Sunday, February 11, 2007

IDCC- A Real Fortress

The Street went into heat last week to celebrate the inauguration of the first NYSE listed hedge fund manager, Fortress Group (FIG.) The 67.6% rise on the intial day of trading indicates that either benevolence is breaking out at Goldman and Lehman, or perhaps more likely, irrational exuberance is breaking out among the great unwashed.

Don't get me wrong...Fortress is an outstanding hedge fund manager. There is abundant intellectual capital, after all it has managed to attract $30 billion in assets. FIG describes its business in the prospectus as follows: "We are an intellectual capital business. The management of alternative assets is a highly specialized undertaking that demands talent, skill, and experience."

Of course, I was completely thunderstruck by this revelation. Seems to me that I had read a quote recently in the International Herald Tribune (12/12/2006) about hedge fund performance:

"This year is the third straight year that the global equity markets and long-only managers outperformed hedge funds."- Christy Wood, senior investment officer for global equities, CALPERS

Fearing the law of large numbers, the bane of every investment managers existence, I thought that perhaps a $30 billion hedge fund may find itself in this law's cross-hairs.

Grabbing an Eveready battery version of Diogenes lantern, and some 10-K wizardry, I set out on my quest for sentient beings outside of the hedge fund world, especially the mega-fund world.

Here's what I found!

InterDigital Communications Corporation (IDCC) designs, develops, and licenses digital wireless technologies which are incorporated into wireless equipment, and mobile handsets.
The bulk of the company’s revenues are generated through licensing its intellectual property, primarily to original equipment manufacturers (OEMs) of 2G, 2.5G, and 3G mobile handsets and infrastructure. In fact, its inventions and technology are embedded in every 2G, 2.5G and 3G device. The company has been involved in wireless for three decades (who knew?) and created some of the widely used TDMA and CDMA technologies for which it receives licensing revenues as well. Our friends at FIG have been at it since 1998, almost one decade.

The company continues to develop new technologies as it spends some 14% of revenues on R and D. The company is currently involved in developing standards for 3G, Next Generation Networks (NGN), and IEEE 802.11x technologies, among others. In the meantime, it holds some 6000 patents. That's a tremendous amount of intellectual property. Little wonder, that this business based in King of Prussia, PA has generated over $1 billion in licence fees over its history.

Licensing is enormously profitable with near 100% gross margins. The revenue is essentially a pure cash flow stream. Not unlike a successful hedge fund operation.

The company is brain-intensive, not labor or capital intensive. It employs 315 people including 202 engineers of which 71% have advanced degrees, among them, 30 PhDs.

What are the negatives? This is one of the most litigious industries that I can think of. Every major handset maker seems to have been involved in some large dispute with licensors such as Qualcomm (QCOM) or IDCC. Nokia and QCOM have a 3G licensing agreement that ends this April...there has been at least a year of dispute regarding renewal. IDCC is in a legal dispute with Samsung involving some $175-$200 million in back fees relating to 2G technology. Lawyers have generally done very well by this industry, perhaps third only to the pillage of the tobacco or asbestos industries. Think of lawsuits between RIMM and NPD, Samsung and Ericsson, Broadcom (BRCM) and Qualcomm, etc, etc. Despite the unceasing legal battles, the effect of most disputes is to delay rather than invalidate the revenue stream.

There is a strong chance that IDCC will sign agreements with all major handset manufacturers of 3G equipment over the next couple of years. Fees tend to average somewhere around $1.00 per handset easily resulting in several hundred million dollars in licensing fees over time. I suspect that the industry is taking a bit of a wait and see attitude pending the outcome of Nokia/ Qualcomm's renewal.

The company is a strong cash flow generator. In the last four quarters, IDCC has generated $322.5 million in free cash flow as compared to its revenues of $426 million, a FCF margin of 70%! Based on its enterprise value of $1.51 billion, this is a FCF yield of 21%. Though it does not pay a dividend, the company has been an active buyer of its stock. It recently expanded its buyback program from $200 million to $350 million. Since 2003, the company has bought back about 18% of its fully diluted shares.

The hedge fund business is known to be enormously profitable. In 2005, the last complete reporting year for FIG, the business earned net income of $192.7 million on a revenue base of $1.005 billion. This translates into a net margin of about 19%. To be fair, let's add in another $444.57 million in deferred incentive fees. Hence, the net margin of FIG is a whopping 63%.

Let's look at IDCC's profitability. Not that shabby. For 2005, on $163 million in revenues, the company made net income of $55 million or about 34% net margin. But compared to an S&P 500 net margin of 9.13%, it looks terrific.

Valuation differences are scary. FIG trades at an EV/EBIT of 57.8 times based on TTM EBIT. Interdigital trades at an EV/EBIT of 4.86 times.

Investors can be mesmerized by the audacious profitability and powerhouse intellectual capital of a hedge fund. Remember the law of large serves to undermine most fonts of knowledge. Intellectual capital can be found in many less conspicuous places. The hedge fund industry has no monopoly on smarts.

IDCC has not only the library of patents to provide licencing revenues into the future, its profitability ranks amongst the highest in technology. Qualcomm at 32% is almost there but is considerably more expensive (at 22 times EBIT) than IDCC.

Disclaimer: I, my family, or clients have a current position in IDCC, NOK and QCOM. No positions are held in any of the other securities mentioned.

Thursday, February 08, 2007

Earnings Season and The Uselessness of Forecasts

We are in the midst of one of the most well-established rituals of Wall Street , earnings season. This is an incredibly intense time for analysts on both sides of the Street, buy-side and sell-side. Conference calls abound, earnings releases flow, and models are quickly reviewed and revamped. Research associates groan under the stress, analysts hit the phones to listen in, or to call out to their Rolodex of clients. A stream of "research" is written, promulgated, and occasionally read. On the buy-side, some analysts and portfolio managers are intently involved in the game of looking for "surprises." The tape is studied to see how the stock is "acting." In other words, how is everyone else thinking.

As a value investor, I find the routine loathsome. The task of following earnings releases is tedious and often quite fruitless because meaningless statistics are forced from such a brief snippet of a company's history. "Proofs" based on a single quarter provide some investors with "irrefutable" evidence of the value of a business. Forecasts and estimates shift, opinions change, and the world transacts.

I checked out how many earnings releases were anticipated for today. Based on "Street Events," a Thomson service, there were 281 conference calls today. A total of 482 earnings releases were also anticipated, without the now-standard conference call. That's a total of 763 securities in which to change your mind. It makes you wonder how much thinking actually takes place outside of earnings season. Is it actually possible to think about a business without looking at the last quarter or listening into a conference call?

A word of revolutionary advice...come to your investment conclusions outside of earnings season. It's a little like not being permitted to do your homework in front of the TV. Too many distractions, too little information, a really rotten time to contemplate what value drivers are really changing in the business that own or want to own. Sound decisions come out of silence.

I found a terrific quote in Value-Stock-Plus, a fellow blogger who in my opinion seems to get "it." He quotes Timothy Vick, the author of Wall Street on Sale who describes the investment problem perfectly:

“Each year, the leading business schools graduate thou­sands of finance students taught the same arcane formulas, the same trading strategies, the same valuation principles, and the same forecasting models. It's no wonder that so few can see the broader context of their actions. No wonder, too, that so few beat the market over time; they futilely spend their days trying to beat each other. These graduates, who are today's market strategists, analysts, and fund managers, have become like Marshall McLuhan's fish that don't know they live in water. They swim in a tank separate from another fully functioning world, yet they believe the people on the outside of the glass need assistance. They, however, are the ones trapped."
A very complete article on the uselessness of forecasts, written by Chetan Parikh is also highly recommended. As he puts it,

"In short, Wall Street exists to sell you something. All the financial information it issues, whether brokerage recommendations, price targets, market forecasts, earnings estimates, or performance figures, can be twisted to serve the purposes of whoever issues it. Wall Street generates reams of statistics for investors to digest, little of which has any relevance to your specific situation. In general, investors should be skeptical of almost all data offered them and never buy a stock based on future esti­mates other than those they themselves make."

The future is always difficult to divine. Successful value investors always start with something as close to terra firma as they can. Like Bruce Greenwald suggests in his book, start with the most reliable information first...what is the asset value now...what are the assets themselves worth. The second most reliable information is based on current earnings, or at least current earnings power. There is a substantial difference. But appreciating a business that has long lasting earnings power is the only reason why one would pay more than current asset value for a business. The last and most difficult step in valuation is the third step, forecasting that earnings power into the future with a growth rate.

Unlike CNBC commentators who relish dumping on analysts, I respect them highly. Much of the street needs instant analysis. It is required of them, but not of you! If you think about it, there are 91 days in a quarter. The time to think about your investment need not be relegated to just one day in that quarter. The remaining 99% of the quarter is a much better time to think about it.

One final quote: "When investing is buoyed by short-term earnings-which in turn, swims on the current of predictions-it ceases to be investing, and becomes gambling."

Tuesday, February 06, 2007

Adds and Drops of Research Coverage-Analysts Pile In and Storm Out

Finally, some research analyst at a brokerage firm has added one of your holdings to his/her coverage list. You get a little excited that the analyst has discovered some jewel that you have treasured for some time and will finally revealed its merit to the rest of the planet. You feel a little smug, don't you?

Apparently, you shouldn't. A recent paper by Ambrus Kecskes at the University of Toronto and Kent Womack at Dartmouth says that perhaps you should worry a little.

Analysts strive to cover stocks that are institutional favorites...they have the greatest trading activity. High market capitalization, high trading volume, spells glamor in many cases. Initiation of coverage tends to prompt increased liquidity. Analysts score well with their research directors and especially with the heads of capital markets if they can get "it" on the tape.

Lesser known names which have potential as M&A candidates or other investment banking services also come front and center. Nothing impresses an investment banking client more than wheeling in the resident expert, the research analyst, and having him/her wax poetic about the industry. Of course, with Sarbanes-Oxley concerns, this performance now takes place in front of a securities lawyer who ensures that nothing inappropriate is said, no offerings of warrants or other favors to influence opinion are suggested. The production of a research report satisfies the analyst's need for recognition and the firm's need for commish and investment banking fees.

Typically, an analyst drops coverage when something untoward becomes non-communicative, earnings become unpredictable, or a better opportunity comes along to earn commish or underwriting fees. Sometimes, the assigned investment banker has done something to muck up the relationship. After all, there is only a finite amount of time and earnings maximization requires an optimization of the coverage list.

What happens to the stock price when coverage is assumed or when coverage is dropped? What are the longer-term implications?

Interesting results according to K &W ! In the year before and the year of an increase in coverage, stock returns are relatively higher. In the year before and the year of a decrease in coverage, stock returns are relatively lower. Surprisingly, however, in the year after a change in coverage, returns reverse. Specifically, excess of market returns are -1.2 percent following adds of coverage and +3.5 percent following drops.

Therefore, the market does seem to react to analysts' coverage decisions and in the right direction, but judging by the return reversal the following year, the market's contemporaneous reaction seems to be excessive.

Two findings are striking. First, even when other factors were accounted for such as size,turnover, institutional ownership, momentum, valuation, or risk fixed, the stock performance of firms for which analysts add coverage is at least as good as, if not better, than the performance of drops in the year of the coverage decision. Hence, increased analyst coverage does have a positive effect in that year. Second, adds always have relative better stock performance than drops in the year after the change in coverage. In fact, the increase-decrease spread ranges from 1.9 to 9.2 percent.

If drops are clearer signals than adds, then the market's negative reaction to drops will be greater. Insofar as the market overreacts more, the subsequent positive reversal following drops of coverage will be greater.

Bottom-line, the market tends to over-react to changes in analyst coverage. Over the near term, go with the flow. A drop in coverage can be viewed as a sell signal over the near term. A pick-up in coverage, over the near term is generally positive. But look for bargains among the orphaned stocks without coverage a year later. Getting sent into the reject pile takes a near-term toll, but provides a great entry point later. The market reads too much into analysts' coverage decisions, misreads piling in or storming out, and subsequently corrects itself.

Saturday, February 03, 2007

The 3M Company-Misunderstood, Maligned, Cheap-Inefficiently Structured

There is a mistaken notion by some value investors that the only time that you can make serious money occurs when you can find an unknown, small-cap name that is inefficiently priced because it is off everyone's radar screen. Yet, there have been many times in my career where a large cap name was staring me in the face that was misunderstood, maligned, and cheap. Efficiency is a function of everyone thinking the same, not necessarily that everybody is thinking! I feel this way about MMM. The release of Q4 earnings and 2007 guidance has created an interesting opportunity in my view. The inefficiency exists not only in the way the consensus views the company, but also in the way that management has structured the capital.

What can one say about 3M? With well-known products such as Scotch tape and Post-it notes, the company enjoys a broad portfolio of products that address the needs of just about every economic sector that exists in just about every geography that one can think of. From a simple P/E basis, the company is selling below an S&P 500 multiple (about 16.6 times TTM versus 21.0 times TTM for the S&P despite long term fundamentals that have generally exceeded those of the broad index. Consider that even with the supposedly difficult environment that created the earnings shortfall, the business generated 22.5% return on invested capital for the year.

Where were the shortfalls? Let's look at the diverse segments which will give you some idea of just how broad this company's reach is.

The largest part seemed to come from the "display and graphics" group which houses the LCD film business, 3M provides distinct products for five market segments, including products for: 1) LCD computer monitors 2) LCD televisions 3) handheld devices such as cellular phones 4) notebook PCs and 5) automotive displays. Additional optical products include touch screens, touch monitors and lens systems for projection televisions. Consumer demand for LCD television has seen double digit unit growth, but with about 40% of LCD film sales oriented to larger format LCD's, profitability has declined. Production yields for large format films are lower than for smaller LCD's, consequently, profitability is not as good. As well, as the technology becomes more competitive and mainstream, pricing suffers. Other aspects of the graphics business have performed very well, but the formerly very high margin LCD film business is starting to look less extraordinary. Despite the lamentations, this remains a 27.9% operating margin business though down some 400 basis points YOY.

Another interesting business which fell short of expectations was the roofing granules (for asphalt shingles) business. This is contained within the "Safety, Security, and Protection Services" business. This segment also produces "Thinsulate" Insultation and Scotchtint Window film. Apparently, there has been a sales decline of 50% YOY in roofing granules. Historically, some 70% of shingle demand has come from replacement rather than new construction. This is a 19.5% operating margin business. Ex-roofing granules, operating profit would have over 23%, slightly better than a year ago.

The transportation segments serves automotive, marine and aircraft markets with graphics, masking tapes, fasteners and tapes, interior paneling and carpeting, etc. Op margins here were 18.8%.

The healthcare segment weakened as a result of the divestiture of the pharma division in early December. 3M is a supplier of medical tapes, dressings, wound closure products, orthopedic casting materials, electrodes and stethoscopes. In infection prevention, 3M markets a variety of surgical drapes, masks and preps, as well as sterilization assurance equipment. In health information systems, 3M develops and markets computer software for hospital coding and data classification, as well as providing related consulting services. 3M provides microbiology products that make it faster and easier for food processors to test the microbiological quality of food. Tape closures for disposable diapers, and reclosable fastening systems and other diaper components, help disposable diapers fit. Nevertheless, what remains has the highest operating margins in MMM at 29%.

The Consumer and Office segment is the home of Scotch tape and Post it notes. However, sales to construction of masking tapes and sealant products declined. Sales growth overall pre-currency effects was about 6%. Operating margins here are the lowest in the firm at 17%.

The Electro and Communications segment serves the electrical utility industry, telecommunications as well as electronics industry. Major electronic and electrical products include packaging and interconnection devices; high−performance fluids used in the
manufacture of computer chips, and for electronics cooling and lubricating of computer hard disk drives; high− temperature and display tapes; and insulating materials. Operating margins here are just under 18%.

What is unusual and what has gotten the "Street" frosted about the stock is that YOY, each of the operating segments suffered a decline in operating profitability . Some of that may be related to ongoing and incomplete restructuring efforts, some may relate to currency effects, much relates to peculiar and unique cyclical influences over certain businesses.

One other aspect of MMM that I found a little strange was management's response to redeployment of the cash generated from the sale of the pharmaceuticals business. About $1.2 billion came in early December followed by $850 million in early January from the sale of the European pharma biz. Management indicated that it would pay down its commercial paper...this is a company with steady free cash flow generation and a debt to capital ratio of only 14% or so. Debt to toal assets is less than 5%.

Given a long tradition of innovation and growing the business (and given the ROIC of plus 20%, they should reinvest!) MMM's capex was up 23% for 2006 and will be up another 25% for 2007 at about $1.5 billion.New plants will increase capacity geographically and improve some production facilities. Specific areas include medical tapes and drapes, optical films, and industrial tapes. Plants are being built in Korea, China, Russia, Poland, India and Turkey. Clearly streamlining efficiencies in distribution and logistics will lower costs and reduce working capital needs. I believe the capital plans make a great deal of sense.

Innovation is an inherent part of the MMM corporate culture. Researchers are encouraged to dedicate 15% of their time to projects that interest them rather than corporate mandated research.

Check out Exhibit 1 in this link which describes 3M's quest for innovation: Innovation

What goes wrong here? MMM is sensitive to world GDP with international sales representing 63% of revenues. European growth last year was 10.5% (breathtaking for Europe!) and Latin America grew 10.2%. China and India saw 20% growth in revenues. A global slowdown naturally would affect a business of this breadth and size. The balance sheet has the formidability of a battle ship. So far, MMM has used small bolt-on acquisitions. A large acquisition would be upsetting.

The company has been a buyer of its own stock and has actually effectively reduced its share count. The company spent about $2.4 billion on share repurchases in 2006, reducing the share count by about 3%. Fully diluted shares are about 761 million versus about 813 million at the end of 1999. The company has another $750 million left in its authorization which runs out at the end of this month.

The street consensus for 2007 eps has move down to a range of $4.53-4.80 with a median $4.65.

Consensus target price is about $85 for Wall Street. Over the near term, I can't argue with the analysis. Though analysts are agonizing over short term issues and an inordinate amount of "analysis" is dedicated to the LCD film business, most people are missing the point. This company would benefit tremendously from a more efficient capital structure. Rather than paying down debt, this company would benefit tremendously from either buying back stock at current valuations (which are generally at decade lows) or paying out a significant special dividend.

Here is a valuation for MMM with a 15% debt to cap structure. I come up with a present value of about $115 about 55% north of where we are today!

MMM DCF with a Sensible Capital Structure

What is the likelihood of the company undertaking a tender offer for its stock to achieve greater efficiency of capital? Who knows? Some investors have been pressing for this to occur. For example Lee Cooperman of Omega Advisors has recognized MMM's conservatism:

"One thing I’d add here is that the company has a ridiculously unleveraged balance sheet – it ought to buy back $2-4 billion of common stock immediately at current prices. One reason we own it is that we expect a very significant cap shrink."

This is a great company available at a very attractive valuation. The reputation for innovation is well-deserved and operating profitability remains strong, though competition and cyclicality have shaved a bit off the edges. The yield at 2.5% is above that of the S &P at about 2.1%. Dividend growth in the last five years has been 9% compared to the S&P at about 2.9%.

The current buyback runs out later this month. The steady cash flows allow for a much more aggressive capital structure.

I think this is a terrific opportunity for someone with an investment horizon that extends beyond settlement date.

Disclaimer: A long position in MMM is currently held by either myself, my family, or my clients.

Back in the Saddle Again!

I apologize for my long absence from the blogosphere. I appreciate the inquiries from those who wondered if I had been hit by the proverbial bus or whether I had been paralyzed by writer's cramp. To all the well-wishers, thank-you!

My time has been entirely consumed by year-end needs of my investment business. Year-ends necessitate report writing , performance measurement, and client service. Investment strategy, though reviewed constantly, receives a thorough scrutiny to ensure that portfolios comply and reflect.

SEC compliance requirements have blossomed over the years for those of us in this business. Assessing new software to ensure compliance has also had an appetite for time.

A few interesting private equity deals also demand negotiation and due diligence. Despite the popularity of the concept, there still appears to be potential for extraordinary returns in some of these vehicles.

Finally, some changes in the distribution of our products due to a merger have created a great deal of excitement and, taken some time.

I appreciate your patience, and your kind thoughts. I hope to provide a more continuous interpretation of value discipline through the year.


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