interest Rates Affect EPS Key Leverage Calculations Net Debt/EBITDA Interest Coverage = EBITDA/Interest Expense 11

13 Financial Statement Overview
3/25/ :35 AM Financial Statement Overview Cash Flow Statement – Direct Impact on Balance Sheet FCF = Net Income + Depreciation/Amortization - Changes in Working Capital and Capital Expenditures Capital Expenditures = Maintenance or New Investment Recurring vs Non Recurring Depreciation vs Capex The Cash Dilemma: What to Do? Management Needs a Well Thought Out Process for Assessing ROIC Stock Buyback is Easy Answer but is it Best? Buyback Often Signifies Slower Growth High Correlation Between Incremental ROIC and Multiples Common Stock or One-Time Special Dividend 12

14 Relative Equity Valuations
3/25/ :35 AM Relative Equity Valuations 13

15 Equity Valuations P/E Ratios EV/EBITDA FCF Sum of the Parts
3/25/ :35 AM Equity Valuations P/E Ratios EV/EBITDA FCF Sum of the Parts CBS: A Case Study 14

16 Valuation Equity Valuations Growth ROIC Diversification Leverage
3/25/ :35 AM Equity Valuations Growth ROIC Diversification Leverage Fundamentals Complexity Valuation 15

17 3/25/ :35 AM Equity Valuations Things to Think About: Think Before You Input; Watch for Straight Line Approach Fundamental Analysis Key …But Do Not Forget Technicals Keep Emotions Out of Equation; Let Data Speak Fighting Tides is Often a Lost Cause; Watch Valuation Trap Find a Catalyst or Unlock the Value Keep it Simple; Do Not Over Analyze 16

18 Equity Valuations Define Companies in Universe
3/25/ :35 AM Equity Valuations Relative Valuation Define Companies in Universe Understand Drivers of Business Model Analyze Prospects for Growth Financial Strength/Flexibility Other Industry/Company Specific Dynamics Economic/Macro Product Risks Sales Concentration Risk Political Risk Management Return on Invested Capital 17

19 Equity Valuations Earnings Drivers Vary By Industry
3/25/ :35 AM Equity Valuations Understand Industry Drivers Earnings Drivers Vary By Industry Retail – Comp Sales, Square Footage Growth Media – Advertising Banks – Asset Quality Energy – Commodity Prices Industrial – GDP Technology – Supply/Demand Cycle Healthcare – Regulatory 18

20 Equity Valuations Bankruptcy Risk Chapter 11 and Chapter 7
3/25/ :35 AM Equity Valuations Excess Leverage Could Impact Valuation Bankruptcy Risk Chapter 11 and Chapter 7 Decreases Financial Flexibility Shareholder Value M&A Higher Borrowing Costs Equates to Lower Net Margins Limits Reinvestment; Creates Asset Drain Key Ratios Net Debt/EBITDA Interest Coverage = EBITDA/Interest Expense Dependent on Industry Dynamics – Cyclical vs. Stable 19

21 Equity Valuations Absolute Relative PEG
3/25/ :35 AM Equity Valuations Price/Earnings Absolute Relative PEG TTM Versus Forward -- Must Normalize for One Time Items Normalized Earnings Fully Diluted Variables Growth – Projected and Historical Industry/Sector Trading Liquidity Management Debt Complexity: Structure, Financing, Accting, Businesses, Control, 10k Thickness 20

22 3/25/ :35 AM Equity Valuations EV/EBITDA EV = MV of EQ + Debt – Cash – Non Consolidated Assets (Hidden Assets) EBITDA = Earnings Before Int., Taxes and Depreciation Variables Debt Levels/Balance Sheet Growth – Projected and Historical Industry/Sector/Risks Capital Intensity of Sector/Amount of Reinvestment FCF Complexity 21

23 Equity Valuations FCF = Net Income +Depreciation/Amortization -
Free Cash Flow FCF = Net Income +Depreciation/Amortization - Changes in Working Capital and Capital Expenditures FCF Used to Determine Cash on Cash Returns Cleaner than EPS/Measures Cash Creation Uses Reinvestment/Acquisitions Debt Reduction/Stock Repurchase Dividends – One Time or Annual Key Calculations FCF Yield = FCFPS / Stock Price FCF Conversion = FCF / EBITDA 22

24 Equity Valuations Break Up Value of the Company
3/25/ :35 AM Equity Valuations Sum of the Parts Break Up Value of the Company Used in Complex Multi-Industry Situations Accounts for Non Consolidated Assets Assists in Measuring Franchise and Brand Value 23

25 Equity Valuations Sum Of the Parts Example: AOL Time Warner 24

26 Equity Valuations Back Drop: Spin Off From Viacom Mature Assets
3/25/ :35 AM Equity Valuations CBS: A Case Study Back Drop: Spin Off From Viacom Mature Assets High Free Cash Flow Strong Balance Sheet Complex Asset How to Value? 25

27 Equity Valuations Determine Universe Examine Business Composition
Where Do We Start? Determine Universe Examine Business Composition Analyze Growth Prospects Are there Company Specific Risks? Industry? What is the View of Management? Should Brand Value be Taken into Consideration? How Does the Economic Outlook Impact Fundamentals? Is there a Dividend or Other Means to Enhance Shareholder Value? How Does Leverage/FCF Compare to Peers? Complexity/Accounting Concerns 26

28 Equity Valuations Valuation Screens Often Precede Fundamental Analysis
Concluding Comments Valuation Screens Often Precede Fundamental Analysis More Than One Methodology Usually Required Relative Valuation Methods Vary by Sector Stocks are Sometimes Cheap for a Reason Sector Driven Management Track Record Product Pipeline Combining Fundamentals with Valuation Helps Minimize Risk Good Companies Make Great Investments Bad Companies Make Poor Stocks 27

29 Markets are Inefficient….
3/25/ :35 AM Concluding Comments Markets are Inefficient…. Valuation is a Key Investment Tool! 28

30 Follow-up Reading/Courses
3/25/ :35 AM Follow-up Reading/Courses Graham & Dodd Security Analysis The Bible! You Can Be A Stock Market Genius, Joel Greenblatt Stocks for the Long Run, Jeremy Siegel Investment Valuation: Tools and Techniques, Professor Aswath Damordaran Think About Taking CFA 29

31 3/25/ :35 AM Appendix 30

32 Appendix Consumer Discretionary & Staples Energy Financials
3/25/ :35 AM Appendix Consumer Discretionary & Staples Energy Financials Health Care Industrials & Materials Info Tech Media Telecom Utilities Strategy / Converts 31

33 Consumer Discretionary & Staples
Consumer spending as a share of GDP is on the rise and near 70% Trend towards more durable goods purchases; sourcing is more global Consumer credit up-cycles last 34 months on average Huge diversity in consumer proto-types Income trends impact decisions Inflation 32

34 Consumer: Retail Very low margins and few barriers to entry
Keeping customers from competing stores is a huge challenge, long-term Unique products are hard to keep unique; so low price model often wins out Category killers (HD, LOW, ODP, SPLS, WMT) achieve economies of scale in traditionally mom and pop or regional businesses. Move off the mall trend has hurt the traditional anchor tenants – duel income families don’t have time to find selection, quality, and reasonable prices at different places. They go where they get it all and get it fast (WMT, TGT, KSS) 33

35 Things to Watch and Monitor
Same store sales comps – investors often over-react to one month’s bad comps Sales per square foot and inventory trends Valuation and macro trends since the strongest models are well known Most have little debt on the BS but be mindful of off-BS obligations (leases) Employee moral and culture (PT vs. FT workers) – they interface with shoppers Cash conversion cycle trends: days inventory + days receivable – days payable On-line competition 34

36 Consumer: Consumer Goods
Slow growth but very profitable, steady performers Scalable models Old, already largely consolidated industries Market share wars common (Coke vs. Pepsi) New products differentiate growth trajectory (Gillette Sensor and Mach 3 Razor) Growth by acquisition Defensive investments 35

37 Things to Watch and Monitor
Slow growth means the focus is on costs and quality of acquisitions Slow growth means international sales (and currency trends) are very important Valuation and FCF Use of enormous CF – dividends and share repurchases Economies of mass scale Recurring charges after acquisitions Branding – is it being supported with adequate advertising? Increasing power of key retailers (WMT) Litigation risk – tobacco and high fat products 36

38 Energy Mature industries; high CF
Two thirds of the world’s energy is oil and gas Two thirds of known oil reserves are in the Middle East The U.S. imports 60% of the oil it uses Each $10 per barrel change in oil = 0.4% change in U.S. GDP Each $10 per barrel change in oil = 3.2% change in S&P 500 EPS Exploration and Production (E&P) firms are “upstream” Refineries are “downstream” The “upstream” is more profitable than the “downstream” because OPEC maintains oil pricing way above production costs 37

39 Things to Watch and Monitor
Use of CF – dividends and share repurchases Reserve replacement ratio > 1.0 For Servicers & Drillers – Trend towards deep-depth drilling should help an industry that has barely earned its COC over time Higher oil prices help E&P firms/hurt Refiners Lower oil prices help Refiners/hurt E&P firms Higher oil prices help overall industry profits Risks: OPEC losing its influence, regional instability, Russian supply, and new fuels down the road (nothing on the radar screen) 38

40 Financials Growing share of U.S. profits
Share of S&P 500 index (22%) where past sectors have hit the wall Benefits from more trade, longer lives, older populations, and rising affluence Has exposure to world growth no matter which sectors generate it Vital and strategic part of any developed economy for liquidity and capital 39

41 Financials: Banks Extremely capital intensive
Regional oligopolies; high switching costs Not as rate sensitive as they used to be years ago Net interest income (loan rates higher than deposit rates) Non-interest income (fees) – depositors literally pay banks for liquidity Huge, diverse loan portfolios reduce risk and enable lower capital costs FDIC guarantees over half the industry’s liabilities Key strategies include global reach (C), national reach (BAC), attracting cheap deposits (WFC), right side of balance sheet focus (FITB), and location and customer service (CBH) 40

42 Things to Watch and Monitor
Strong asset base: equity–to-assets ratio of 8-9% (the level varies) High levels of loss reserves relative to nonperforming loans ROEs of 14-20% (if its much higher, double-check the loss reserves) ROAs of % or better Since bank assets are financial and liquid, P/B is the most common valuation metric and a ratio under often projects good value for a strong large bank ROIC analysis is preferred because banks can quickly change their balance sheets, and this analysis is only published by Lehman Brothers, Inc. at present DCF analysis is also preferred to P/B and is available at Lehman Brothers, Inc. 41

43 Things to Watch and Monitor (Continued)
Lending profitability: net interest margins of 3-4%: high end when rates are low and low end when rates are high Fee income share of revenues and fee income growth trends Efficiency ratios of 55% or less (operating costs as a share of revenues) Credit quality: BS, loan categories, nonperforming loan and charge-off trends Risk: almost everything known about credit quality is after the fact, sometimes fast growth signals riskier lending standards Portfolio diversity Aggressive collection procedures Asset (loans) sensitivity in a rising rate environment is preferred; liability (deposit) sensitivity in a falling rate environment is preferred 42

44 Financials: Asset Managers
Wide margins and excellent economies of scale Stock prices reflect market optimism or pessimism (pays to be contrarians) The most valuable assets are the PMs Diversity of assets and products helps weather various market cycles and allows asset rotation to stick within the firm Assets held in tax deferred portfolios are sticky assets Reputation and regulatory risk 43

45 Things to Watch and Monitor
Assets under management (AUM) = cash flow Stocks have higher fees than bonds; bonds have higher fees than cash Inflows in a variety of market environments 44

46 Financials: Asset Services (Custody)
High barriers to entry; size begets more clients Lower fees and more economies of scale than Asset Managers Frequently outsourced by Asset Managers Typically offers performance analysis analytics, pension consulting, etc. 45

47 Things to Watch and Monitor
Assets under management (AUM) Economies of scale have lead to consolidation Generous lending to custody clients (BONY loans to Telecom and Cable in 90s) 46

48 Financials: Life Insurance
Mature, slow growth industry with easy to substitute products Thin margin between ROE and cost of equity Best to adopt a value approach investing in these stocks Regulatory and huge capital requirements are only real barriers to entry Complex products and financial statements Takes many years to know if a policy was priced correctly Claims normally 75% of premiums Extensive distribution system is a core asset; so biggest firms have an edge Net income tends to revert to the mean over time, although investment returns can vary greatly one year to the next 47

49 Things to Watch and Monitor
Near industry premium growth is preferred, as this is an industry where under-pricing risk to increase sales is bound to fail Credit rating (AA or better) – people want to know their insurer will be around Diverse investment portfolio and risk management culture (low junk bond to tangible equity or total assets ratios) Since there is little detail on actuarial assumptions and returns are hard to predict, tangible book value ex-marked-to-market gains or losses on available for sale securities from shareholder’s equity (in the 10-K) is an important metric 48

50 Financials: Property & Casualty Insurance
Commodity business Thin net margins; low ROEs Low levels of pricing power; very hard to predict costs Claims normally 70% of premiums They invest the float (premiums received long in advance of paying claims) Good management can often play the insurance cycle and acquire poor performers when they are very cheap and turn them around 49

51 Things to Watch and Monitor
Make sure management has some skin in the game (owns part of firm) Combined ratio is the key profit measure, less than 100 means profitability Firms with a combined ratio over 105 for more than a short while typically have trouble recouping their losses via investment earnings Unless Warren Buffet is the PM, look for a small equity share of investments Investment ratio + combined ratio = operating profit ratio 50

52 Things to Watch and Monitor (Continued)
Social trends: there has been a tendency for juries to award huge claims that were written years ago under more conservative judicial assumptions (Asbestos) Regulation: insurance rates are often approved on a state-by-state basis and are often required to insure less profitable customers without charging them higher premiums as compensation. In many states, insurers are required to fund the losses of competitors who become insolvent Voting mood: CA Prop 103, 20% cut in premiums. Customers can lobby states. Best to invest with a value approach 51

53 Health Care Strong growth characteristics: 9% of GDP in 1980 and 15% of GDP now $5,444 per capita spending in 2002 in US, 50% higher than next closest country 60% of elderly in bottom 2 income quintiles; 75% of uninsured live in households of $50k or more in annual income Aging population, longer life spans, desire to be active and healthy later into life High barriers to entry: high start-up costs, patent protections, significant product differentiation, economies of scale, long drug development cycle Intangibles: provider networks, clinical track records Pricing issues: costs paid by insurance plans limits consumer price sensitivity 52

54 Health Care: Pharma High margin, high FCF, near debt free, $500m and yrs to make a new drug Procedures are expensive and create demand for cheaper drug solutions. e.g. surgery vs. pill Many new drugs are evolutionary rather than revolutionary 53

55 Things to Watch and Monitor
ROICs – look for mid 20%+ Gross Margins – look for around 80% Net margins – look for 25-35% Focus on high FCF - needed to fund R&D Political pressures Pipeline –new drugs to offset looming patent expirations Preclinical Trails – focus on potential toxicity Phase I – focus on safety and efficacy Phase II – how well the drug works vs. what’s out there Phase III – most costly trial. Focus on efficacy. Blockbusters need to be bigger to create meaningful percentage growth Greater specificity of future drugs means smaller target population per drug 54

56 Health Care: Generics Excellent growth outlook: half of all scripts are generics and the share is rising Few pure plays After 180 day exclusivity the edge goes to the lowest cost producer 55

57 Things to Watch and Monitor
ROICs – look for around 10% Gross Margins – 40-50% Net margins – 15-20% 1st patent challenges Re-importation and foreign competition 56

58 Health Care: Biotech Diverse industry with value drivers varying widely by company Highly complex and evolving industry Leading edge of molecular biology, IT, mathematics, quantum physics, combinatorial chemistry, electronics and material science Drugs and bilogics with greater specificity of action vs. Pharma Biologic process (cellular and molecular) vs. chemical process of Pharma Many one drug or one technology companies; fewer well diversified product suites 57

59 Things to Watch and Monitor
High FCF and cash on BS – needed to fund R&D Research productivity versus financial discipline EPS and sales growth Relative Valuation – volatile swings between optimism and pessimism. Often pays to buy on big dips Script trends 10-Ks – often the best description of what’s going on Independent sales force – reduces dependence on partners Many late stage trials are the best assurance of forward growth 58

60 Health Care: Medical Devices
Excellent growth outlook – aging population that wants to be active High switch costs with Doctors; sales force often assists in surgery Switch costs lower with cardio devices than orthopedic devices Long clinical histories, patent protection, and economies of scale Patents protect devices and tools for their installation Most improvements are evolutionary rather than revolutionary 59

61 Things to Watch and Monitor
Product innovation and diversification (10-Ks best place to look) Strong margins and earnings trends Relative Valuation Excellent pricing power – Medicaid/Medicare reluctant to limit brand choices Legal strategies often used as a defensive tactic vs. competitors 60

62 Health Care: Health Insurance/Managed Care
Litigation risks and regulatory pressure reduce attractiveness Insurance companies run the risk of under-estimating health care costs Rising health care costs makes fee based businesses relatively more attractive, such as claims processing or network access 61

63 Things to Watch and Monitor
Medical loss ratios (medical costs paid/premium revenue) of 85% or less w/trend in right direction Minimal dual-options – more choice allows customers to shift costs based on asymmetric knowledge to the provider and creates more industry competition Exposure to government accounts – reimbursements generally lag health care inflation rates 62

64 Industrials & Materials
Classic old economy: materials, machinery, equipment, etc. Long established replacement cycles Highly cyclical Huge operating leverage Many have financing subs (GE, CAT) Exposure to defined benefit (DP) pensions and Asbestos 63

65 Industrials & Materials: Materials
Simple financial statements Limited top-line growth; poor ROICs Low-cost producer wins in most commodity products (AA) Investments in technology can lead to low-cost status (electric arc furnace in steel) Product innovation is still happening: AA is making lighter, stronger aluminum products. However, the return on R&D often goes to the users not the investors 64

66 Things to Watch and Monitor
Total asset turnover and fixed asset turnover Market share gains than come at the expense of asset turnover often signals ill-advised price cutting Cash conversion cycle trends: days inventory + days receivable – days payable Regular and growing dividends, which reduce some of the cyclicality inherent in these stocks Debt levels – due to the cyclicality of these companies Acquisitions – are tempting due to slow growth of industry; acquisition-associated charges often inflate future margins 65

67 Industrials & Materials: Industrials
Good companies in bad industries: MMM, UTX, PBI Finance subs are common: GE, CAT Low debt levels can make the difference in these very cyclical industries (DE survived the early 1980s farm recession) Sector also includes people-based service businesses: CD, APOL, RHI, MAN, MNST, etc. People-based services have more variable costs and are, thus, less attractive than technology or processing based services (see Information Technology section) 66

68 Things to Watch and Monitor
Total asset turnover and fixed asset turnover Market share gains than come at the expense of asset turnover often signals ill-advised price cutting Cash conversion cycle trends: days inventory + days receivable – days payable Regular and growing dividends Cost leadership Debt levels – due to the cyclicality of these companies Acquisitions – are tempting due to slow growth of industry; acquisition-associated charges often inflate future margins Organic growth, differentiation of services, and labor market trends in people-based businesses 67

69 Information Technology
Growing share of equipment and total capital spending IT spending is influenced by the incentive to substitute capital for labor Only true cyclical growth sector 64-bit generation of products in very early stages Most aggressive users of stock options as compensation Trend towards processing and technology-based outsourcing services 68

70 Information Technology: Software
Intense competition but high customer switching costs Huge economies of scale High FCF; high ROICs Simple financial statements Excellent growth prospects High labor costs encourage the use of software for time-consuming tasks Software helps companies grow in good times and cut costs in lean times, but it is highly cyclical and depends on IT spending Many types: operating systems, database, enterprise resource management, customer relationship management, security, video games, etc. Back-end loaded quarters with majority of revenue booked in final days are the norm and this raises the odds of having big surprises 69

71 Things to Watch and Monitor
Network effects – people will create documents or files and use software if they know the majority of PC users have the same software (Acrobat Reader, Excel) Branding –easier for small business or retail software (QuickBooks, TurboTax) Sales, EPS, and CF trends Expanding margins over time due to scalable models Large, stable installed client base 70

72 Things to Watch and Monitor (Continued)
License revenue best reflects current demand for products and leads service (less profitable) revenue Deferred revenue shows cash the company has received before it performs a service and is a good metric for gauging future revenue Days sales outstanding (DSO) – trend matters more than level Watch out when a firm changes its rules for revenue recognition Watch out when a vendor and customer simultaneously buy each others products They always look expensive 71

73 Information Technology: Hardware
Cost of computing and storage is going down Able to manufacture in low cost countries and sell in developed ones Highly cyclical industry Short product cycles, price competition, and technological advances make it hard to sustain the lead, so distribution channels, scale, and broad product lines are needed to establish a more secure position Key asset is the ability to innovate Switching costs are higher in telecom equipment Low cost model often wins Analog chips are highly proprietary and lack direct substitutes and work on temperature, weight, pressure, and sound rather than 0s and 1s 72

74 Things to Watch and Monitor
Network effects – hardware needs to run on an operating system and be maintained by people who must invest time to operate the product Market share Marketing focus Flexible models – since demand us so unpredictable Gross and net margins Intellectual property sales Best to invest with the cycle – very cyclical stocks often look rich near the trough and cheap near the peak on valuation metrics 73

75 IT Services B-to-B is growing faster than the overall economy
Outsourcing trend apt to continue Technology and data processing services can spread systems development costs over many firms Benefits from falling cost of technology Long-term contracts lead to recurring revenue Have earned above average returns Economies of scale prod acquisitions to achieve higher and higher levels of volume: ADP, FDC High barriers to entry 74

76 Things to Watch and Monitor
Services vary a lot by company Service differentiation – needed to protect sizable investments in software, hardware, and sales networks Sales, EPS, valuation 75

77 Media & Cable CDs, movies, and books generate one time transactions and are dependent on stars and authors; costs precede revenue Subscription-based models generate recurring revenue; revenues precede service costs Advertising models have high operating leverage Intangible assets: licenses, trademarks, copyrights, and brands. Few cities can support more than one newspaper Cable faces challenged from satellites teaming up with RBOCs 76

78 Things to Watch and Monitor
FCF margins of 7-10% Deregulation: has lessened competition in broadcasting Recurring capital investment to fend off competition Transforming mergers (AOL/Time Warner) Family run firms Complicated cross-ownership structures Ridiculous CEO compensation 77

79 Telecom Telecom looks nothing like it did 25 years ago and in another 25 years it will probably have little resemblance to what it looks like today Long distance deregulated in 1984: AT&T break-up Local deregulated in 1996: Telecom Act of 1996 allowed AT&T and WorldCom/MCI to lease networks at discounted rates Poor and declining ROICs; low asset turnover ratios Rural carriers least affected by deregulation Recurring expenditures and huge fixed costs to build a network Competition from cable and wireless networks Most of U.S. population has access to 1-2 local services 80% of U.S. population has access to 5 or more wireless carriers 78

80 Things to Watch and Monitor
ROICs – borrowing regulatory changes, firms may never earn their cost of capital again on long distance Churn – firms need recurring revenue to pay for network costs Operating margins of 20-30% - below this level makes it hard to provide customer service, maintain the network, and earn the cost of capital EBITDA margin trends – as a guide to cash generation for capital spending needs and the ability to service debt Operating CF – EBITDA can obscure accounts receivable Financial strength and flexibility to technological and regulatory change 79

81 Utilities Enormous operating and financial leverage
Utilities generate, transmit, and distribute power Generation has the lowest barriers to entry; distribution has the most (final mile of cable) Federal Energy Regulatory Commission (FERC) 1992 rule changes started the deregulation process Deregulation is furthest along in generation Most recent focus of deregulation has been access to the grid or transmission Northeast and Southwest are more deregulated than the Plans or Southeast states 80

82 Things to Watch and Monitor
Utilities are not the safe havens for widows and orphans they used to be Debt levels – given the turbulent regulatory environment. Utilities often have 45-55% debt-to-assets ratios Use of CF – dividends and share repurchases Northeast and Southwest are more deregulated than the Plans or Southeast states Changing regulatory landscapes Rate cases in a still low interest environment. Many % ROE situations could be reset to 9.5% or so 81

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