Intel’s restructuring announcement yesterday

Yesterday, Intel (INTC) announced 1Q16 earnings that were up year on year and more or less in line with the Wall Street consensus.  It did, however, lower full-year 2016 guidance a bit, based on a weaker than anticipated PC market.

More important, the company also disclosed a major restructuring aimed at orienting INTC away from its legacy personal computer business and toward the cloud.  The restructuring will eliminate about 12,000 jobs, or 11% of INTC’s workforce.  It will result in a $1.2 billion charge against 2Q16 earnings and is intended to be saving $1.4 billion annually a year from now.

The plan appears to be at least in part the brainchild of Venkata Renduchintala, recently hired away from Qualcomm to be INTC’s president–with the intention of having him make the kind of changes just announced.

Reading between the lines, this is a good news – bad news story.  The good news is that INTC, seeing the Ghost of Christmas Future in Hewlett Packard, is making significant changes to reorient its business.

The bad news is that it sounds to me like there may be a significant anti-change bureaucracy entrenched at INTC.  This is what I read the Oregonian as saying when it cites “a lack of product/customer focus in execution” as Mr. Renduchintala’s conclusion from his review of INTC’s manufacturing operations.  That’s also the reason, I think, for changes in senior management.  Maybe a fat-cat attitude is not so odd for big corporations in general,  but it’s of disappointing for a firm whose former chairman and manufacturing chief wrote a management book twenty years ago titled Only the Paranoid Survive, stressing market awareness as key to success.

In practical terms, I think what this means is that INTC is still a bit more GM-ish than I had thought possible. In consequence, the transformation INTC has been talking about for years and which current top management clearly wants won’t take place overnight. Still, I think that the moves INTC is making are needed and are an overall plus.

Pre-market reaction has been mildly negative.  I guess that’s about what one should expect.  Personally, I’m encouraged and remain content to collect the dividend and wait.  I’d be tempted to buy more on a selloff.

plusses and minuses of using book value

on the plus side…

–book value is a simple, easy to understand, concept.  Discount to book = cheap, premium to book = a potential red flag.

–it’s very useful for financials, which tend to have huge numbers of often complex, short-lived transactions with hordes of different customers, and where financial disclosure may not be so transparent (financials aren’t my favorite sector, by the way).  So the 30,000 foot view may be the best.

…maybe a plus?…

–in the inflationary world most of us grew up in, and that is still reflected in the financials of older companies, historical cost accounting tends to understate the current value of long-lived assets.  Think:  a piece of land bought in Manhattan or San Francisco in 1950 or an oilfield discovered in 1970–or 1925.  Many of the older retail chain acquisitions of the past twenty years have been motivated by the undervaluation on the balance sheet of owned real estate.

…definitely a minus

–in my experience, accountants tend to be very reluctant to compel managements to write down the value of assets whose worth has been impaired by, say, advanced age or technological obsolescence.

–more important, we are living in a period of rapid change.  The Internet is the most obvious new variable, although I think we tend to underestimate how profound its transformative power is.  In the US, we are also seeing a generational shift in economic power away from Baby Boomers and toward Millennials, who have distinctly non-Boomer preferences and a desire to live a different lifestyle from their parents.

Online shopping undermines the value of an extended physical store network.  Software (which by and large doesn’t appear on the balance sheet) replaces hardware (which does) as a key competitive edge between companies.

intangibles…

Warren Buffett’s key innovation as an investor was to recognize the value of intangibles like this in the 1950s.  In his case, it was that the positive effect of advertising expense and strong sales networks in establishing brand power appeared nowhere on the balance sheet.  In a world where his competitors were focused only on price-to-book, he could buy these very positive company attributes for free.  Price to book was still a solid tool, just not the whole picture.

…vs. structural change

The situation is different today.

The Internet is eroding the value of traditional distribution networks and of other physical assets positioned to serve yesterday’s world.  The shift in economic power to Millennials is likewise calling into question the value of physical assets positioned to serve Boomers.

In more concrete terms:

Tesla doesn’t need a car dealer distribution network to sell its cars.  A retailer can use Amazon, or Etsy or a proprietary website, rather than an owned store network.  A writer can self-publish.  These all represent radical declines in the capital needed to be in many businesses today.

Millennials like organic food and live in cities; Boomers eat processed food and live in the suburbs.

This all calls into question the present economic worth, still expressed on the balance sheet as book value, of past capital spending on what were at the time anti-competition “moats.”

Another issue:   I think that the institutional weight of the status quo has pressured managements of older companies into ignoring the need for substantial repositioning–including writedowns of no-longer viable assets–so they can compete in a 21st century environment.  Arguably, this makes low price to book a warning sign instead of an invitation to purchase.

using book value as an analytic tool

historical cost

Generally speaking, all of a company’s balance sheet data are recorded at historical cost (adjustments for currency fluctuations for multinational firms are he only exception I can think of this early in the morning).

book value

If this accurately reflect’s today’s values, and sometimes this can be an IFthen

…book value is an accurate indicator of the market value of shareholders’ ownership interest in the firm.

asset value

That means that price/book (share price divided by book (shareholders equity) value per share) can be an indicator of over/undervaluation.  In particular, if a company’s shares are trading below book, then it could potentially be broken up and sold at a profit.

management skill

We can also use return on book value (yearly net profit divided by book value) as a way of assessing management’s skill in using the assets it controls to make money.  This can be a particularly useful shorthand in the case of, say, financial firms, which tend to have fingers in a lot of pies and to disclose little about many of them.

Notes:

–price/book is not a linear or symmetrical measure.

On the one hand, a basic tenet of value investing is that when the return on book is unusually low either the company’s board or third parties will force change.  So weak companies may trade at smaller discounts to book than one might think they deserve.

On the other, strong performing firms will likely trade at premiums to book.  However, the amount of the premium will depend both on the state of “animal spirits” and more sober judgments about the sustainability of above-average results.

return on book vs. return on capital.  Return on capital is the same kind of ratio as return on book and has the same intent–to assess how well management is using the assets it is entrusted with.  The difference is that ROC factors in any long-term debt a company may have.

Return on capital is defined as:  (net profit + after-tax interest expense) divided by (long-term debt + shareholders equity).

Return on capital and return on book value are the same if a company has no long-term debt.  Return on capital is typically lower than return on book if a company has long-term borrowings, debt capital usually costs (a lot) less than equity capital.

using return on capital

ROC and the spread between ROC and ROB can be important.  We should think of ROC as the profitability of the business enterprise and the difference between it and ROB as the return on financial leverage.

For instance, for a given firm, the ROC may be 10% and the return on book (equity) 15%.  The difference, 5 percentage points, is the result of “financial engineering,” or the leveraged structure of the company.  Those figures may be ok (and, for the record, I’m not against leverage per se).  But if the ROC is 2% and the ROB is 12%, virtually all the profits of the firm come from financial leverage–not from the underlying business.  That’s a risky situation, in my view–one that owners should be aware of.

More tomorrow.

 

 

 

 

 

price to book: a traditional, but flawed, tool

what book value is

It’s another term for shareholders equity, the financial accounting tally of the total amount of money shareholders, as owners have provided management to work with–through purchases of stock from the company and through profits retained in the business.  It’s called “book” value because the figure is taken from the company’s accounting books.

An example:

We form Ace Investment Advice (AIA) by selling 100,000 new shares to backers at $10 each.

Our balance sheet is simple.  We have cash of $1 million on the asset side, no liabilities and net worth (aka shareholders equity or book value) of $1 million, or $10 a share.

Let’s say AIA earns $200,000 in its first year of operation and distributes nothing to shareholders.  At the end of the year, net worth/book value is $1.2 million, or $12 a share.

how it’s used

return on equity and management skill

AIA management took $1 million and earned $200,000 with it during the year.  That’s a return of 20%  (yes, if management earned that money in a linear fashion through the year, the number is slightly lower, but let’s not worry about that refinement here).

I can compare this performance to what the management of similar firms has accomplished to see whether that’s good or bad.

price to book

I can also compare this performance with that of the managements of all other publicly traded companies, to see if this is a stock I should want to own.

If management is regularly able to achieve a 20% return on the shareholder funds, I probably do want to be a shareholder.  And I’m likely to be willing to pay a premium to book value–let’s say 1.5x book, or even 2.0x book– to become one.

On the other hand, if AIA consistently earns a 2% return on shareholder funds, then the stock doesn’t look attractive to me at all, at least not at book value.  Maybe I only want to pay 50% of book value for it.  And even then I’m probably betting that the board of directors will find better management to run the firm or that an acquirer will be attracted by the discount to book value and make a bid to take it over.

More on Monday.

 

 

 

 

 

 

 

which recovers first, crude oil or base metals?

I’m in the oil first camp.  (My private opinion is that it could take a decade or more for base metal prices to perk up.  Whether that turns out to be true or not is less important to a long-only investor like me than the idea that recovery is not soon.)

How so?

history

Leading with (the opposite of what you’re supposed to do) my weakest reason, look at the last cycle of gigantic investment in expanding natural resources production capacity.  Oil and metals prices both peaked in 1980-81  …and then plunged.  Oil stabilized and began to move up again in 1986; for metals recovery was over a decade later.

closing the supply/demand gap

There’s only a gap of a couple of percentage points between the amount of oil the world is demanding and the amount producers are willing to supply.  Growth in the car industry in China, the replacement of scooters and motorcycles with cars in other high-population countries like India and the strong increase in gasoline consumption in the US now that prices are lower all argue that the shortfall between demand and supply is, little by little, being erased.

On the other hand, the extent of base metals overcapacity is less easy to put your finger on, but is, nevertheless, massive.  Demand is also more cyclical–therefore less dependably growing, as well, but that’s less important than that mining capacity is added in gigantic chunks.

the nature of the enterprise

The up-front cost of a base metals mining project is very high.  There’s the mine itself, the huge machines that rip the ore out of the earth and the sometimes elaborate plants that crush or grind or otherwise separate it from the ordinary dirt.  Then there’s the transport link with the outside world.  All of this infrastructure can lie fallow for long periods without impairing the mine’s ability to be restarted–even expanded from its prior size–very quickly.

For oil, in contrast, finding new fields is a much more important issue.  Drilling new wells in an existing field is, too, in many cases.  As time has passed, the focus of the big oil majors has increasingly been on mega-projects that make them look much more like base metals miners than they did when I was covering the oil industry as a securities analyst in the late 1970s – early 1980s.

Hydraulic fracturing, however, has changed the industry for good.  This technology has made huge numbers of projects economically viable that have limited output that goes on for relatively short periods.  This converts 21st century oil exploration, in the US at least, into a sharp-pencil engineering business that even small firms can excel at.  Granted, the fact that production can turn on very rapidly when prices are high enough puts a cap on how far they can rise.  But the fact that several millions of barrels of daily output can be turned off equally quickly argues that the response time of the oil industry to a supply/demand imbalance will be much quicker than has been the case in the past.

 

the Sequoia Fund (iii)

tax factors

Mutual funds are corporations of a special type.  In return for agreeing to limit their activities to portfolio investing and to distribute basically all their net realized gains to shareholders, mutual funds are exempt from paying corporate tax on those profits.  Net here means after subtracting realized losses.  Realized means that the winning/losing stock has been sold and the gain/loss recorded in the fund’s accounts.

Typically, distribution of gains occurs once a year, in November or December.

In my experience, almost no one other than the fund manager thinks much about the profits and losses imbedded in a fund, whether realized or unrealized.  There are certain situations, though, where they can be important.

net losses

In my career, I’ve turned around a couple of global mutual funds where the single most valuable asset on the day I arrived was the funds’ realized tax losses.  They allowed me to trade the portfolio aggressively without shareholders incurring any tax liability.

net gains

Most funds today are in the opposite situation.  Given that the S&P 500 is at all-time highs, funds tend to have large accumulated unrealized gains.  Tax on these gains is only due when stocks in the portfolio are sold and profits distributed to shareholders.  Also–and this is important–the tax is the obligation of the person who receives the yearend distribution.  That’s not necessarily the same as the person who enjoyed the rise in net asset value of the fund.

sales and redemptions

The potential per share value of losses falls if the fund is having net sales (meaning the number of outstanding shares is increasing), and rises if it is having net redemptions.

The potential per share tax obligation of gains also falls if the fund is having net sales and rises if it is having net redemptions.

the Sequoia situation

If the Wall Street Journal is correct, Sequoia is experiencing substantial net redemptions.  If it has to sell stocks where it has large gains in order to meet these outflows, it could be setting the stage for shareholders who stay loyal to the brand to incur a large income tax liability this year.

What the firm appears to be doing to reduce this burden on remaining shareholders is to meet large (over $250,000) redemptions mostly by distributing shares of stock from the portfolio rather than by (selling them and distributing) cash.

While this may be unusual and inconvenient to redeeming shareholders, it does not hurt them, since their cost basis on in-kind distributions is not the fund’s.  Rather, it’s the closing price on the day they receive the stock.  At the same time, distributing stock protects shareholders who don’t redeem from getting a whopping income tax bill at yearend.

 

 

 

 

the Sequoia Fund (ii)

large position sizes

At the end of June 2015, the Sequoia Fund had assets of $8.7 billion, of which 28.7% was in shares of Valeant Pharmaceuticals (VRX) and another 10.6% in Berkshire Hathaway.

How did these positions get so large?

a.  The portfolio managers chose to have nearly 40% of their fund in two names.  In fact, as VRX began to decline in the second half of last year, the managers bought more.

Don’t ask me why.  To my mind, following Bernard Baruch’s dictum to have all one’s eggs in one basket may have been ok for the renowned speculator way back when, but it makes no business or economic sense for mutual funds today.  According to the Wall Street Journaltwo members of the board of directors of the fund resigned last year because they disagreed so strongly with the strategy.

b.  SEC diversification rules permit this.  The pertinent regulation has two parts:

  1.  The fund can’t make a purchase of a security if doing so would make its total holding in the security more than 5.0% of fund assets.  At the 5% threshold, the manager can allow the existing position to grow; he just can’t buy more.  Growth can come because the security is outperforming and/or because the total asset size is shrinking.
  2. 25% of the fund’s assets are exempt from rule 1.

The second provision is much less well-known than the first.  I’m not sure why the SEC wrote the rules the way it did (my guess would be lobbying from the fund management industry), but I can’t recall an instance where having a whopping position like Sequoia has with VRX didn’t end in tears.  And I can only recall two other cases, one involving a junk bond fund, another a Pacific Basin fund, where managers took such large bets with shareholder money.

More tomorrow.