Wynn Resorts and Wynn Macau: a strong March 2010 quarter

the results

WYNN reported surprisingly good March quarter results after the market close yesterday.  Earnings per share were $.26 vs an analyst consensus of $.14 and a loss of $.27 a share in the year-ago period.  (Remember, I own both WYNN and 1128, Wynn Macau.)

The main reasons for the strong performance were a huge increase in table games revenue from Wynn Macau (coming from basically the same facilities as a year ago–the new Encore in Macau opened earlier this month); and, in Las Vegas, higher table games revenue and a rebound from last year’s abnormally low “win” percentage (amount retained by the casino per dollar bet) of 17.7% to 23.2% (21%-24% is normal).

While it’s striking that Wynn could post operating profit up 82% year on year from Macau, the firm’s performance is actually better than that.

For casinos that cater to typical bettors or that have a large percentage of slot machines (which may be the same thing said another way) individual wins and losses almost always even out during a quarter, so that the casino’s overall win percentage stays relatively steady.  Not so with casinos, like WYNN’s, that cater to high rollers.  Their individual customers can win or lose millions of dollars at the tables in a single night.  While clients’ “hot” or “cold” streaks even out over, say, a year, they can make a noticeable difference to quarterly results.  Win in the first three months of this year for Wynn Macau was 2.7% from its high roller VIP segment.  That’s at the low end of the normal range of 2.7% – 3.0%.   And it compares with a win percentage of 3.55% a year ago.  That may not sound like much, but it’s a 30% negative swing.

the numbers

Operating income from Wynn Macau was $125 million vs. $68.7 million a year ago.  Las Vegas had an operating loss of $34.5 million vs. a loss of $58.4 million in the opening quarter of 2009.

EBITDA (earnings before interest, tax and depreciation and amortization), which is basically the cash the properties generate from operations, was $181.6 million for Macau vs. $114.6 million.  It was  $60.3 million vs. $43.9 million for Las Vegas.  The main difference between EBITDA and operating earnings in Las Vegas is adding depreciation for the casinos back in.  For Macau, it’s depreciation plus management fees paid to WYNN.

From an operating earnings perspective, then, Wynn Macau now accounts for more than 100% of WYNN’s results.  Looking at EBITDA, Macau is “only” 75%.  As Steve Wynn has often said, WYNN is now a Chinese company.  In fact, WYNN is planning to move parts of its corporate headquarters to Macau when it completes an anticipated new resort in Cotai.  Assuming WYNN gets government permission, construction will begin in 2014.

Macau

It sounds like good news will continue to come for WYNN from the SAR.  For one thing, the win percentage from its VIP tables, which produce the vast majority of the company’s operating profit there, will likely return to normal.  For another, WYNN’s revenue per table is continuing to expand at a faster rate than the market’s–evidence that the WYNN high roller strategy is working in Macau.  Also, the newly-opened Encore will begin to make a contribution to results in the current quarter.

In addition, the government of Macau is determined to run a market that grows in an orderly–and profitable–manner.  It has already slowed down the pace of new construction–Encore got in just under the wire–and set a (low) limit on the total number of table games permitted in the market through the end of 2013.  And, when a bidding war began to break out a while ago over the fees paid to managers of high-roller junkets to Macau, the SAR stopped it by setting a legal cap on these payments.  All of these moves favor WYNN.

In a short –and sometimes slightly testy–conference call, Steve Wynn made an interesting comment about why he thinks the mass-market strategy in Macau will not be the best one.  In his view, China has 300 million affluent citizens that the central government wants to encourage to spend more.  The country also has a billion poorer citizens that it doesn’t want to see gambling their money away.  Therefore, a high-roller strategy is in line with what Beijing wants; a mass-market approach runs counter to government policy.

Las Vegas

In my experience, casino revenues in any market are a function of available market floor space and of the rate of GDP growth.  Las Vegas has just seen the last of a series of huge increases in floor space come on line in MGM’s CityCenter–whose novelty has taken customers, at least temporarily, from other casinos, including WYNN’s.   Although the worst is over on this front, it will take years for the market to absorb all the new floor space now in operation.  In addition, while GDP growth has resumed, the pace of advance is likely to continue to be slow.

My guess is that WYNN will continue to gain market share and steadily march back toward operating breakeven.  As smaller, less proficient and less well-capitalized competitors fall by the wayside, WYNN’s business in Las Vegas will also benefit.  The real question is how long this process will take.

An addendum, a couple of hours after I first published this:

How to value WYNN and 1128

A lot depends on how you allocate overheads, debt and the value of the brand name.  Here’s one approach:

From the minority interest line, we can see that 1128 earned HK$864 million in the quarter, or about HK$.17 a share.  I think HK$.80 is a reasonable guess for the full year, but HK$1 isn’t out of reach.  If we apply a 20x multiple to the HK$.80, that would mean a price of HK$16 by yearend.

That would make WYNN’s interest in 1128 worth about US$7.5 billion.

What do we say about the Las Vegas business, then?  My instinct would be to consider this on a cash generation basis, as if the company were split into two parts, one (Macau) for growth investors, the other (Las Vegas) for income investors. I think this produces a fairly conservative value.

Las Vegas generated about $60 million in cash flow this quarter.  Against that, let’s apply the interest expense for 3/4 of the overall company debt, or about $37 million (the rest is on the 1128 balance sheet). This leaves $23 million, or maybe $100 million for full-year 2010.  If we capitalized this flow at 6%, a low number but we’re also hopefully at a very low point for cash generation, that would yield a value of about $1.7 billion.

WYNN has about $2 billion in cash.

Add the three pieces up and we get about $11 billion, or about the current market cap.

In other words, assuming Macau perks along and Las Vegas stays at the status quo, WYNN is fairly valued now.

What could go right, in a way that would make this number too low?  1128 could earn HK$1 instead of HK$.80, which would raise our sum of the parts by about US$ 2 billion.  Or, Las Vegas operations could get better, faster than anticipated, either by the market starting to grow again or WYNN taking market share.

Either could happen.  I think the first is more probable, but the second would have more positive leverage on profits and would come as a bigger surprise.

Personally, I’m content to watch and wait–though my wife and I may donate some stock we bought a year ago to charity.


Surveys (I): general

In my post of two days ago, I referenced an academic article based on an internet survey conducted by three professors.  In this post, I want to write about the quirks of internet surveying, as far as I know them.  Internet surveying is in its infancy, however, and, as I see it, most of the craft skill involved in it is still kept as trade secrets in the firms doing this cutting-edge survey work.

(My own experience with surveying comes from a couple of years I spent as an business school adjunct, working on a course whose heart was traditional and internet surveying.  I was lucky enough to work with colleagues had many years of practical experience in surveying, so I learned a lot. Unfortunately, that’s all in the past.  From an academic point of view, my area–although very popular with students–had several defects:

–we had on average maybe twenty years of actual business experience

–we did more teaching (for much less money) than tenured professors

–we were unique in producing an operating profit for a business school awash in a sea of red ink.

What happened?  As a “cost-cutting” measure, the school discontinued the program and laid us all off.)

Anyway, I think the best way to understand internet surveying is to contrast it with traditional surveying, done through the mail, by phone or in-person interviews.  A thumbnail sketch of the latter is what I’m going to write about in this post.  Tomorrow’s will talk about the internet.  Here goes:

traditional surveys

Traditional surveying is a little more than a century old.  Its model is the government census that countries periodically perform, although surveyers rapidly expanded its use into such diverse areas as political polling, including election-day exit polls, and divining consumer attitudes, either consumers’ general frame of mind, or the attributes of specific products they like and dislike.

Researchers assume, with a lot of historical justification, that standard statistical methods can be used to draw reliable quantitative conclusions about the data.

their structure

Every survey starts with information that the surveyer wants to find out about a target population.  Let’s say the trade association for American cereal manufacturers wants to know what people eat for breakfast in the US and how it might get non-cereal eaters to switch to cereal.

There’s a whole subsector of the surveying industry whose job is to turn that desire for information into a specific survey instrument, whose questions are designed to get the required information.  A lot of effort will go into designing questions that minimize the chances that the respondent will misunderstand them, and crafting answer choices that minimize the possibility that the respondent ends up picking the wrong choice by mistake.

Tons of research has been complied over the years, a lot of it the result of trial and error, about how to do this.  There’s even more about how to follow up and how to persuade people to become respondents.

There are many tricks of the trade.  Other than to point out that sometimes small changes to a question’s phrasing or to a survey’s layout on paper can make a big difference to the answers respondents give, I’m going to skip over this.

steps in conducting the survey

target population

In the cereal survey I mentioned above, the target population is everybody in the US.  But, as the periodic government censuses show, even the government isn’t going to get to communicate with everybody.  And who else has the money to try?

sampling frame

Even the government has to select a sampling frame, that is, a collection of members of the target population who actually have a chance of being surveyed.  Our cereal trade group might decide, for example, that it will take the set of people who are listed in all the telephone books in the US as its sampling frame.  Or it could take the set of all people with street addresses.  Or, at the other end of the spectrum, it could decide to purchase the one-time use of the contact lists of a number of newspapers and magazines.

Clearly, the sampling frame and the target population are not the same thing.  Squatters or migrant workers probably won’t have street addresses.  A potentially more serious problem, a large percentage of Americans under thirty don’t have fixed-line phones, but use cellphones instead.  Among the complications with this group, interviewers are legally barred from using computer dialing machines to access cellphones.  And many people aren’t happy about interviewers using up their minutes.  There are workarounds, but for how long?

The selection of the frame is obviously also bound up with the type of survey you decide to do.  If it’s a phone survey, you’ll only be able to contact people with phones that work–most likely landlines.  If it’s a mail survey, you’re limited to the names and addresses you have access to.

The potential mismatch between the target population and the set of people you can actually reach with a survey instrument is called coverage error. It’s becoming an ever bigger issue, I think.

sample

Let’s say the cereal group decides to do a telephone survey and has access to a database with 50 million phone numbers.  Instead of calling everyone, it will select a random sample from the 50 million.  The sample size can be quite small, say, a thousand or two numbers.  There are well-established conventions for selecting the sample–that dictate the minimum size and govern now the individual numbers are picked (usually computer-generated, and checked against phone databases).

respondents

Not everyone in the sample will respond.  Non-response comes in two flavors:  a refusal to answer a specific question or a refusal to answer the entire survey.  Non-response rates are the lowest for face-to-face interviews, which are also by far the most expensive to administer.  They are higher for telephone interviews and the highest for survey instruments sent through the mail.

Men tend to decline to answer more frequently than women.  City dwellers decline more often than their country cousins.  For many populations, a request from a university or from the government yields higher response rates.

Non-response rates have been steadily rising over the years, however.  In fact, response rates for very recent mail surveys may be as low as 1% or 2%.  Response rates for phone interviews may be 25%-30%.

Nonresponse error is an increasingly serious problem.  If response rates are low, say 10% or 20% (and even these levels may be hard to achieve), you have to at least worry that only the lunatic fringe has responded to your survey and their responses are in no way indicative of what the sample as a whole is thinking. Traditionally, this is the single biggest headache for surveyers.

post-survey adjustments

Statisticians may adjust the actual responses to make them more meaningful, in either of two ways:

–if a respondent hasn’t answered a particular question, like family income, an estimate based on past experience may be substituted, and

–the survey may be reweighted to adjust for known differences in sub-group response rates, such as the tendency for urban response rates to be lower than rural ones.

Three types of traditional survey

mail

The greatest bulk of past research work has been done for mail surveys.  Respondents have historically been more truthful in mail surveys than in phone or person-to-person interviews.  But partly because of changes in the way people communicate with each other in the post-internet world, partly because junk mail companies have become increasingly clever in disguising their offerings as “legitimate” mail, response rates have dropped to very low levels.

Paper surveys are a thing of the past for everyone except the government.

phone

Historically, other than the issue of higher cost, the biggest risk with phone surveys is that people tend to be less than truthful.  For example, if the interviewer asks for the head of the household, the person who answers the phone is likely to say he/she is that person, whether this is true or not.  Also, interviewees tend not to give answers they regard as socially unacceptable.

In today’s world, however, the overwhelming problem with phone interviews is the inability to reach cellphone-armed twenty-and thirty-somethings, as well as households that have switched to cable or other phone providers.

For political polls, this may not be a burning issue, since younger people tend to vote less than older citizens.  There’s also some evidence that young landline users, in political polls anyway, may be an adequate substitute for their untethered peers.

But it would be one for our cereal trade group.

in person

This gathers the most information, but it’s expensive and time-consuming.  It’s harder to train and supervise face-to-face interviewers than telephone workers.  And computer dialing machines can let a phone interviewer race from number to number, while an in-person interviewer has a lot of transit time getting from one interview to the next.

summary

That’s the traditional survey world.  Statistically valid conclusions drawn from data derived from surveying small samples of target frames that most of the time pretty accurately represent the target population.  Going on for over a century, most of the kinks have been worked out.

Two problem areas:  declining response rates across all survey types, and, in the case of phone surveys, the worry that the target frame of landline users, the meat and potatoes of this kind of survey, may not accurately represent the underlying population, which includes a growing number of cellphone-only people as well.

That’s it for now.  Internet surveying tomorrow.


tax rate, earnings per share, dividends and cash…: (II)

lots of cash

A few days ago the Financial Times ran an article pointing out the huge amounts of cash that IT companies have been piling up over the past year.  According to the newspaper, the top ten public firms in technology have added $65 billion to their cash holdings since the market bottom last March.  Together they have about a quarter-trillion dollars on their balance sheets.  The FT points to the lack of anticipated merger and acquisition activity (anti-trust?) as one reason for the accumulation, and suggests that the industry will soon begin to buy back shares to reduce the size of their holdings.

Not all the big ten are as flush as the FT makes them seem, however.  EMC, IBM and ORCL have long-term debt that pretty much offsets the cash they have.  DELL, and to a lesser extent, AMZN, are negative working capital companies.  That is, they collect money from their customers before they have to pay their suppliers.  So they enjoy a kind of “float,” the same way that a restaurant or a hotel does.  There is at least some risk to the cash that appears on the balance sheet for this reason.  If the business slows, the cash begins to disappear as suppliers are paid.

Nevertheless, there are a number of tech firms with staggering amounts of cash and little or no debt.  They include:  AAPL, GOOG, INTC, MSFT and QCOM.

an important question:  where is the money?

As I suggested in yesterday’s post, at least some of the cash is overseas.  How much, no outside observer knows.

Oddly, as I was researching the 2004 amnesty that allowed firms to repatriate money to the US without paying much tax, I found an article that suggests that six years ago, some of the companies themselves, despite their financial control software, didn’t know where the money was, either.  And some had to postpone repatriation while they upgraded their treasury departments to create a mechanism to start the process and handle the incoming money.

Would companies like another amnesty?  An academic study that I also cited yesterday suggests they would.  Professors from Duke, Michigan and Washington conducted an internet survey on this topic.  Two-thirds of respondents said they would like a repeat of the 2004 amnesty.  The median amount anticipated to be repatriated was half of current foreign cash holdings.  Most of the money sent to headquarters would come from cash balances, though some would come from added foreign borrowing. (In the next few days, I’ll post on the limits to the confidence one can have in surveying in today’s world, and in internet surveying in particular.)

Other academic research suggests that the requirement to pay income tax on repatriated earnings does motivate companies to keep large foreign balances, and even to invest the funds in projects that will not be as lucrative as competing investments in the US.

stock buybacks

I’m not a big fan.  Maybe it’s age, but I’d prefer dividend increases.  It may be more tax efficient to buy back stock.  My objection, though, is I think every company has a compensation plan that features a policy of shifting a set percentage, say, 1% a year (but a lot more for small, fast-growing firms), of the ownership of the enterprise away from its shareholders and to its management.  I’m not sure the ordinary shareholder realizes this.  And it seems to me that most stock buyback plans retire just enough stock to offset dilution from stock options–thereby keeping this part of the compensation process from becoming evident through an ever-increasing share count.

looking at the numbers

The table below lists the big tech companies with the largest amounts of net cash (= cash and marketable securities minus long-term debt).  Although, as I mentioned above, there’s no good way to tell the location of a company’s cash, the lower the tax rate the more foreign earnings–and, I think, the larger the amount of cash parked abroad.  Note that I didn’t factor in long-term investment securities.  (You have to draw the line somewhere, and I decided I wasn’t comfortable deciding about the liquidity of firms’ non-current investments.)  You may want to do this differently, and the company financials are easily available on the Edgar site.

I also show the dividend yield, if any.  The following column shows dividend payments as a percentage of free cash flow ( = cash flow minus capital spending needs).  It gives mostly “negative” information.  That is, if the percentage is high, the company has little scope to increase the dividend, or even support the current payout in bad times.  A low percentage would be a good thing for dividend seekers, if we knew the location of the cash–i.e., whether the cash is available to be paid out.

The next-to-last column shows the stock’s pe based on consensus estimates of earnings to be reported in calendar 2010.  The final column shows what the pe would be if all the foreign-generated cash were to be repatriated and tax paid in the US.

—–stock price–cash/share—–tax rate——-divd—–divd/fcf—–pe—-pe”normal”tax

AAPL      $262            $27           27%        none         n/a           19x             21x

CSCO      $27.01        $4.20        19%         none        n/a           19x             24x

GOOG      $529           $78          22%         none        n/a            21x            25x

INTC        $23.35        $2.50        30%         2.9%      35%         12.6x         13.6x

MSFT      $30.84        $3.70       26%         1.7%       33%            14x            16x

QCOM     $37.92        $7.15        17%         2.0%      38%           18x            23x

my observations

1.  The absolute amounts of cash are huge.  They were astoundingly high percentages of the firms’ stock market capitalizations at the market bottom.  But they no longer are big enough to be a primary feature of the stocks as investments, in my opinion.

2.  The group divides into two camps:  fast growers–AAPL and GOOG; and more mature companies–INTC, MSFT and QCOM.    QCOM is somewhat of an anomaly.  The other stocks declare their growth characteristics through their pes and the presence/absence of a dividend.  QCOM hasn’t expanded much during the last half-decade and pays a dividend, yet has a higher pe than either INTC or MSFT.  This is probably due to its smaller size and its focus on mobile.

3.  GOOG seems to still be a more expensive stock than AAPL, despite the year-to-date outperformance of the latter over the former by about 40 percentage points.  AAPL’s pe is lower and its growth rate higher.  GOOG’s lower tax rate suggests more earning power outside the US, but also the potential issue (perhaps non-issue to everyone except me) of tapping overseas cash.

4.  The INTC/MSFT comparison is also interesting.  They are the two stalwarts of the “Wintel alliance” of the pc era, one the hardware genius, the other the software guru.  The market worries that time has passed both firms by.

INTC has a higher dividend yield and a lower pe, which I think expresses the market’s logical preference for a software company over its more capital-intensive hardware analogue.  Wall Street also believes, I think, that MSFT has an easier migration path away from the pc to more compact internet-centric devices than INTC, which has an obvious rival in ARM Holdings plc.  On the other hand, (I think) INTC has a much stronger management than MSFT.

INTC is paying a higher portion of its free cash flow in dividends than MSFT is, but the difference is slight.  INTC also has a much higher tax rate, indicating higher potential to tap offshore cash.

I don’t own either.  If I had to buy one, I’d pick INTC–but I would also watch very closely developments with the company’s Atom chip line and how it is faring against ARM offerings.

tax rate, earnings per share, dividends and cash on the balance sheet: (I)

In writing about tech companies like INTC and AAPL, I’ve been struck by the large amount of cash these firms, virtually debt-free, have on their balance sheets.  I’ve also been surprised–even though I knew in general terms it was the case–how little of their profits are now coming from the US.  (True, some companies like INTC make components in the US that they ship abroad to device manufacturers who sell their finished products back to US customers.  So what appears as foreign revenue to INTC is actually a function of domestic demand.  But this is not as big a phenomenon as it was, say, ten years ago.)

That got me thinking about the four items listed in the title above, taxes, eps, dividends and cash–because they’re all interconnected.

tax rate

One salient feature of today’s stock markets worldwide is that investors seem to me to care only about after-tax earnings per share.  They have no interest in the rate at which those earnings have been taxed.

Hasn’t it always been like this?  No.  When I came to Wall Street in the late Seventies, analysts routinely noted in their reports if a firm’s tax rate was below the statutory norm in the US.  Also, when thinking about price earnings ratios investors mentally adjusted earnings to what they would be if fully taxed.

When I first saw UK research in the mid-Eighties, I was surprised to see that the historical income statement series in them always featured earnings “normalized” to the statutory tax rate in the home country of the firm, not the (almost always lower) actual tax rate paid.  Analysts only went to the trouble of doing this because the normalized figures were the ones their customers wanted to see.

What made it this way?

1.  Different times, different customs.

2.  UK investors then were intensely focused on a company’s dividend-paying power (more about this below).  In my experience Wall Street has never been anywhere near as concerned about dividends as the British, but a generation ago it was certainly much more interested in income than it is today.

3.  Investors believed–incorrectly, as it turns out–that a low tax rate was a temporary phenomenon, something like earnings growth achieved through cost-cutting, that should be factored out of the profits being capitalized (a fancy term for having a pe applied to them to determine a stock price).

foreign earnings and dividends

Take a US firm (really any firm with a high home country tax rate) that makes money in a low tax rate country abroad and repatriates the funds to the US.  When it does so, it owes Federal tax at 35% on the money, less a credit for any tax paid overseas.

This may entail a substantial haircut to the funds brought back to the home country.  For example, if $3 in profits have been taxed at 0% in Hong Kong, when the money is brought back to the US, the company is left with $1.95.  (What about state taxes?–companies routinely repatriate through states like Nevada that have no income tax.)

But any money used to pay a dividend to US shareholders has got to be in dollars at a US financial institution (ever tried to cash a foreign-currency check at a local bank?).  In other words, the money has to either result from profits earned in the US or to have been repatriated, and given a potential buzz cut.

So, if you’re principally interested in dividends, a low tax rate may be a warning sign.

the 2004 amnesty

Then there’s the amnesty question.

Normally, in order not to return foreign earnings to the US, corporations have to tell the IRS that the money is permanently invested abroad (Citigroup’s “Doomsday” plan [my name] to use up its tax loss carryforwards is to reclassify many billions of dollars of foreign profits now classified as permanently invested abroad and temporarily return them to the US–see my posts on Citi and Mike Mayo).

In 2004, however, as part of the American Jobs Creation Act, Congress declared a temporary exclusion of 85% of the tax due on repatriated earnings, as a way of stimulating economic growth here.  Stimulative or not, a ton of money was brought back from abroad, presumably because it was only taxed at 5.25%.

From time to time, the topic is brought up again.  One of the main counterarguments is that if we make a habit of periodic amnesties, firms will simply wait and never repatriate anything.  They’ll even borrow to fund spending plans here.  But they do this anyway (support is buried in this very interesting academic paper).

foreign earnings and eps growth

Given the maturity of the US and western European economies, as well as the severe body blow that the big banks have delivered to them through the financial crisis, it seems to me that the more exposure an investor has to emerging markets (subject to the amount of risk your financial situation and your blood pressure allow) the better.  So what follows is not a knock on having money in Latin America or the Pacific.

For many people, the best way to do this will be to own US-based multinationals, ranging from AAPL and AMZN to MSFT and INTC.  If so, it’s important to keep in mind that there’s a certain “phantom” aspect to the rate of earnings growth these companies are achieving.  This is not a key investment consideration today, just something to keep in the back of your mind.

an example

Let’s take a company that earns $400 pre-tax, all in the US, and taxed at 35%.  After-tax income is $260.

Assume that some years later the same company still earns $400 pre-tax, but that half of that profit is recognized in Hong Kong.  What is the net?  $200 x. 65 = $130 (the US portion)   +    $200 x 1.0 = $200 (the HK portion), which equals $330.

The second number is 27% higher than the first.  If the transition happened over 10 years, that would be an addition of 2% to the annual growth rate.  That’s probably not so important.  But, if for some reason the company had to repatriate its current and future Hong Kong earnings, that would effectively be about a 22% drop in the level of eps.  That would be.

It seems unlikely to me that external events would force a firm to repatriate foreign earnings.  More plausible is the possibility that as the Baby Boom ages, dividends will once again become important to investors (I think this is already starting to happen) and that they would therefore begin again to mentally decrease the pe multiple they would pay for unrepatriated profits.

That’s it for today.  The rest tomorrow.


A Goldman Sachs mistake?

the Goldman press release

In a press release dated April 16 2010, Goldman made “further comments” on the SEC fraud complaint arising from an Abacus derivative transaction.  The first of four “critical points” made in the release is:

“• Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90 million.  Our fee was $15 million.  We were subject to losses and we did not structure a portfolio that was designed to lose money.”

What are we supposed to make out of this statement?  At first blush, the meaning appears very straightforward.  Goldman thought this was a good deal, invested its own money in it expecting a profit and lost a large amount instead.

The New York Times commentary

New York Times ran a subsequent story about the transaction in question, in which it asserts that:

1.  Goldman never intended to participate in the transaction and did so only when the buyer of a portion of the deal backed out at the last minute;

2.  Goldman tried to sell this piece of the deal but was unsuccessful;

3.  The Times implies, but doesn’t state outright, that Goldman then neutralized its Abacus position by establishing an opposite position as a hedge, with the result that the money Goldman lost on Abacus was offset by gains on hedging.

Assuming the Times story is true–and doesn’t seem to have been retracted–the real state of affairs appears somewhat different from what the press release contends.

conversational context counts

Consider the following situation:

A man who’s an inveterate, and always losing, gambler takes part in a card game in which he loses $5,000.  He goes home and his spouse, seeing his downcast face, asks him how much he lost this time.  His reply:  “$10.”

What should we make out of that statement?

The short answer is, “It depends.”

The statement itself is factually correct.  The man did lose $10.  In one way of looking at it, the statement is just incomplete.

Lots of factors can make a difference in what’s being communicated, like body language, tone of voice, prior conversations of the same type.  But the one I want to focus on is the relationship between the two speakers.

In this case, the speaker is talking with his spouse, with whom he presumably has a relationship of open communication and trust.  Does he have an implied obligation to give a full and complete account, or is it ok to give the partial and potentially misleading one he renders?

I think that if the questioner were a friend at work or a nosy neighbor, the “$10.” answer would be ok.  But I think the spouse is entitled to the full story.  In this case, the “$10.” answer is inappropriate.

back to Goldman

Among the rituals in the give and take between publicly traded companies and professional securities analysts, one is that a company can’t answer a question with a factually incorrect statement.  But if it doesn’t really want to give out the information, it can give an incomplete response.  The unwritten “rules” of the game say it’s the questioner’s job to realize this possibility and ask a follow-up question.  If the questioner doesn’t and ends up forming the wrong conclusions, it’s the questioner’s fault for not being skillful enough to pin the company down, not the company’s.

In dealing with securities analysts (and, I suspect, with lawyers) , a Goldman answer of “$10.” would be perfectly fine.  I think that’s what he company has done in its press release.

I think the general public, on the other hand, regards itself as more like the loving spouse who is in a relationship of trust and expects a full and complete account.  Rather than looking at the Goldman press release and the subsequent NYT article and admiring Goldman for having made an elegant and artful statement about its Abacus situation, it’s easily possible the public won’t approve.  If so, and if this indictment is mostly about politics, Goldman itself may be helping to make the SEC’s case.




MSFT’s March 2010 quarter

MSFT reported its fiscal third (ending 31 March) quarter earnings results on April 22.  This is what I thought was interesting from the numbers themselves and the related company conference call.

the results

Revenue, factoring back in sales that are deferred under GAAP, was up 8% year over year.   Operating earnings were up 17%.  The operating leverage is due partly to the fact that incremental copies of software cost virtually nothing to make, and are therefore almost pure profit.  It also comes from continuing strong cost control.

Operating income benefitted a bit from the absence of severance charges ($290 million in the year-ago quarter), but that was offset by higher legal expense and the costs from the search agreement recently concluded with Yahoo and okayed by government regulators in February.

Net income was up by a much larger percentage, around 36%.  Although MSFT didn’t highlight this on the call, the most important reason the number was in the thirties rather than the teens was a $589 million swing from loss a year ago to profit this March on selling investment securities.  A lower tax rate helped a bit as well.

the reasons

Windows 7 adoption has been the fastest of any Microsoft OS, with 10% of personal computers worldwide now running it. (As a frustrated former Vista user writing this on a Mac, I’m tempted to analyze this as more a comment on Vista than on Windows 7.  But I have to acknowledge that W7 seems to have stemmed customer defections.  So it must be good.)

Sales in emerging markets were up by 20%+ year on year, with sales in developed markets advancing around 5%.  MSFT has begun to notice small- and medium-sized businesses upgrading their software, with revenues in this segment up 15%+.

Piracy is down.  Part of this is MSFT’s litigation efforts to enforce its intellectual property rights abroad.  Part is the increasing market share of global branded computer manufacturers vs. independent no-name “white box” makers, where software piracy is more prone to occur.

Worldwide PC sales are up 25% year on year.  MSFT estimates that consumer purchases are up 30%- and business buys up 15$.  Netbooks, where unit revenues are lower but where MSFT currently has almost all the market, are about 10% of the total.  MSFT unit sales are outpacing market growth.

upcoming quarters

Office 2010, the new Office suite, and a number of server software upgrades launch in the June quarter.  They should provide a steady boost to revenues over the next year or two.

In MSFT’s mind (and who would know better?), large corporations worldwide are clearly preparing for a major refresh/upgrade of their computer systems.  Most have pilot or prelaunch Windows 7 efforts under way now.  They’re planning to deploy W7 as quickly as they can, on the server infrastructure they have today.

Why the holdup?  I presume it’s the usual– IT chiefs want to be sure all the major bugs have been worked out of software before risk the firm’s information backbone by using it.  That takes time.

MSFT also has a large “cloud computing” business, its Online Services Division, which looks like it will report full-year operating losses of more than $2 billion.  At some point–I have no guess as to when–those losses will likely begin to diminish and eventually turn to profit.

What does MSFT do for an encore?

This is the (perhaps cruel or ungrateful) question Wall Street will eventually ask about MSFT.  The company generates enormous cash flow, has negligible debt and is in the midst of an extra-profitable period of upgrades to its basic products—the PC operating system/user interface and the collection of Office-brand business applications.

But the consumer portion of this transition, which is bigger than the business side, is quickly closing on its peak.  And since the market lows in March 2009, MSFT’s stock has doubled.  It has outperformed the S&P 500 by about 20 percentage points over this span, which already discounts at least some of the current good news.

my thoughts

I see two striking features of MSFT:  its enormous cash flow, and how that cash flow is deployed.

On the conference call, MSFT displayed justifiable pride in the fact that March quarter cash flow was a stunning $7.4 billion.  The total for the first nine months of the fiscal year was $18.5 billion.

What is MSFT doing with this money?

stock repurchases          $7.4 billion

additions to cash          $5.5 billion

dividends to shareholders          $3.5 billion

capital spending           $1.2 billion.

If I’ve read the balance sheet numbers correctly, about half of the stock repurchases go to offset the issuance of new stock to employees who are exercising stock options.  But about $3.5 billion has been used to shrink the number of shares outstanding by about half a percent.

MSFT already has about $40 billion in cash and short-term investments on the balance sheet?  Does it need more?  I don’t think so.

Anyway, it seems to me that MSFT could easily double its current dividend (not necessarily all at once; a steady increase over a year or more would be ok), which would produce a yield of 3.5%.  To do this would require a courageous further recognition by the company’s management of the firm’s maturity–a judgment Wall Street has long since made.  My guess is that it would do wonders for the stock’s price, even from here.

My initial reaction is that chances aren’t good.  But we can watch for signs.

By the way, I tried using Firefox to access the conference call and download the 10-Q, because I knew that MSFT doesn’t like Safari.  But the 10-Q wouldn’t download, the conference call narrative broke down twice and the timeline bar to skip/rehear portions appeared only intermittently and didn’t work.  I’m sure Redmond residents find this mirthful, but the humor doesn’t travel.


How expensive is US housing?

residential real estate

Many observers (including myself) think that the housing market in the US began to bottom a little more than a year ago, as savvy property buyers began to return to key markets to pick up prime properties at prices they (correctly) thought would not go much lower.

Soon after midyear, overall housing-related indices began to bottom and then to rise.

Recently, signs of stabilization have emerged even in the worst-hit markets, like Miami, which suffered from wild speculation, massive overbuilding and heavy reliance on large multi-unit residential structures.  (In south Florida, unlike the case in most of the US, projects take longer to complete and when they’re done you don’t just have one unsalable detached house. You have maybe 100 unsalable condominium units.)

Despite all this good news, the question still arises whether this is simply an elaborate technical movement–sidewise price action based mostly on the market needing time to absorb the stunning depth of the declines of the past three years, but to be followed again by another fall off the table.

the Economist analysis

In a recent issue, the Economist observes these phenomena and addresses the valuation question.  For a variety of countries, it calculates the historical relationship between rental income and house prices.  It then uses this figure to figure what home prices should be, given today’s rents.  The results?

the US

1.  For the US, the magazine does three calculations.

Using the Case-Shiller ten-city index, house prices are 3.9% overvalued.

On on the Case-Shiller national index, house prices are 3.7% undervalued.

Taking the Federal Housing Finance Agency index, which eliminates anything financed with a sub-prime loan–in other words, is really biased to the upside–house prices are 13.1% overvalued.

If this simple measurement is close to correct, then the US housing market is on relatively firm footing.  It may not go up, but the floor is unlikely to disappear from beneath us.

undervalued markets

2.  Other fairly-/undervalued markets?

Japan, 33.7% undervalued

Germany, 14.6% undervalued

Switzerland, 7.1% undervalued

China, 2.7% overvalued.

I’m not sure where the data come for China.  This certainly cuts against the conventional wisdom, though, and lines up with the brave few who are arguing that the rise in property prices in the Middle Kingdom are just keeping pace with its rip-roaring economic growth.

overvalued markets

3.  Overvalued markets?

Australia,  56.1% overvalued

Spain,  53.4% overvalued

Hong Kong,  49.1% overvalued

France, Sweden, Britain and Belgium, all 30%+ overvalued.

Of  these, prices in Hong Kong, Australia, Britain and Sweden are rising.

what to make of this

The US, the first place where housing troubles emerged, appears to be most of the way back out of the woods.  This doesn’t mean that prices will be going back up much from here.  Who knows?  But it suggests that housing is not going to provide more negative economic surprises.

The undervalued markets are by and large in moribund economies.  China is an outlier.  It’s hard to know what to say about it.

The overvalued markets are split between fast-growing areas in the Pacific and the euro-zone.  Sounds like more potential trouble brewing in Euroland–as if they needed more.