A Few Brief Thoughts on United Health Group, Inc.

This is a stock I purchased in my IRA on September 1, 2010, when it was trading at $32.48/share.  Today it trades at $58.92/share.  Needless to say, it has been a big winner for me.  However, it was always a small position, at a $617.12 original cost basis.  I only bought 19 shares.  By comparison, I own over $4,000 in XOM stock, and have similarly “large” (for me) positions in MSFT, INTC, and BRK.B.

The position has remained small because I have been guilty here of price anchoring.  I think I got afraid of the increased nominal price, and have failed to pay attention to the underlying business.

It’s time for an update.  In my update, I conclude that the company is not wildly undervalued.  It would be a strong buy at $54.88, not far below where it is today.  If it goes above $82.32/share, and the fundamentals have not changed, it is time to say adios.  It is obviously nowhere near that level.

Here is my most recent sheet.  As you can see, I keep things fairly simple.

I have used a WACC of 11% here, which is in-line with consensus.  I assume no debt or cash.  (The actual net cash/debt position is about $4 billion of debt, but I assume based on its cash generation it can basically maintain that in perpetuity.)  For my free cash flow growth rate, I’m only assuming 3% growth over the next ten years, even though in last nine years it has averaged 9.67% annualized growth.  The problem is in the last three years that stalled to 7.59%, and in the last year, the annualized growth was only 3.12%.  I attribute most of this decline to recent regulatory changes, but I never assume higher growth than present growth.  In fact, even my 3% growth assumption may prove too optimistic, and is the thing I’m most worried about in my analysis.  

On the other hand, it matches Morningstar’s analysis closely, and even if you assume 1% growth, the stock is worth around $61/share.  My pessimism is also tempered by the fact the company has reduced its diluted share count by 16.2% in the past four years, which is great, and future such reductions should prove accretive to the value of future free cash flows attributable to my shares.  

Substantively, my thesis from 2010 has not been blown:  Obamacare will not destroy this company, its scale confers massive advantages in such a highly-regulated industry, and it is well-run.  Nothing since 9/2010 has changed these basic assumptions.  I actually think Morningstar in evaluating United Health’s ”moat” is probably being too pessimistic in assigning the company only a narrow moat, given the regulatory environment in which it operates. They likely attribute the declining free cash flow growth to moat issues, whereas I attribute it to regulatory changes.

That said, I think the massive gains here are likely done.  That is because these gains were to be had before the world had digested Obamacare as fully as it has now.  I do think the stock remains somewhat artificially depressed because of lingering and overblown concerns about the full implementation of Obamacare, which is why opportunity remains.  

Also, the dividend is quite low — 1.44%, even after it was increased from a quarterly $0.13 dividend to a $0.21 quarterly dividend, or a 61.5% increase, in the time I have owned it.  That seems to be the level this company wants to be at, and it is not enough to attract all those seeking yield in a ZIRP environment, so I do not attribute its share appreciation to a hunt for yield.  The fact that its P/E ratio has not really increased much at all since 2011 (in a time when the S&P P/E ratio has gone from under 14 to the 18 neighborhood) supports this view.

In short, I think this company remains highly investable.  I should consider doubling my position notwithstanding the recent share price appreciation I have seen, particularly since the share price has basically been stalled for the past year.  However, before doing so I should conduct a deeper analysis of Humana (HUM), which appears to be performing even better than UHN has been.

A Brief Update on Coke

There has been a lot of talk about overvaluation of consumer stocks like Coke (KO) lately, some of it by me on Twitter.  And I think inarguably stocks like this are somewhat leading the market right now.  I therefore decided to take a quick check today to see if I should consider selling, if it was that overvalued.  It has been awhile since I actually ran the numbers.

My results are here. What I found surprised me.  I used a WACC of 7% as my discount rate, even though some sources put the WACC at 6%.  Still I come out with a valuation roughly in the $39/share range.  That puts me squarely in between Morningstar ($42) and S&P ($36) — I always check them AFTER I have run my numbers.  

So as of today we’re around $42/share.  Is the stock cheap?  No.  Is the stock wildly overvalued?  No.  I have pegged $48/share as a potential sell price, assuming the stock clears that level without further substantive improvement in the business.  But for now, while there is always risk of a decline, I think the coast is fairly clear.

As many have said, part of what is driving stocks like $KO is the perception of safety, and the desire for the dividend.  Fair enough.  There has been talk of a “dividend bubble” lately, so I must note I first talked about the elevation in values of dividend stocks in a pitch on the fool.com website in 10/2010 for Intuitive Surgical (ISRG).  Good thing I didn’t avoid dividend stocks since that time, though!  This isn’t over.  The Fed isn’t done what it’s doing, and we aren’t about to see ZIRP end, and the reality is, while dividend stocks are outperforming the market now, and some like Coke have been for years, this could go on for at least another year or two.  And even when it ends, the reality is, Coke is not that overvalued.  It’s not cheap, but at least part of what is going on here is a reach for moat, as well as a reach for yield.  And the reach for moat won’t go away when ZIRP ends.

Checking in on Microsoft

I have been a holder of Microsoft shares since the financial crisis in early 2009.  I have added to my position since then, and it is one of my four largest positions, along with ExxonMobil (holding and adding since 1998), Berkshire Hathaway (holding and adding since 2009), and Apple (holding and adding since 2011).  Unlike those three, most of my Microsoft stock purchases over the last three years have strongly underperformed the market.  

The issues are of course well-known.  First, Microsoft is the epitome of “dead money.”  The stock price has gone nowhere since July 1998, nearly fifteen years.  I was in college in 1998.  Bill Clinton was President.  AOL and Timewarner had not merged.  That is a long, long time.  Second, the Wintel monopoly on the corporate and even moreso on the consumer market is ending.  Duh.  Thematically, Microsoft doesn’t work.  It puts out crappy products like Zune, and overpriced (sorry, but it’s true) products like Surface.  

It’s CEO looks like a titanic oompa loompa.  He is anti-cool.  He is kryptonite to cool.  Worse, he does things like try to purchase Yahoo for too much money, pay tons of money for an ad company that leads Microsoft to the write-off billions of dollars.  And of course the attempt to compete with Google in search has largely been a failure.  Etc., etc.

So why do I own?  Why do I continue to own?  It’s important not to check one’s brain at the buy button.  And it’s even more important not to check one’s brain once one has hit the buy button.  Is my thesis wrong?  What is my thesis?  My thesis is fairly simple:   The company still makes a bunch of money, will continue to make a bunch of money, and even as the Wintel monopoly ends, this is not the end-of-the-line for Microsoft.  And because everyone thinks it is the end-of-the-line and Microsoft is going to go the way of Research in Motion, it’s cheap as hell.

Even during the disastrous fiscal year that ended in June 2012, the company generated record free cash flow of $29.321 billion, and $3.44 of free cash flow per share, also a record.  And record revenue.  Against around $11 billion in long term debt, it was holding over $50 billion in cash and cash-equivalents.  

These aren’t really new facts to anyone who follows Microsoft.  More recently, earnings-per-share were down from $0.78 per diluted share in 11/2011 to $0.76 per diluted share in 12/2012.  The future is all that matters.  The trend is all that matters.  What’s the saying? — I’d rather pay up for a quality business than get a bad business for a good price.  Something like that.

Well, let’s see more concretely what this last year hath wrought.  I last checked in on Microsoft’s valuation in April 2012.  (I’m a long term kind of guy, I don’t follow the ticker every day.)  At the time, as you can see in that sheet, I assumed 4% yearly free cash flow growth for ten years and 1% thereafter.  I assumed a WACC of 9.2%, and a share count, then-existing, of 8.593 billion diluted shares.  I discounted the cash (less debt) that Microsoft was holding by 35% to assume Microsoft would eventually have to pay taxes on all of the cash it holds overseas, or else will blow some of its money on stupid acquisitions, and lose some to inflation.  That gave me a valuation of around $45/share, give or take.  (This isn’t a science, and anyone who tells you otherwise probably wants you to pay for some worthless subscription or newsletter.)

Note, by the way, that although I assumed 4% yearly free cash flow growth, in this actual first of my ten years from the above calculation free cash flow actually grew 19% from year-end 6/2011 to year-end 6/2012, from $24.639 billion, to $29.321 billion.  We can’t really expect to see that repeated this coming year-ending 6/2013, but we shall see.

Now this year, from the 6/2012 starting-point, we have only 8.444 billion diluted shares outstanding, because of share repurchases.  The WACC is still about the same.  Some sources say only 9%, but I’ll stick with 9.2%. Note that debt is now up from last year, to over $14 billion, because Microsoft has taken advantage of stupid-low interest rates.  And cash is up to $68.312 billion as of 12/2012.  I continue to just write-off 35% of Microsoft’s cash when making my analysis, for the same reasons as above.  The result I get is that Microsoft is now worth around $54.60/share, more than it was last year, and that it is nearly 50% discounted.  Even if you completely write-off all of its cash, it’s still way undervalued by this analysis.

Can this be?  Can Microsoft really be so cheap?  I think so.  That’s why it’s such a large position for me.  If you think its earnings are about to fall off a cliff, as is its cash generation, you may disagree.  But I’ve been covering Microsoft pretty extensively for four years now.  If you think that now, you have probably thought it for four years, and that time, during the advent of the iPhone and the iPad and Google Chromebooks, etc., Microsoft has grown its free cash flow from $15.9 billion at the bottom of the financial crisis, to over $29 billion, yo.

So what say you?  I still say it’s a buy.  And while I wait for the market to agree with me, and hope that my thesis is correct, I’m happy to collect the 3% dividend yield, and happy to see that so far its actual free-cash-flow generation confirms my thesis.

Taking an Initial Look at Parker Hannifin Corp: Another Lubrizol?

Every so often I literally just start plugging various letters into morningstar.com’s quote box.  I do this to help myself move beyond my cognitive biases, one of which is that I tend to focus a lot on the stocks of companies I already own, another of which is I tend to concentrate my energies in companies people are already talking a lot about, and still another of which is that I tend to focus on particular industries.  I was doing that a few weeks ago and out popped Parker Hannifin Corporation (PH).  This is a highly investable company, though my research is not yet complete.  Here are some rough thoughts:

What are some cool things and interesting facts here?

  1. This is a $14 billion company that people rarely talk about.
  2. It’s the self-described #1 motion & control company.  It makes things that go in other things, largely, and/or that are sold to other businesses instead of directly to consumers.  It makes 816,000 different products, and employs 60,000 people in 40-some countries.
  3. It’s clearly a cyclical company with some lag.  Revenue tanked hard in 2009 and even 2010.
  4. But revenue is more than double what it was nine years ago.
  5. Free cash flow is four times what it was nine years ago.
  6. Share count is down over 11% from nine years ago, including a big repurchase in the 2012 fiscal year.
  7. Earnings per share are up three-to-four times what they were nine years ago.
  8. During this time financial leverage has remained steady.  And now debt-to-equity is in the 30% range.
  9. Dividends have more than tripled in the last nine years.
  10. 2012 was a record year.
  11. Company is about 100 years old.

What are a few warts?

  1. Highly cyclical, to the extent this counts as a wart.
  2. Exposed to defense industry cuts.
  3. Exposed to currency fluctuations.
  4. Pension underfunding.  (Though see note 10 of the recent annual report, which indicates it has reduced the discount rate of its pension obligations significantly, to 3.91%.  This is in response to ZIRP and pension-related laws, and likely means it is is over-estimating its pension liabilities.)
  5. Dividend yield is only 1.70%, and recent dividend growth has stalled.

What do we think of valuation here?

  1. On my quick-and-dirty chart I derive a valuation estimate of $119.60/share, with a range from $95 all the way up to $145/share.  Current market appraisal is about $97/share, so it’s trading in the low range of my estimates.
  2. Assumptions:  I’m using a WACC of 11% as my discount rate, as I believe is most appropriate.  I’m assuming annual FCF growth of 6% for ten years, and 2% thereafter.  That 6% matches annual FCF growth since 2008, through the Great Recession, but is significantly lower than it has shown if you look back for nine years.
  3. Caveat:  There is no such thing as an accurate valuation of a company, and the future is unknowable.

Things I’d like to know:

  1. More about the individual business segments.
  2. How long the CEO has been in charge.
  3. More about compensation policies.

Conclusion:  This is a great company and warrants further research.  It is highly “investable.”  It is only wildly undervalued if growth returns to a higher rate.  But it’s a solidly-run shareholder-friendly business based in Ohio.  I would have no problem initiating a position today.  I may back-up-the-truck the next time we have a real cyclical downturn in this country.  If I were buying the whole company I might even pay as much as $120 or even $130/share today.  I think this is a “Lubrizol-like” company (and a similar market cap prior to acquisition) that just had a record year and is firing on all cylinders, and it would not surprise me at all if Berkshire Hathaway under Buffett bought it, assuming diligence on the management checked out.

A Quick Check-In With Johnson & Johnson

I have owned shares of Johnson & Johnson ($JNJ) for quite some time.  I first bought during the financial crisis at about $55/share.  I doubled my stake in May 2010 at about $67/share.  In April 2011 I upped my position by 25% at just under $60/share, when I estimated an intrinsic value somewhere between $63 and $68/share.  In May 2012 I did another DCF analysis (which I freely acknowledge is largely bull) and found an intrinsic value of around $65.60, but since the stock was at $64/share then, I didn’t add.  I have sold nothing, and today the stock trades at $76.04, as of this moment in time.

Now it’s time for a very quick check-up.  First, it’s important for you to understand something.  In my prior analyses, I used to always use a WACC of 10 or 11 for large companies, as my discount rate, period.  I no longer do.  Somebody famous had said that was the conservative value investor thing to do, so I did it.  Now I use the actual WACC for the particular company.  I think WACC for all its flaws is the most appropriate discount rate for a company’s future cash flows.  If you think I’m wrong, feel free to tell me so.  Here is a terrific old explainer from Morningstar that agrees with me though, which also refers you back to this.

You can get various analyses of JNJ’s WACC, but they all range between 6% and 7% these days.  I’m going with 7%, because it’s higher than what I have seen out there, and the higher the discount rate, the less the stock is worth, all other things held equal.  (I.e., that’s the conservative choice.)  Since JNJ’s WACC used to be around 8%, too, it makes sense to use a higher-than-current-day WACC, to account for possible upwards variation over time in my prospective DCF analysis.

As you can see on my sheet, this lower WACC means JNJ is worth more than I thought it was.  However, growth has sucked so much in recent years that I’m only assuming it can grow at a 1.5% rate for the next ten years, with 2% perpetuity.  (Yes, I realize it’s arguably absurd to include perpetuity growth in a calculation at all.)   I get an intrinsic value in the range of roughly $86/share, and a buy price at around $69.50, to assign a 20% discount to estimated intrinsic value.  If JNJ grows more than expected while maintaining a similar WACC (note that its WACC was correspondingly higher ten years ago when its growth was stronger), it could theoretically be more significantly undervalued.

So, I still don’t think this is a massive buy, but within the constellation of dividend stalwarts, it’s not exactly massively overvalued either.  I realize Buffett and/or his new young studs have sold off $BRK’s stake lately to fund other purchases, but they’re playing a different game than I am.  I think it’s a straight up buy at anything less than $70/share, and it’s a straight up sell over $100/share, and anything in between is a gray area where there are reasonable arguments either way.  

I choose to continue to hold because of my low cost basis, my desire not to pay taxes on a sale, the lack of compelling investment ideas (haven’t had tons of time to look at new companies), the dividend, the strength of the company notwithstanding recent hiccups, and the chance it may grow more than I expect it currently to grow.  I think there’s even a decent argument for adding, just as a place to park capital in relative low-beta (0.54 as of this writing) safety, and get a decent yield.  So there you have it.  And now, it’s time to go to work and do my real job.

The Pensions Crisis That Isn’t

There is a lot of talk about unfunded pensions, both in the public sector, and with regard to companies.  For example, here is Forbes from 2010.  Here is TIME from 2012.  Here is a website that looks like the design was last updated in 1996, called “pensiontsunami.”  

Now despite my deliberately-provocative title, I’m not saying everything is peaches and cream.  But the situation is a LOT less worrisome than you think.  It’s important to understand how ideology comes into play in such arguments.  It is no accident that conservatives are the ones typically screaming about such issues.  Conservatives more commonly hate private corporate pension plans (they prefer 401ks).  And conservatives loathe government pensions for “public sector union” employees.  Ideology.

How does it impact analysis?  Well I wish to speak of corporate pensions today.  Here’s a recent NYT article about how AT&T took a huge earnings hit because of its so-called underfunded pension.  But why?  Why? 

Because interest rates are low.  Because of the Fed’s so-called ZIRP policy.  Altria gives a perfect example of this on its 2011 annual report, available here.  On page 33 it notes how it reduced its discount rate on its obligations from 5.5% in 2010 to 5.0% in 2011.  Because interest rates have dropped.  Because of the Fed’s actions.  

As anyone with even a passing familiarity with discounted cash flow analysis knows, when you drop the discount rate at which you discount the future cash flows of a company, you increase the value of those cash flows, and the value of the company.  That is why *estimating* (there is no such thing as knowing) a correct discount rate is so important.  Go on, you can try it here, with this spreadsheet I put together in May 2012 for pre-spinoff Abbott Laboratories.  Just mess around with the number in field C-16.

The corollary is that when a company reduces the discount rate at which it values its future obligations, the value of those obligations rises.  That is exactly what companies (and municipalities) have been forced to do over the last four or so years because of ZIRP.

This matters.  This matters to you if you are a long term investor.  Many of the same people who are screaming about ZIRP are also screaming about pension liabilities.  And they are wrong on both accounts.  I have explained elsewhere why ZIRP is necessary during a private deleveraging (and like 95% of actual economists agree), and here above I explain, hopefully, why the second point is wrong.  But let me state it as clearly as a possibly can:  when ZIRP ends, and interest rates rise, unfunded pension liabilities are going to drop, because the discount rate used to calculate those future decades of obligations is going to rise.  When that happens, it will positively impact corporate earnings, and municipal finances.

What are the criticisms of this idea?  Well, the one I most commonly hear/see is: (hands over ears) “MAH-MAH-MAH-MAH!!!!  I can’t hear you!  Ideological dissonance…., can’t….take…ideological dissonance….!”  

But another more intelligent criticism is that because corporations are being forced to hold cash in such low-interest bearing Treasury bonds now, they are permanently reducing the amounts they have available to pay for those future liabilities, so it evens out.  

Here is some math that doesn’t quite prove I’m right, but shows I’m more right.  Holding other things constant, assuming 2% growth in liabilities. $10B starting liability, a reduction in the discount rate from 5.5% to 5% increases discounted liabilities by over $2.05B!  By contrast, a reduction in the rates a company can earn on equivalent starting pension assets for five years (dating from 2008-2013) is only $0.85B.  

Now obviously its more complicated, because if the company had that $0.85B it could earn a non-linear amount of additional money in the future, by compounding.  But by turn, I only assumed a 2% growth in liabilities on the negative side.  Up that, and the difference becomes more stark.  And, moreover, I think I’m accounting for that missed asset-compounding by discounting the obligations to present value, since what I’m talking about in both instances are present values.  (Happy to hear if you disagree, since I threw this whole post together in about 30 minutes.)

Even if there is some evening out, ALL we hear about is the bad side.  The point is, if you are a long-term investor, you need to strip out ideology.  Daily traders (some of whom are quite good) can afford to be ideological.  Fund managers who trade constantly can afford to be.  But if you are thinking about what the true value of a company is, you need to know that the pensions crisis is just not as bad as people are telling you that it is, and make some attempt to calculate what the real story is.  This matters.

Just How Overvalued is ConEd?

There has been a lot of talk about how utility stocks are overvalued, and I agree with it. I thought I would put together a little free cash flow analysis of one of the most well-known of the Utes in order to illustrate the issue: Consolidated Edison (ED).

The resulting link is here; that spreadsheet is my standard sheet, which I try to keep pretty simple.

By my calculation, which is generous in terms of the starting free cash flow figure it gives to ED, you can roughly say that ED is fairly valued if it manages to grow free cash flow at a rate of 4%/year for the next ten years.  That is with no margin of safety.  To buy with a 20% margin of safety you would need to pay $42.82/share, whereas as of this writing it trades just shy of $60.  

But here’s the thing:  ED has had NEGATIVE free cash flow in six of the last ten years!  And if you average out its free cash flow over the last five years, it has averaged about $54.5 million in free cash flow per year.  Keep in mind that my above valuation assumes a starting point of $757 million in free cash flow, because that is the trailing twelve month figure.  I ask you, do you think ED is going to do 4% free cash flow growth for the next ten years, from that baseline?  Morningstar, it should be noted, does think ED will have positive free cash flow through 2016, four more years, so that at least is something.  But I think it’s a little optimistic to think that Ed is going to grow this much, and there is certainly no room for error.

Oh and the dividend yield is about the same as Intel’s as of this writing.

No thank you.

Abbott Labs Is Cheap, Not Quite Cheap Enough

Please see my latest post, in which I do a brief analysis and valuation of Abbott Labs.  Abbott has been in my portfolio since early 2010.  I conclude that while my previous investments have strongly outperformed the index (I added in January 2011), right now the stock is no more than 11% undervalued, which means it is not a buy for me.  I also briefly analyze the Humira situation, and conclude, as many have, that AbbVie is likely to be dumped by people after the spin-off.  At that time, AbbVie may present a short-term opportunity, as pessimism may well price in all of the potential downside and then some.  See the full piece here.

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ExxonMobil Remains a Buy Below $80/Share

I’m continuing my process of reevaluating all current positions.  I conclude in this recent article that I still really like ExxonMobil.  At $84/share I think it is undervalued, but not quite at my margin-of-safety buy level, based upon my discounted free cash flow analysis, which says it’s worth about $100/share.  Accordingly it’s a great buy at $80/share or below, and it’s a strong, strong buy below $70/share.  For the full article and link to my calculations spreadsheet, see the link above. 

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