Warren Buffett's annual letter to shareholders came out last week..

 by Stansberry & Associates Investment Research

Warren Buffett's annual letter to shareholders came out last week… And the first thing I noticed was that Berkshire Hathaway's per-share book value (Buffett's favorite method of valuing the company) grew 4.6% compared with last year… one of the three worst years in the company's 47-year history. Still, Buffett said he's happy with the results. He outperformed the S&P 500 (which returned 2.1% pre-tax, nearly all in dividends). He wrote…

Our major businesses did well last year. In fact, each of our five largest non-insurance companies – BNSF, Iscar, Lubrizol, Marmon Group, and MidAmerican Energy – delivered record operating earnings. In aggregate these businesses earned more than $9 billion pre-tax in 2011. Contrast that to seven years ago, when we owned only one of the five, MidAmerican, whose pre-tax earnings were $393 million. Unless the economy weakens in 2012, each of our fabulous five should again set a record, with aggregate earnings comfortably topping $10 billion.

Buffett also said he thinks book value is a "considerably understated" proxy for intrinsic value.

Hedge-fund manager Whitney Tilson, a foremost expert on all things Buffett-related, said in an e-mail today that he thinks "over time, as Berkshire's value has shifted from its stock portfolio, which is valued at market (i.e., book value), to operating businesses like GEICO and [BNSF Railway], that Berkshire's intrinsic value is a greater percentage premium to book value – yet the stock is currently trading near the lowest premium to book in its history."

Also in the letter, Buffett reaffirmed his intent to repurchase Berkshire shares at 1.1 times book value (or $110,000 a share). Shares currently trade at $120,300. And they're trading near their lowest premium to book value in history. According to the Wall Street Journal…

After dropping 4.7% in 2011 and rising only half as much as the S&P 500 index so far this year, Berkshire shares are trading near their lowest valuation in decades: close to 1.1 times book value, versus its average valuation of about 1.6 times book value over the past two decades.

What struck me most about this year's letter was Buffett's discussion of languishing stocks… and how he likes flat markets (perhaps another reason he was so happy with Berkshire's 2011 performance).

When you buy high-quality companies, as Buffett does, you should only concern yourself with the company's earnings and shareholder payouts… Ignore the market noise. Buffett uses his recent IBM purchase as an example. (Berkshire owns 63.9 million shares, or 5.5% of the company.) As a long-term shareholder of IBM, what should Berkshire wish for over the next five years? Buffett says he wants the stock to "languish." Below is a long excerpt, but his reasoning important…

Let's do the math. If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the "disappointing" scenario of a lower stock price than they would have been at the higher price. At some later point, our shares would be worth perhaps $11.2 billion more than if the "high-price" repurchase scenario had taken place.

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

So the next time someone complains about Microsoft "going nowhere" over the past 10 years, enjoy a private chuckle. And enjoy the increasing earnings power and growing dividends. It's the beauty of buying a capital-efficient business… These businesses earn large returns on tangible assets without large capital expenditures. And they can increase their returns without big increases to capital spending.

Buffett also dedicated part of his letter to discussing his distaste for gold and gold stocks. He still prefers farmland, operating companies, and cash. But according to executives at the world's largest gold mining companies, their stocks are poised to rally.

"At some point, we become so inexpensive on a cash flow per share multiple that it makes no sense for buyers not to acquire the stock," Goldcorp CEO Chuck Jeannes said in a February 15 interview with Bloomberg. Gold-mining shares have fallen out of favor as investors moved capital into gold-backed exchange-traded funds (ETFs) and other proxies for physical gold. Over the past five years, the NYSE Arca Gold BUGS Index (the HUI), which includes the world's biggest mining stocks, has advanced 53%. Spot gold prices have more than doubled over the same time frame. Aaron Regent, CEO of the world's largest gold miner, Barrick Gold, said gold-mining stocks are heading for an "inflection point" and will soon rally.

You should consider buying gold stocks right now…

The opportunity is just too good to pass up. The last time these particular conditions came together, gold stocks rallied 121% in 12 months.

Let me explain the opportunity…

Typically, if gold goes up, gold stocks move even higher. And if gold goes down, gold stocks fall even more.

But during 2011, that relationship broke down. Take a look…

The chart shows the price of gold in blue and gold stocks in black. You can see that in 2009 and 2010, gold stocks performed as expected… They tracked the price of gold, but with more volatility.

But as you can see, that relationship fell apart in 2011… Last year, gold moved higher for the 11th straight year, gaining 10%. But gold stocks actually fell 16%.

Matt Badiali, our resident gold expert, sent me the following note about China's huge appetite for gold…

Imagine going to your favorite Macy's department store to pick up a couple of quarter-ounce bars of gold. In China, you can. Beijing's Caishikou Department Store carries gold jewelry, but it also sells gold bars. The Chinese people are so gold-focused that they are lining up at the gold-bar counter of the department store.

China will likely become the world's largest consumer of gold this year. The average person in China views gold as safety… and so do the country's leaders. China is quietly building up its gold reserves. That could become a major problem for you and me.

Matt has recently released a report describing China's quiet initiative to amass an immense gold reserve… and ultimately back its currency with gold. Given the trillion-plus dollars we owe them and the huge volume of dollars we're creating to cover our debts… this plan represents a danger to our standard of living.

Quotes of the Day

“Twenty years from now you will be more disappointed by the things that you didn't do than by the ones you did do. So throw off the bowlines. Sail away from the safe harbor. Catch the trade winds in your sails. Explore. Dream. Discover.”
― Mark Twain

“It is better to remain silent and be thought a fool than to open one's mouth and remove all doubt.”
― Abraham Lincoln

“I am enough of an artist to draw freely upon my imagination. Imagination is more important than knowledge. Knowledge is limited. Imagination encircles the world.”
― Albert Einstein

Relax your Mind

The Largest Gold-Accumulation Plan of All Time By Porter Stansberry

For more than 30 years, since the start of the country's "Reform Era" in 1978, China has been selling (exporting) more goods than it has imported.  

That's allowed the nation to stockpile trillions of dollars – more money than our entire monetary base totaled before the recent financial crisis.



The way it works is simple to understand. When a Chinese business earns dollars by selling overseas, the law requires the company to hand those dollars over to the country's central bank, the People's Bank of China (PBOC). In return, the business gets Chinese currency (called either the "yuan" or the "renminbi") at a fixed rate.  

There's nothing fair about this. The Chinese people do all the work, and the Chinese government keeps all of the money. But that's the way it goes.

At first, the dollar inflow was small because trade between the two countries was tiny. In 1980, for example, China's foreign currency reserves stood at approximately $2.5 billion. But since then, the amount of foreign currency reserves held by the Chinese government has gone up nearly every year… and now stands at $3.2 TRILLION. That's a 127,900% increase. It's simply astonishing to look at the chart of the increase in currency reserves…  

 
As I mentioned yesterday, the group in China that manages these foreign reserves is called the State Administration of Foreign Exchange (SAFE). This group is engaged in a full-fledged currency war with the United States. The ultimate goal – as the Chinese have publicly stated – is to create a new dominant world currency and dislodge the U.S. dollar from its current reserve role.

And for the past few years, SAFE has had one big problem: What to do with so much money? 

SAFE decided to use most of these reserves to buy U.S. government securities. As a result, the Chinese have now accumulated a massive pile of U.S. government debt. In fact, about two-thirds of China's reserves remain invested in U.S. Treasury bills, notes, and bonds. The next biggest chunk is in euro. Of course, all this money is basically earning nothing to speak of in terms of interest… because interest rates around the world are close to zero.

And while the Chinese would love to diversify and ditch a significant portion of their U.S. dollar holdings, they are essentially stuck. You see, if the Chinese start selling large amounts of their U.S. government bonds, it would push the value of those bonds (and their remaining holdings) way down. It would be like owning 10 houses on the same block in your neighborhood… and deciding to put five of them up for sale at the same time. Imagine how much that would depress the value of all the properties with so much for sale at one time.

One thing China tried to do in recent years was speculate in the U.S. stock market. But that did not go well… The Chinese government bought large amounts of U.S. equities just before the market began to crash in late 2007. It purchased a nearly 10% stake in the Blackstone Group (an investment firm)… and a similar stake in Morgan Stanley. Blackstone's shares are down about 46% since the middle of 2007, and Morgan Stanley is down about 70% since the Chinese purchase.

The Chinese got burned big time by the U.S. equities markets and received a lot of heat back home. They are not eager to return to the U.S. stock market in a meaningful way. So China's U.S. dollar reserves just keep piling up in various forms of fixed income – U.S. Treasury bonds, Fannie and Freddie mortgage bonds, and other forms of debt backed by the U.S. government. These investments are considered totally safe – except that they're subject to the risk of inflation.  

According to a statement by the government: "SAFE will never be a speculator. It mainly seeks to protect the safety of China's foreign exchange reserves and ensure a stable investment return." 

If the Chinese won't buy stocks and the only real risk to their existing portfolio is inflation, what do you think they will do to hedge that risk?  

They will buy gold… lots and lots of gold.

It was no surprise to us when, in 2011, China became the No. 1 importer of gold. For many people in the gold market, this was a big shock – India has always been the world's leading gold buyer. In India, people traditionally save and display their wealth in gold. Their entire financial culture is based on gold. Historically, silver has played the same role in China… but not anymore.

In fact, not only has China become the world's leading importer of gold, it was already the world's leading producer… by far. According to the most recent figures from the World Gold Council, China produces nearly 50% more gold (about 300 tons per year) than the second-place country… Australia. And guess what? Every single ounce produced in China – whether it's dug out of the ground by the government or a foreign company – must, by law, be sold directly back to the government.  

The Chinese are now clearly on a path to accumulate so much gold that one day soon, they will be able to restore the convertibility of their currency into a precious metal… just as they were able to do a century ago when the country was on the silver standard.  

The West wasn't kind to China back then. The country was repeatedly looted and humiliated by Russia, Japan, Britain, and the United States. But today, it is a different story…  

Now, China is the fastest-growing country on Earth, with the largest cash reserves on the planet. And as befits a first-rate power, China's currency is on the path to being backed by gold.  

China desperately wants to return to its status as one of the world's great powers… with one of the world's great currencies. And China knows that in this day and age – when nearly all governments around the globe are printing massive amounts of currency backed by nothing but an empty promise – it can gain a huge advantage by backing its currency with a precious metal.  

As the great financial historian Richard Russell wrote recently: "China wants the renminbi to be backed with a huge percentage of gold, thereby making the renminbi the world's best and most trusted currency."  

I know this will all sound crazy to most folks. But most folks don't understand gold, or why it represents real, timeless wealth. The Chinese do. And in tomorrow's essay, I'll provide more evidence of how they are carrying out the largest gold accumulation plan of all time.

An Imminent Coking Coal Settlement At $195-$210 Per Tonne Had Better Be A Bottom by Peter Epstein

The following report, if confirmed, is moderately negative for coking coal sentiment, therefore coking coal producers such as Walter (WLT), Teck, (TCK), Alpha, (ANR), Arch, (ACI), Peabody, (BTU), Cliffs, (CLF), Patriot, (PCX) and Consol Energy, (CNX).
A few days ago we got the following comment,

It is reported that the Jellinbah group (a privately owned independent Queensland based coal company with operations in Central Queensland's Bowen Basin) has entered into a price settlement with JFE Steel in Japan for the quarter Apr-June. They have set the price for HCC at $205 and PCI at $153/ton.

Yesterday it was reported that coking coal was offered in Asia at $195 per tonne on the spot market. Steve Doyle of Doyle Trading Consultants flagged this news item, but his team is waiting for more definitive news before passing final judgment on 2nd quarter pricing.
First quarter pricing of $235 per tonne is down approximately 29% from the high of $330 per tonne last year. A settlement at $200 per tonne would be a disappointment and may weigh on investor sentiment. However, if $200 per tonne is perceived to be a bottom, which many think that it will, then investors might take comfort.
Last week, Gerard McCloskey stated at coal conference that coking coal prices might bottom around $200 per tonne, McCloskey is quoted as saying,

There will be a correction of prices down towards $200," McCloskey predicted. "It's a great price. Until two years ago we had not had prices above $200 except for one brief period in 2008.

While McCloskey has been dead on in his prediction of where coking coal prices were headed from last summer, I respectfully disagree with his comment that a benchmark coking coal price of $200 is a, "great price." Three or four years ago, a price of $200 per tonne was indeed great. But since then, the marginal cost of production has risen substantially. Some market participants believe the higher end of the cost curve is at $150-$160 per tonne.
There are four main implications here. First, it appears that downside below $200 per tonne should be fairly limited. Second, whereas $200 was a great price 3-4 years ago, it's only a good price today. Third, low-cost producers around the world should be especially attractive going forward. Names that most readily come to mind in this regard are Consol and SouthGobi Resources (SGQRF.PK). Fourth, a price of ~$200 per tonne for the 2nd quarter had better turn out to be a bottom or many coking coal producers will be missing analyst expectations for 2012.
Consensus earnings estimates for coking coal companies appear to incorporate a 2nd half of 2012 up-tick in U.S. economic activity, a rebound / soft landing in China and, to a lesser extent, a slight increase in demand from Europe. Many sell-side research shops have penciled in an average price of $225-$250 per tonne for CY 2012. However, if we average ($235 + $200 = $217.5) in the first half, we will need to achieve 2nd half pricing of between $232.5 to $282.5 to reach a full year average of $225-$250.
This suggests again that 2nd quarter pricing of roughly $200 had better mark the bottom, and that 3rd quarter pricing had better bounce back to $235-$250, or analyst estimates will have to come down. I have repeatedly said that my hurdle rate for investment in the volatile coal sector is 25%. Many investors are excited that coking coal fundamentals are in the process of turning. For me, if a sustainable rally in coal stocks hinges upon a fairly strong rebound in 3rd quarter pricing, I will remain on the sidelines waiting for better visibility.
Disclosure: I am long ACI, CNX, BTU, ANR, PCX.

The U.S. Energy Story No One's Telling By Larsen Kusick

As you know, new technologies have "unlocked" massive amounts of natural gas right here in the U.S. These resources are so enormous, we're now the "Saudi Arabia of natural gas." Within a few short years, we'll be exporting liquefied natural gas (LNG). We'll see thousands of trucks converted to run on natural gas. And hundreds of natural gas-gas stations will pop up all across the U.S.

Companies like Westport Innovations (natural gas engines), Clean Energy Fuels (natural gas fueling stations), and Cheniere Energy (LNG exports) are obvious winners.

But they're not the only ones that will see huge increases in profits.

It's going to take thousands of "intermediate steps" to build out America's natural gas infrastructure… which brings me to the "picks and shovels" plays of the natural gas story.

Whenever you hear about a huge boom in a commodity… look around for the suppliers – the "picks and shovels" plays – that can profit. Because they'll do a steady business through swings in the commodity price, they're often the safe, "sleep at night" way to invest in a resource trend.

And this energy "megatrend" is no exception. You see, natural gas is trickier than liquids like oil and gasoline. A child with a bucket can move a liquid from one end of the house to another. Transporting gas is a different story.

Outside a pipeline, natural gas becomes a headache for anyone trying to move it. To make it manageable for transportation and storage, natural gas needs to be cooled down…. way down, to below -259 degrees Fahrenheit.

That requires a lot of special equipment. You need a machine called a heat exchanger to reach such subzero temperatures. And massive LNG plants have entire systems (known as "trains") that generate millions of tons of LNG each year.

Gas stations that want to sell natural gas will have to buy special equipment and systems. These new businesses will need special storage tanks, piping, safety equipment, and so on.

While the stocks of natural gas producers will boom and bust with small moves in the commodity price, the picks-and-shovels companies will continue to build out America's new natural gas infrastructure.

One likely leader in this new market is Air Products and Chemicals (APD). Air Products is a $19 billion company that has supplied and handled gases for decades.

It's been integral in building LNG plants all over the world since the 1970s. It sells machines such as heat exchangers, as well as a variety of other parts and services needed to operate an LNG plant.

In short, it's one of the few companies in the right place at the right time… just as natural gas use is about to boom in the U.S.

Air Products is already a giant company. The majority of its business comes from selling other industrial gases, like oxygen, nitrogen, and argon. So you won't get as much "bang for the buck" as a company that has more direct exposure. But you're much less likely to see the massive volatility you would with producers.

You can't crack the Wall Street Journal or the Financial Times without reading another story about the natural gas revolution. This is the story no one's telling yet… the picks and shovels story.

With divestitures and rate case successes, American Water's strategy to right its ship is working.

American Water Works is the largest investor-owned water and wastewater utility in the United States. As such, the company enjoys some considerable advantages over its competitors in pursuing the investment opportunities presented by the dismal state of American water infrastructure. Despite its position, we recommend that investors dial back their enthusiasm when considering this investment, as government regulation limits the profits the company can make and creates hurdles to rapid growth.
Much of the U.S. water infrastructure dates back to the Great Depression, and the Environmental Protection Agency estimated in 2007 that it would require about $335 billion to upgrade and repair just community and not-for-profit water systems. With municipalities struggling to finance basic repairs and federal funding unable to bridge the gap, the signs point to massive opportunities for investor-owned businesses.
American Water's size and geographical diversity mean that the firm is better able to capitalize on these opportunities, as it is easier to connect new customers to existing systems and treatment plants than to build new infrastructure. It also helps the company maintain lower rates, as it can balance less profitable operations in one state with more profitable operations in others. This helps with regulatory goodwill but doesn't generally lead to great regulated returns. Continuing economic weakness also weighs on performance, as regulators are more inclined to sacrifice shareholder returns in exchange for political capital.
American Water's regulated businesses occupy local monopoly positions, since it would be prohibitively expensive to reproduce those assets. However, as most of American Water's revenue is dictated by state and local regulators, profits are effectively capped, diminishing the attractiveness of investments the company could make. In our opinion, this is the source of the company's narrow economic moat. Allowed returns are often not achieved, and excess returns are almost never allowed.
An investor must be willing to sacrifice excess returns for stability that is not necessarily guaranteed. In 2003, German conglomerate RWE acquired this company and took it private with dreams of huge growth. It is telling that RWE took only three years to decide to divest its holdings, finding American regulation too onerous. After the initial public offering and three follow-up offerings in 2008 and 2009, RWE no longer holds a stake in the company.
While the company will press ahead with its regulated investments and try to gain some ground with its allowed returns, we think appealing opportunities could lie in nonregulated contract operations. The firm designs, builds, and operates facilities, as well as assuming responsibility for operating and managing existing systems. Given the company's size, expertise, patents, and past successes, we believe this is an area where it could greatly expand its footprint. If it can, this story may get more exciting. The regulated businesses should continue to be a consistent, if unexciting, backbone for profits, and management is committed to paying a steady dividend. The firm has made some sizable divestitures to raise cash, narrowing its focus to a smaller number of states. Still, American Water still has a slog ahead to reach the top tier of regulated investments in our coverage universe.

Valuation
We are increasing our fair value estimate to $27 per share from $26 as American Water has managed O&M and rate activity better than we had forecast. We also incorporate a time-value adjustment. We expect the company to grow at a modest clip, increasing gross margins at an average rate of roughly 5% per year through 2015. We project capital expenditures totaling $4.4 billion during the same period to drive growth, with contributions from minor acquisitions and tuck-ins, given the highly fragmented nature of the industry. Rate cases after years of stay-outs will provide some operating margin improvement. We project operating margins to average nearly 29% through 2015. Returns on equity will be unimpressive but should remain in the 8%-9% range.
One of our key assumptions is high-single-digit average growth in the firm's nonregulated wastewater and contract services segments during the five-year period. We agree with management's assessment that nonregulated design, build, and operate projects as well as operating and maintenance partnerships provide an attractive avenue for growth for which American Water is poised to take advantage. Our fair value estimate is sensitive to our 7.3% assumed weighted average cost of capital, based on a 10% cost of equity. If we decreased our estimated cost of equity by 50 basis points, our fair value estimate would rise to $31 per share. If we increased it by 50 basis points, our fair value estimate would fall to $24 per share.

Risk
American Water Works derives most of its profits from regulated operations. Consequently, the greatest risk it faces is regulation that does not permit the company to earn its allowed return and does not protect it from regulatory lag, which is the time between the incurring and the recovery of costs. A prolonged freeze in the credit markets could force the company to scale back growth expenditures. As acquisitions are a major source of growth for this company, competition with rival regulated utilities is a threat to American Water Works' growth prospects. Municipalities may also resist its overtures, as they did in Trenton in 2010. Its nonregulated businesses are also subject to competition.

Management & Stewardship
American Water Works' senior management has a wealth of experience in dealing with regulation and in the water services industry in particular. Former president and CEO Donald Correll had more than 30 years of experience at water utilities, including 25 years with United Water Resources, and managed to keep the company's house in line despite a difficult period with the RWE debacle. New president and CEO Jeffry Sterba also has a wealth of experience with regulation, having served more than 30 years with PNM Resources PNM, in both power and water. Judging by the regulatory successes in 2010, Sterba has done a fine job at the tiller so far. We like that the average tenure of board members is less than 10 years. The absence of long-term incentives creates a potential conflict of interest between shareholders and management. Current annual incentives are based on short-term financial and operational goals. Furthermore, the firm's newly developed compensation plan should draw skepticism. The plan appears to protect current executive pay by allowing immediate vesting--upon committee approval--in the event that control changes hands. While the use of return metrics is praiseworthy, immediate vesting of options for the executives could dilute future shareholder value.

Overview

Financial Health: American Water carries a significant amount of debt, with a 58% debt/capital ratio at the end of the third quarter of 2011. Coverage ratios should continue to improve with rate increases, and we expect EBIT/interest coverage will average just below 3 times through 2015. Asset sales should help the firm deleverage in the near term, with a large divestiture slated to go through in early 2012.

Profile: 
Founded in 1886, American Water Works is the largest investor-owned U.S. water and wastewater utility. It provides water and wastewater services to residential, commercial, and industrial customers, and operates predominantly in regulated markets, which account for nearly 90% of its total revenue. Its nonregulated businesses include wastewater management operations and public/private partnerships.

Microsoft will successfully navigate the transition to enterprise cloud computing.

Cloud computing is a double-edge sword for Microsoft. The impending move to web-based applications threatens to commodify the Windows PC operating system while opening up new revenue and profit opportunities in the deployment and delivery of cloud-based software services. Microsoft's server and business application software products are well positioned to ride the cloud computing wave even as the Windows PC OS franchise bears the brunt of the incoming tide.
The switching costs that form the moat around the Windows PC OS franchise are declining, and we expect Windows to lose market share and pricing power over the next decade. Software applications aimed at consumers as well as businesses are increasingly being delivered over the Internet for standardized consumption via web browsers. Such cloud-based services sever the historical ties between applications and operating systems and lower the barriers for switching among computing platforms. Further, the proliferation of non-PC computing devices such as smartphones and tablets is exposing users to alternative operating environments such as Google's GOOG Android and Apple's AAPL iOS and could make users more amenable to try alternative platforms for their primary computing device. Easier switching among platforms will directly result in reduced revenue and economic profit opportunities for the Windows PC franchise.
Cloud computing also threatens Microsoft's predominantly desktop-based Office franchise, but we expect the firm to successfully transition this business to a new cloud-based model. The Office 365 initiative is evidence of management's commitment to a software plus services model, and compelling economics suggest that the firm has sufficient incentive to walk the talk. As Microsoft makes services such as Exchange, SharePoint, and Office Web Apps available in a hosted, subscription-based model, we expect commercial customers to stick with their incumbent provider (Microsoft) to ensure consistency of existing workflows and minimize risks through the transition to cloud. This stickiness will prevent competitors like Google from making significant inroads into Microsoft's installed commercial customer base, although competition for new customers will be more intense. Nevertheless, Microsoft's ownership of broad suites of integrated products should help the company win competitive battles and maintain its market share even as the business model evolves, in our opinion.
One business' bane is another's boon. Application developers need software platforms to develop and deploy cloud applications, and Microsoft's Azure is poised to emerge as one of the largest platforms for cloud computing. Microsoft has the opportunity to migrate its existing army of .NET developers to the Azure platform, and the company has wisely focused on making this transition easy for customers. Further, similar to their on-premise counterparts, we expect cloud platforms to be very sticky as a result of high switching costs, enabling vendors to reap significant economic profits. Competitive dynamics should favor early entrants like Microsoft, and we do not expect the playing field to get very crowded; the combination of first-mover advantages stemming from the stickiness of platforms, breadth and depth of technological expertise required to develop a robust offering, and large up-front capital investments pose formidable barriers to entry. As a result, we expect Microsoft to build an economic moat around Azure and generate high returns on invested capital from this business.
While the transition to cloud computing will affect Microsoft's business over a long period, the firm's near-term financial performance will be driven by demand for its current products. Windows 7 is enjoying a strong cycle following tepid customer interest in Windows Vista, and Office 2010 appears to be off to a solid start. The server and tools business continues to grow as SQL Server gains market share and demand for Windows Server remains robust.

Valuation
We are raising our fair value estimate to $35 per share from $32 to account for cash earned since our last report. Our revised fair value implies 2012 price/earnings of 11.3 times, excluding net cash. Major technology transitions take a very long time, and we have modeled Microsoft's performance over a decade to capture the economic implications of the shift to cloud computing. Broadly, we forecast that growing revenue and declining operating margins will combine to deliver flat to low growth in total operating profits. Revenue from the Windows PC operating system business will decline significantly over the next decade, but growth in server and tools revenue, primarily Azure, will more than offset this revenue loss, in our opinion. We expect continued growth in revenue of the Microsoft business division as the software-as-a-service model expands Microsoft's share of customers' IT spending and also increases the market reach of hosted services such as Exchange and SharePoint.
Although cloud services will fuel continued revenue growth, these businesses will generate significantly lower operating margins compared with the firm's historical Windows and Office cash cows, given the hardware and management costs associated with delivering hosted services. The net effect of higher revenue and lower margins will be flat to low growth in operating profits as the revenue mix shifts toward cloud-based services through the decade, in our opinion. Finally, while we do not forecast any material upside from Microsoft's efforts at building a competitive search business, our model does assume that the online services division will stop hemorrhaging cash in the latter half of the decade.

Risk
The inevitable transition to cloud computing is the primary risk to Microsoft's businesses. Although we believe the firm will successfully transition its Office and server products to subscription-based cloud services, business model transitions are notoriously hard to navigate and have tripped up countless enterprises. Apple's and Google's growing share of consumers' spending on technology products could spark a faster-than-expected decline in share of the Windows PC platform in the enterprise.

Management & Stewardship
CEO Steve Ballmer's 3.95% equity stake and chairman Bill Gates' 6.41% equity stake clearly align their interests with those of outside shareholders. Director compensation and executive incentive compensation are both weighted toward stock awards, which generally bode well for long-term creation of shareholder value. Shareholders' ability to call special meetings and cast nonbinding advisory votes on the company's compensation practices also reflects well on the firm's corporate governance. While such policies and practices earn Microsoft an excellent Stewardship Grade, we have a mixed opinion on the firm's management. Over the past decade, management has done well to protect the firm's Windows and Office cash cows and build the server and tools franchise. However, the company appears to have missed opportunities to convert its early presence in several markets such as smartphones and tablets into strong competitive positions. We are skeptical of the firm's record with acquisitions and particularly disconcerted by the failed acquisition bid for Yahoo YHOO in 2008 at significant premium to our opinion of the target company's value at that time. Finally, a stream of recent executive departures raises questions about the firm's direction and strength of the remaining leadership bench.

Overview

Financial Health: Microsoft has a solid balance sheet, with nearly $52 billion in cash and cash equivalents, and about $12 billion in debt. We expect the company to generate more than $20 billion in free cash flow annually, allowing it to comfortably service the debt while continuing to invest in expanding the business.

Profile: 
Microsoft develops the Windows PC operating system, the Office suite of productivity software, and enterprise server products such as Windows Server and SQL Server. The Windows PC and Office franchises collectively account for nearly 60% of the firm's revenue, and the server and tools business contributes 24%. The firm's other businesses include the Xbox 360 video game console, Bing Internet search, business software, and software for mobile devices.

Warren Buffett continues to be a critical element in Berkshire Hathaway's competitive positioning.

A quick glance at Berkshire Hathaway's BRK.ABRK.B 13-F filing for the fourth quarter of 2011 revealed more than a handful of moves by the insurer during the quarter, with some of the transactions actually bearing the mark of incoming manager Ted Weschler. The first transaction of note was Berkshire's purchase of another 22.3 million shares of Wells Fargo WFC, which brings the firm's stake in the bank up to 383.7 million shares (worth $10.6 billion at the end of the fourth quarter). After touting Wells Fargo in his annual review to shareholders last year as a major holding that could see a meaningful increase in its divided, Warren Buffett put his money where his mouth was and snatched up another 41.1 million shares of the bank last year, increasing Berkshire's holdings in the firm by 12%. About the only other transactions we can ascribe to the Oracle of Omaha were the purchase of 6.6 million additional shares of International Business Machines IBM (which we already knew about last quarter), and the sale of 8.4 million shares of Johnson & Johnson JNJ and 2.7 million shares of Kraft Foods KFT.
While the purchase of another 16.1 million shares of The DIRECTV Group DTV looks like a Buffett move, given that the stock position was worth more than $870 million at the end of the fourth quarter, it is more likely a combined purchase from Berkshire's two new hires--Todd Combs and Ted Weschler (who had DIRECTV listed as the second largest holding in his Peninsula Capital fund at the end of third quarter 2011). We assume that it was a combined purchase because Berkshire was already building a stake in the firm in the third quarter, and Weschler's hiring wasn't announced until mid-September). Looking at the rest of Weschler's holding at the end of the September quarter, it looks like he was also the driving force behind Berkshire's new money purchases of 2.7 million shares of DaVita DVA and 1.7 million shares of Liberty Media LMCA, as both firms were top five holdings in his fund. What's interesting to note, though, is the absence of W.R. Grace & Company GRA form the portfolio, given that it was Weschler's top holding at the end of the third quarter (accounting for close to one third of his total stock portfolio).
As for the remaining transactions, which we assume were handled by Todd Combs, Berkshire picked up another 573,000 shares of Visa V to go with the 2.3 million shares that had been picked up with new money during the third quarter. Combs also picked up another 1.4 million shares of CVS Caremark CVS in the fourth quarter, adding to the 5.7 million shares stake that he had initiated in the previous quarter. The same sort of activity occurred with General Dynamics GD and Intel INTC, both of which were new money purchases during the third quarter. In the case of General Dynamics, Combs added 813,000 shares to a 3.1 million share stake. With Intel, it was the addition of 2.2 million shares that brought Berkshire's stake in the semiconductor firm to 11.5 million shares at the end of the fourth quarter. We also assume that Todd Combs sold of the remaining 422,000 shares of ExxonMobil XOM, which was originally purchased in the third quarter of 2009, and was never a meaningful position in the portfolio.
With regards to the only other transaction in the filing, the addition of 1.3 million shares of Verisk Analytics VRSK, we don't believe that it was a purchase. Verisk is essentially a technology company that provides insurance companies with data and software that they need to run their business. Prior to its initial public offering in October 2009, Verisk had been funded by a number of large insurance companies--including Berkshire--that received shares in the company as it went public. With restrictions placed on the Class B shares the insurers received as part of the IPO, Berkshire has held approximately 7.1 million shares of Verisk's Class B common stock since that time. With half of these shares automatically converting to Class A common stock in early April of last year, and the remainder converting in early October, it was the conversion rather than an outright purchase of Verisk that is responsible for the change in Berkshire's 13-F filing.
Stay tuned as we intend to publish a much deeper look at Berkshire's holdings as part of our Ultimate Stock-Pickers content.

Thesis 09/12/11
Berkshire Hathaway's wide economic moat has been built on the firm's track record of acquiring and managing a portfolio of businesses with enduring competitive advantages. Whether through direct ownership of individual companies, or via significant stock holdings, famed value investor Warren Buffett has looked to acquire firms that have consistent earnings power to generate above average returns on capital, have little to no debt, and have solid management teams. Once purchased, these businesses tend to remain in Berkshire's portfolio, with sales occurring rarely. Buffett strives to raise capital as cheaply as possible to support Berkshire's ongoing investments and measures the success of the portfolio by per-share growth in intrinsic value. Book value per share, which is the main proxy used to measure the intrinsic value of the firm, has increased 20% per year on average over the last 45 years. Given the current size of its operations, the biggest hurdle facing Berkshire will be its ability to consistently find deals that not only add value but are large enough to be meaningful. The other major issue facing the firm is the longevity of Buffett and managing partner Charlie Munger, both of whom are octogenarians.
Berkshire's most important business continues to be its insurance operations. Not only do they contribute a significant portion of the firm's profits but they also generate low-cost float (the temporary cash holdings arising from premiums being collected well in advance of future claims), which is a major source of funding for investments. Berkshire underwrites insurance through three main units: GEICO, General Re, and Berkshire Hathaway Reinsurance. GEICO, which is the third-largest auto insurer in the United States, relies on direct selling to consumers, a model that provides it with cost advantages over some of its competitors. While this practice has become more common, GEICO was a pioneer in the channel and continues to generate solid underwriting profits and negative cost of float for Berkshire.
The firm's two other main insurance businesses are both reinsurers. For a premium, they will assume all or part of an insurance or reinsurance policy written by another insurance company. General Re is one of the largest reinsurers in the world based on premium volume and shareholder capital, while Berkshire Hathaway Reinsurance's claim to fame is its ability to take on large amounts of super-catastrophe underwriting, which covers events like terrorism and natural catastrophes. These unique policies often contain large tail risks which few companies (other than Berkshire, with its strong balance sheet) have the capacity to endure. When priced appropriately, though, these types of transactions can generate favorable long-term returns on capital for the firm.
Berkshire's non-insurance operations include a wide array of businesses from Burlington Northern Santa Fe (railroad) to MidAmerican Energy (energy generation and distribution), McLane (food distribution), Marmon (manufacturing), Shaw Industries (carpeting), Benjamin Moore (paint), Fruit of the Loom (apparel), Dairy Queen (restaurant), and See's Candies (food retail). Of the more than 70 non-insurance businesses in its portfolio, the two largest contributors to Berkshire's operating earnings are Burlington Northern, which the firm acquired in full in February 2010, and MidAmerican, in which Berkshire maintains a 90% stake (having initially added the company to its holdings more than a decade ago).
Buffett's shift into such debt-heavy, capital intensive businesses as railroads and utilities is a marked departure from other investments, which have tended to require less capital investment and have had little to no debt on their books. While running railroads and utilities requires massive reinvestment, Berkshire has entered these businesses because they can earn decent returns on incremental investments, ensuring that the large amounts of cash generated by other operating businesses are reinvested in value-creating projects. And while Berkshire does consolidate the debt of these two subsidiaries on its own balance sheet, the firm guarantees none of it.
All of Berkshire's operating businesses are managed on a decentralized basis, eliminating the need for layers of management control and pushing responsibility down to the subsidiary level, where managers are empowered to make their own decisions. This leaves Buffett free to focus on capital allocation decisions and managing the investments in Berkshire's portfolio--two things that he has been extremely adept at doing during the last four-plus decades. While we could certainly argue that Buffett is not the sole reason for Berkshire's success, he has been (and continues to be) a critical element in the firm's competitive positioning. In our view, Buffett's ultimate departure would cause the firm to lose some of the significant advantages that have resulted from his being at the helm.

Valuation
We've lowered our fair value estimate for Berkshire Hathaway's Class A shares to $133,500 from $140,000 to account for the impact we believe underwriting losses from the firm's insurance segment will have on operating earnings this year. We also expect Berkshire to be adversely impacted by the downturn in the equity markets, which not only impact the value of the firm's investments (which would diminish book value per share) but the value of its equity derivative contracts as well. Our new fair value estimate is equivalent to 1.4 times the company's reported book value of $98,716 at the end of the second quarter of 2011. Over the last decade, Berkshire's Class A shares have traded in a range of 1.1 to 1.9 times book value, with a median value of 1.5 times. Our fair value estimate for the Berkshire is derived from a sum-of-the-parts methodology, which values the different pieces of the company's portfolio separately, then combines them to arrive at a total value for the firm.
With Berkshire not expected to post an underwriting profit from its insurance operations this year, and the value of its equity investments diminishing in a down market, and the firm losing lucrative investments in Goldman Sachs GS, General Electric GE, and Swiss Re (which are all likely to be paid off by the end of 2011), we estimate that Berkshire's insurance segment is worth $73,400 per Class A share (versus $82,800 in our previous valuation). As for the firm's noninsurance subsidiaries, we believe Berkshire's manufacturing, service & retailing operations--which include Lubrizol for our valuation purposes--are worth $24,500 per Class A share ($1,600 higher than our previous estimate, a direct result of the segment seeing much stronger operating profits through the first six months of 2011 than we had been forecasting for the year). We estimate that Berkshire's railroad, utilities and energy division is worth $30,000 per Class A share (relatively unchanged from our previous valuation), as stronger than expected growth from Burlington Northern this past year has been stymied by higher-than-expected capital expenditure projections for MidAmerican Energy over the next five years. Finally, we estimate that Berkshire's finance and financial products division is worth $5,500 per Class A share ($1,000 less than our previous estimate, as revenues and operating earnings from the segment continue to come in significantly lower than we had been forecasting).

Risk
Berkshire is exposed to large potential losses through its insurance operations. While the company believes its super-catastrophe underwriting will generate solid long-term results, the volatility of this particular line of business, which can subject the firm to especially large losses, could be high. That said, Berkshire maintains higher capital levels than other insurers, which we believe helps mitigate some of the risk. Several of the firm's key businesses--insurance, energy generation and distribution, and rail transport--operate in industries that are subject to higher degrees of regulatory oversight, which could impact future business combinations and the setting of rates charged to customers.
Berkshire also is exposed to foreign currency, equity price, and credit default risk through its various investments and operating companies. The firm's derivative contracts, in particular, can impact Berkshire's earnings and capital position, especially during volatile markets, given that they are recorded at fair value and, therefore, are periodically updated to record the changes in the value of these contracts. Many of the firm's non-insurance operations, meanwhile, are exposed to the cyclicality of the economy, with results typically suffering during economic slowdowns and recessions.
Finally, Berkshire is highly dependent on two key employees, Warren Buffett and Charlie Munger, for almost all of its investment and capital allocation decisions. With both men now in their 80s, it has become increasingly likely that our valuation horizon will end up exceeding their expected life spans. We also believe investment returns and capital-allocation quality are likely to deteriorate under new management. The departure earlier this year of David Sokol, who many assumed was the heir apparent to the CEO role, has also raised serious questions about Berkshire's internal controls and, to some extent, has tarnished the firm's legacy of strong ethical behavior.

Management & Stewardship
Warren Buffett has been chairman and CEO of Berkshire Hathaway since 1970. Charlie Munger has served as vice chairman since 1978. Berkshire has two classes of common stock, with Class B shares holding 1/1,500th of the economic rights of Class A shares, and only 1/10,000th of the voting rights. Warren Buffett is Berkshire's largest shareholder, with a 34% voting stake and 23% economic interest in the firm. While there are many aspects of Berkshire's corporate governance that fall short of our standards, such as having the chairman and CEO roles combined, Buffett has tended to be a strong steward of investor capital, consistently aligning his own interests with those of shareholders. This makes it even more important that his legacy remains intact once he no longer runs the firm. Succession was not formally addressed by Buffett until 2005, when he noted that his three main jobs--chairman, chief executive, and chief investment officer--likely would be handled by one chairman (expected to be his son, Howard Buffett), one CEO (with just three potential internal candidates identified), and three or more external hires (reporting to directly to the CEO) to manage the investment portfolio. The resignation of David Sokol, who had been assumed to be the heir apparent to the CEO role, has thrown succession planning back into the spotlight this year. In our view, whoever steps into Buffett's role as chief executive is going to feel more pressure from shareholders and analysts than Buffett has ever been subjected to, which means that the board will have to work all that much harder to ensure that the remaining candidates are thoroughly prepared for the role. That said, the real long-term question for investors is whether any of them can replace the significant advantages that have come from having an investor of Buffett's caliber, with the knowledge and connections he has acquired over the years, running the show.

Overview

Financial Health: 
Berkshire's financial strength was tested by the collapse of the credit and equity markets in 2008, which ultimately led to the company losing its AAA credit rating in 2009. That said, Berkshire remains one of the most financially sound companies we cover, with the firm managing its risk through diversification and a conservative capital position.

Profile: 
Berkshire Hathaway is a holding company with a wide collection of subsidiaries engaged in a number of diverse business activities. The firm's core business is insurance, run primarily through GEICO (auto insurance), General Re (reinsurance), Berkshire Hathaway Reinsurance, and Berkshire Hathaway Primary Group. The company's other businesses are made up of a collection of finance, manufacturing, and retailing operations, along with railroads, utilities, and energy distributors.

Despite its aggressive push toward oilier plays, Chesapeake remains heavily tied to natural gas.

Chesapeake Energy CHK provided more color Monday on how it intends to bridge the sizable gap between cash flow and investment in 2012, although not much new information was revealed, nor were very many specifics. First up are $2 billion in planned monetizations of Mid-Continent assets, including a volumetric production payment deal and a financial transaction similar to the one previously executed in the Utica (under which investors owned perpetual preferred shares in a separate subsidiary). Chesapeake anticipates receiving proceeds from these deals in the next 60 days. The company also announced it is pursuing joint ventures across its Mississippi Lime and Permian Basin positions. Somewhat surprisingly, Chesapeake disclosed a near doubling of its Permian acreage since late last year, to 1.5 million net acres, and announced that it may consider an outright sale of this position if it receives a compelling offer. Between the joint ventures (or an outright Permian sale) and other minor asset sales, Chesapeake estimates potential proceeds of $6 billion-$8 billion by the end of the third quarter of this year. Finally, the company reiterated plans to monetize certain midstream and service company assets and other investments, which could generate $2 billion in proceeds. Combined, these transactions should effectively bridge the gap between estimated cash flow ($3.9 billion) and investment ($9.7 billion) in our model for this year. We have long believed it to be a mistake to bet against the Chesapeake asset sale machine, and this time is no different, despite a lack of clarity on timing and eventual sale amounts (none of the deals in Monday's press release are under binding agreements). Our fair value estimate is unchanged at $32 per share.

Thesis 12/16/11
Chesapeake is among the most aggressive operators in the U.S. E&P space, able to quickly build dominant positions in emerging plays through its vast network of land brokers and a general willingness to offer more favorable lease terms than its competitors. While this approach has helped Chesapeake amass a portfolio that comprises almost every leading unconventional play in the U.S., it has also led to ongoing questions about the sustainability of the firm's business model, given its propensity to outspend available cash flow. Despite the potential for some fits and starts over the next few years as Chesapeake works through how to best monetize its extensive inventory, we're bullish on the company's ability to increase production and reserves going forward, given management's knack for creatively financing its operations and the relevance (that is, the attractiveness to third-party investors) of its current leasehold positions.
Chesapeake's portfolio includes more than 14 million net acres of onshore oil and gas assets. The firm holds leading positions in the Barnett, Haynesville/Bossier, Marcellus, Eagle Ford, Niobrara, Permian, Utica and Anadarko Basin regions, among others, and continues to build its presence in liquids-rich plays as part of an ongoing strategy to diversify away from natural gas. Given impending lease expirations (or a sizable inventory of wells waiting on completion) in a number of its plays, we expect Chesapeake to push its drilling and completion plans hard over the next several quarters in order to hold acreage and bring production on line, especially in the Haynesville and Barnett regions. There is generally less urgency in Chesapeake's Marcellus, Eagle Ford, Utica, and Granite Wash acreage, although we expect joint venture considerations and takeaway commitments to drive drilling activity in these regions to a certain extent.
Chesapeake's "land rush" strategy has led to charges that the firm marginalizes the economics in its plays, given its willingness to accord higher royalties and pay top dollar for leases. Chesapeake would counter that it is locking up once-in-a-lifetime assets and would point to subsequent transactions that validate its above-market cost basis. We concede that Chesapeake appears skilled at securing large blocks of land within emerging plays--a combination of its "land machine" and technical skill--and find it hard to argue with the prices that have been paid by third parties for portions of its acreage. That said, Chesapeake's approach has at times led to serious problems for the firm, as in 2008, when a steep drop in natural gas prices forced the company to sell assets and raise external capital to help shore up its balance sheet. To Chesapeake's credit, the financing methods it put in place at that time--most notably volumetric production payments, or VPPs, and a handful of joint ventures--have helped the company stay afloat longer than most thought possible and served as an essential financing tool for the firm as it expands its operations. Nevertheless, we believe these financial maneuvers--in particular JVs--have benefited Chesapeake to the detriment of the broader E&P industry, in large part through carries that help support uneconomic drilling meant to achieve HBP status.
Based on the success it has had with such structures, we expect Chesapeake to continue utilizing JVs and VPPs going forward. The firm has entered into seven JVs and nine VPPs since late 2007, generating total proceeds of approximately $22 billion ($3.1 billion of which remains to be earned over the next several years in the form of drilling carries). Chesapeake's key JV partnerships include Statoil in the Marcellus, Total in the Barnett, and most recently CNOOC Ltd. in the Eagle Ford and Niobrara.
Chesapeake is more vertically integrated than most large producers. The firm takes an active stance on costs by investing directly in its service providers: Chesapeake holds interests in the fifth-largest rig contractor, the third-largest hydraulic fracturing company, and the second-largest compression business in the U.S. and also operates its own core sample testing center. In addition, Chesapeake owns and operates a good portion of its midstream pipeline assets, in part through a publicly traded master limited partnership (Chesapeake Midstream Partners, L.P.). We highlight the potential for takeaway bottlenecks in some of the firm's newer plays--particularly the Haynesville, Marcellus, and Eagle Ford regions--and note that we expect sizable ongoing midstream spend over the next several years.
In short, despite Chesapeake's past missteps and some ongoing uncertainty as to how the firm best realizes the potential of its inventory, we expect additional JVs, VPPs, and trust offerings to help fund drilling activity across the firm's 14 million net acres, leading to strong growth in production and reserves throughout our forecast period.

Valuation
We are raising our fair value estimate for Chesapeake to $32 per share from $29 after incorporating third-quarter results (which included an accelerated shift toward liquids and the successful execution of a JV in the Utica Shale). Our new fair value estimate implies a forward 2012 enterprise value/EBITDAX multiple of 7 times, and is based on our five-year discounted cash flow model and an assessment of trading multiples, comparable transactions, and longer-term resource potential.
We project average daily net production of 3.2 Bcfe in 2011, 3.5 Bcfe in 2012, and 3.9 Bcfe in 2013, representing an 11% compound annual growth rate over 2010 levels. Chesapeake remains one of the most active drillers in the U.S. exploration & production industry, with approximately 170 operated rigs across its acreage. The firm's push to achieve HBP status in certain plays, along with JV partnership obligations and minimum takeaway commitments, should continue to fuel high levels of drilling activity over the next few years, funded in part through Chesapeake's approximately $3.1 billion in remaining drilling carries. We expect the firm's Marcellus, Eagle Ford, and Anadarko Basin acreage to drive most of its production growth throughout our forecast period. Within the Anadarko Basin, we forecast net production of 602 mmcfe/d in 2011, 669 mmcfe/d in 2012, and 779 mmcfe/d in 2013. In the Marcellus, we forecast net production to increase from 381 mmcfe/d in 2011 to 549 mmcfe/d by 2013, driven by the $1.4 billion in drilling costs the firm will collect from JV partner Statoil. Across Chesapeake's Eagle Ford acreage, we forecast net production growing from 98 mmcfe/d in 2011 to 630 mmcfe/d by 2013.
Driven by production growth and an ongoing shift toward liquids, we forecast EBITDA of $5.2 billion in 2011, $4.6 billion in 2012, and $6.1 billion in 2013. Chesapeake's hedges cover approximately 20% and 40% of our 2012 and 2013 estimated natural gas production, respectively, and 40% and 30% of our estimated oil production, which should help reduce near-term cash flow variability.

Risk
Chesapeake's biggest risk is a substantial and prolonged drop in oil and gas prices, which would depress profits, slow development plans, and reduce the value of its properties. Other risks include a disruption in the asset market, which would limit the company's ability to monetize its acreage holdings, a shrinking universe of potential JV partners with which to transact going forward, execution risk within Chesapeake's emerging plays (in particular the Haynesville, Marcellus, Eagle Ford, Anadarko Basin, Utica, and Niobrara regions), potential midstream bottlenecks, especially within the Marcellus and Eagle Ford, and regulatory headwinds that could ultimately eat into profitability.

Management & Stewardship
Chesapeake is led by chairman and CEO Aubrey McClendon, who has served in these roles since co-founding the company in 1989. McClendon maintains a fairly visible--and, some would argue, controversial--presence in the E&P space, in part through his role as a de facto spokesman for the U.S. natural gas industry as well as his highly promotional approach to Chesapeake's business dealings. One of McClendon's key reports, CFO Marc Rowland, left the company in late 2010 after 18 years to become president of Frac Tech, a hydraulic fracturing company in which Chesapeake owns a minority stake. Rowland was succeeded by Domenic Dell'Osso, who joined the firm in 2008.
Chesapeake's stewardship has come under fire at times for what many view as a lack of focus on key per-share metrics and discretionary compensation practices that appear disconnected from company performance. Chesapeake's top officers routinely collect some of the biggest compensation packages in the E&P industry (executive perks alone make up more than $1 million of total compensation in certain cases), with each of Chesapeake's independent directors making in excess of $400,000 a year. The firm's decision to award McClendon $75 million in incentive pay in late 2008 was especially controversial and viewed by many as nothing more than a make-whole for McClendon in the wake of a margin call that forced him to liquidate substantially all his Chesapeake stock holdings. Collectively, the firm's top officers own less than 1% of common shares outstanding.

Overview

Financial Health: 
Chesapeake has historically paired its aggressive operating strategy with a similarly aggressive financing strategy. From 2005 to 2010, the firm's capital spending significantly outpaced operating cash flow, resulting in net borrowing of $11.8 billion and the implementation of several nontraditional financing vehicles to help meet cash shortfalls. During this time, Chesapeake's debt/capital ratio averaged 47%, with average debt/proven reserves and debt/EBITDAX ratios of $0.91 per mcfe and 2.5 times, respectively. The firm has taken a number of steps to improve its financial position during the last several quarters, including the redemption of close to $3 billion in senior notes and the issuance of more than $3 billion in preferred securities.
We expect Chesapeake to continue its strategy of funding investment activity through a combination of operating cash flow, VPPs, JV transactions, asset sales, trust offerings, and debt financing through 2013, with free cash flow becoming positive in 2014. We forecast a debt/capital ratio of 40% in 2011, 47% in 2012, and 49% in 2013, with the firm's debt/proven reserves and debt/EBITDAX ratios remaining elevated, as well. We estimate the firm's outstanding obligations for its VPPs will be $1.8 billion by year-end 2013. (Note that none of the preceding credit metrics incorporates Chesapeake's ongoing VPP obligations.)

Profile: Chesapeake Energy, based in Oklahoma City, explores for, produces, and markets primarily natural gas within the United States. The firm focuses on unconventional plays, with large positions in the Barnett, Eagle Ford, Haynesville, and Marcellus Shales, as well as leaseholds in a number of liquids-rich basins. Chesapeake holds approximately 14.9 million net acres across its properties. At year-end 2010, the firm's proved reserves totaled 17.1 Tcfe, with daily production of 2.8 Bcfe. Natural gas made up 90% of proved reserves.

The moat around Apple's iOS platform continues to widen.

The list of once-great consumer electronics companies is long, but Apple has staying power because it has developed an ecosystem that connects success in one generation of devices to successive consumer purchases.
Apple is transcending the risks of the classic product cycle. Historically, consumer electronics companies have competed for the consumer's attention with the latest and greatest gadgets. Success of this type has proved fleeting, as brand loyalty is largely dead. For example, when shopping for televisions, customers look for the best combination of price and features, with few consequences arising when they replace a Sony with a Vizio. In handsets, the Motorola Razr was a breakthrough phone that dominated the market, but Motorola fell apart because it misfired on the following product cycle and lacked a connection that would pull the user from one generation of the Razr to the next. A Dell PC is easily replaced with a Hewlett-Packard PC, but for decades the user likely would be running Microsoft Windows. Apple is replicating what worked for Windows, minimizing the risk of losing customers between product cycles by using software to connect the user to not just a single device, but an ecosystem of applications and content spanning multiple devices and creating a relationship that survives the useful life of any single device.
The key difference for Apple is iOS, the operating system that spans the company's portfolio of devices. IOS envelops the user in an ecosystem of applications and content that makes it inconvenient to switch to another vendor's device down the road. A typical Apple user experience may begin with an iPod or an iPhone. The user builds a content library, a collection of applications, and routines that are not convenient to move to a competitor's device. Once the consumer enters the market for a replacement phone or additional device (tablet), the cards are stacked in Apple's favor because of the existing dependence on iOS. Once multiple devices are in place, the switching costs are magnified, because many people will be reluctant to replace their phone, tablet, and possibly other devices at the same time, but equally reluctant to split their Web and media consumption habits between ecosystems. Competitors' devices will not always be inferior, but Apple is capturing a large portion of a user base that is trading freedom of choice for an enhanced user experience.
Apple's economic moat may be widening with iCloud. We believe iCloud takes switching costs to the next level by creating a virtual presence in the cloud that encapsulates all of the consumer's communications, preferences, and content, breaking the tether to any specific device. The bond created between the user and the presence in the cloud is perpetual, and much stronger than the bond between a user and any specific device with a limited life span. The service itself may not generate tens of billions of dollars, but it secures the customer and makes it more desirable to interact with multiple devices.
The Apple story is not without risks. Co-founder and former CEO Steve Jobs was special, and even if those who follow him bring the rare combination of vision and ability to execute, it remains to be seen if they will inherit the moral authority that enabled Jobs to drive his agenda. Additionally, HTML5 and other platform-agnostic technologies could provide users with access to third-party applications on devices from all manufacturers. Finally, a stumble (albeit unlikely) on a product cycle in the early innings of smartphone adoption would come with a tremendous opportunity cost in terms of lost users. Users are only locked into Apple's ecosystem after they join, so as the nascent market emerges, each user that falls into a competitor's ecosystem carries away a significant loss of value. However, Apple already has established a narrow moat, and it will be some time before these issues present a risk to the growth of its customer universe.

Valuation
We are raising our fair value estimate to $560 from $530 per share to account for greater near-term momentum with the iPhone and iPad than we had originally forecast. The iPhone remains the cornerstone of Apple's consumer strategy, and few opportunities loom larger than the global handset market. The iPhone already accounts for more than 50% of revenue, and we expect this percentage to grow to more than 60% during the forecast period. We envision a total addressable market of approximately 1 billion smartphones by 2015, with Apple claiming approximately 28% of the market. The iPad and any other devices that may emerge will also contribute to Apple's success, but we find it very difficult to envision another device that emerges as an iPhone-scale winner. Likewise, the Apple halo effect from success in handsets and tablets will drive interest in PCs, but the opportunity to penetrate this mature market is limited relative to the emerging markets for portable devices, and we think the Mac will become a smaller portion of the Apple story over time.
We anticipate firmwide gross margins will fall during the forecast period from 40% to the lower-30% range. Though the firm's economic moat will drive impressive returns, we believe increased competition will provide some pressure on Apple's pricing power. Additionally, we believe Apple will trade margins for growth in the near term. Most likely, the firm will employ strategies such as concurrent availability of multiple iPhone versions at different price points to ensure the broadest possible market penetration. The impact on the financial statements should appear in the form of slight margin compression and revenue growth trailing unit growth in key segments.
We award Apple a high fair value uncertainty rating because of its dependence on the ultimate size of the addressable markets for smartphones and handsets. We are in the early innings of development for these markets. Apple's ability to penetrate and the size of the mobile computing market are by far the most critical assumptions for our valuation. Though we are comfortable with Apple's economic moat and its potential to increase its already impressive revenue, visibility into the size of the firm's addressable markets five years from now remains limited.

Risk
In our view, Apple's success during the last decade is largely attributable to the leadership of Steve Jobs, and his passing has dealt a heavy blow to the company. We think CEO Tim Cook is an able manager and Apple has an extremely deep talent pool. But we also believe Jobs' product- and user-focused vision had been instrumental to Apple's renaissance and had served investors incredibly well. There is clearly some continuity in the transition, and a full pipeline of Jobs-approved launches will drive the firm forward for a few years, but Jobs' death chips away at our faith that Apple can continue to innovate faster and better than competitors in the long-run. Ultimately, asking "What would Steve do?" is a lot easier than getting the answer correct.
Apple has created a powerful position in the minds of consumers, but its current feature set only creates moderate switching costs, in our opinion. Long-term value creation will be a function of Apple's ability to raise these switching costs with iCloud.
Finally, any stumble in the early product cycle as smartphone adoption sweeps the globe would come with a tremendous opportunity cost in terms of lost users. Users are only locked into Apple's ecosystem after they join, so as the nascent market emerges, each user that falls into a competitor's ecosystem carries away a significant loss of value.

Management & Stewardship
Steve Jobs' passing was a major blow for Apple, as he was an irreplaceable leader. Nonetheless, the co-founder of Apple established a sustainable culture and strategy for the firm and we expect the current management team has enough structure and momentum to deliver a long period of success. Jobs personally recruited much of the current management team, and most have worked with him for a long time. CEO Tim Cook came to Apple from Compaq in 1998. CFO Peter Oppenheimer has been with the company since 1996. Nonetheless, Jobs was special, and even if those who follow him bring the rare combination of vision and ability to execute, it remains to be seen if they will inherit the moral authority that enabled Jobs to drive his agenda.
The stock-option backdating scandal raises our stewardship concerns, but we believe aggressive moves by the board have enabled the company to turn the page. Apple has taken other steps in the right direction, including the appointment of lead co-directors in 2006. The majority of executive compensation is aligned with shareholder interests in the form of restricted stock units tied to long-term company performance. We applaud the board's long-term view in awarding Cook 1 million options vesting over 10 years, aligning his long-term interests with those of shareholders.

Overview

Financial Health: 
The company has $30 billion in cash and short-term investments, holds another $68 billion in long-term investments, and generated more than $33 billion in free cash flow during fiscal 2011. It carries no debt.

Profile: Apple designs consumer electronic devices, including PCs (Mac), tablets (iPad), phones (iPhone), and portable music players (iPod). Its iTunes online store is the largest music distributor in the world; it sells and rents TV shows and movies and sells applications for the iPhone and iPad. In early 2011, Apple launched the Mac app store, an online store that sells first- and third-party applications for Mac desktop and notebook computers. Apple's products are distributed online as well as through company-owned stores and third-party retailers.

We think intellectual property fears are overblown, and Google is as strong as ever.

Google GOOG announced fourth-quarter earnings Thursday against a backdrop of high expectations, with results modestly ahead of our forecast but meaningfully below consensus, resulting in a dramatic sell-off in the shares. We are not changing our fair value estimate and consider the shares to be undervalued, although we would prefer a bigger discount before encouraging new investment.
Results were strong across the board, with quarterly revenue from Google properties (primarily including Internet search and YouTube) and revenue from ads placed on partner sites growing 29% and 15% versus 2010, respectively. With total advertising revenue growing 27% versus 2010, we still believe Google is modestly gaining market share in online advertising, a remarkable feat given the size of this Internet behemoth and a testament to its wide economic moat. Additionally, controlled spending helped improve quarterly operating margins to 33%, ahead of our expectations.
Although costs per click (or CPC, the average amount advertisers pay when consumers click on an ad) declined 8% from the prior quarter, we think it is important to look beyond that single metric to paid clicks, which grew 17% versus the third quarter. Google regularly tweaks its advertising algorithms and enhances ad formats to improve the user experience and maximize revenue. According to product vice president Susan Wojcicki, algorithm changes had a positive effect on revenues. In other words, we believe that every search generated higher revenue per search, despite the decline in CPC. The increase in paid clicks is the greatest quarterly gain since the fourth quarter of 2006.
Over the course of the next quarter or so, we expect some regulatory overhang and investor angst as Motorola Mobility MMI is folded into the Google family. Although we do not expect either issue to affect our overall thesis, uncertainty surrounding Google has historically led to volatility in the stock price.
Lastly, we have little doubt the Internet search market is maturing, and Google’s tweaks to its advertising algorithms can only go so far. Heavy investment by Google in Android (a mobile operating system), Google+ (its social network) and YouTube as well as other initiatives is warranted, in our view. History has not been kind to Internet companies that failed to invest into adjacent markets and exploit key competitive advantages. Many of these initiatives may take several years to generate free cash flow, but we believe management's long-term view will ultimately generate excess returns on capital and strong shareholder returns.

Thesis 10/18/11
In today's lexicon, the words "Google" and "search" are practically interchangeable. Every day, the average user searches on the Internet at least twice. Last year, these searches generated about 20 billion clicks per month. This seemingly trivial activity has generated billions of dollars of cash and provided Google an opportunity to build a strong portfolio of assets for users and advertisers. This portfolio not only provides a long runway for Google to continue growing, but also gives the company the most defensible position in the Internet segment of our coverage list, in our opinion.
As the pre-eminent leader in search, Google maintains more than 60% of worldwide market share; no other competitor has even 10%. We believe the company's early technical advantages attracted users who now use it habitually, creating a switching cost based on familiarity with the engine. While the firm may face near-term headwinds from efforts by Microsoft's MSFT Bing and social network Facebook, we expect the larger players to win share from weaker players, including AOL AOL and IAC's IACI Ask. Although we expect small movements in market share, we believe Google's dominance will persist and not lose more than 3-5 points of share.
A strong secular growth trend for online advertising is core to our thesis, although Google will suffer in the short term if we enter into another global recession. Still, faster growing geographies such as Asia are propping up overall growth rates as western Europe has recently been slowing. We forecast global Internet ad spending to grow in the midteens annually during the next five years. We expect that Google will leverage its dominant position in Internet search and support strong growth in display and mobile advertising, allowing it to meet or exceed the overall industry growth rates.
Although competitors like AOL and Yahoo YHOO have routinely claimed competitive advantages in display advertising for content rather than search, Google is not on the sidelines. In fact, the company generated $2.5 billion in display advertising in 2010, exceeding Yahoo's display revenue for the year. While we would be more enthusiastic if it announced large deals with branded advertisers, we still expect Google will participate quite aggressively in this market. The company is continuing to innovate around its DoubleClick Ad Exchange in an attempt to offer advertisers ways to incorporate real-time bidding and directly target audiences with specific demographics as opposed to choosing websites. Ultimately, advertisers want specific targeting; providing technology that helps automate this targeting delivers tremendous value in maximizing budgets. Furthermore, Google recently announced a plan to invest an additional $100 million in its heavily trafficked YouTube website. As rich video content continues to move online, we are optimistic about YouTube's value and ability to monetize its content.
Google's shrewdest move as of late has been its heavy investment into the mobile arena. In 2005, Google purchased a small mobile software company called Android. Android was open-sourced (the code is shared with the community using a free software license) to allow handset manufacturers and users to load applications that software makers build. During 2010, Android's share of smartphone shipments vaulted to 23% according to IDC, well ahead of market leaders Apple AAPL and Research in Motion RIMM. While many industry watchers are scratching their heads over the significance of a business that generates no direct revenue for Google, we are more enthusiastic: The move protects the firm's economic moat and provides new revenue streams. With Android living on smartphones, more users are likely to use Google's services. In fact, we have seen estimates of Google's market share in mobile search exceeding 90% last year.
Still, there are risks on several fronts. First, we cannot ignore the potential impact of social networks such as Facebook, Twitter, and LinkedIn. While we believe these will not be an immediate or direct threat to Google's search business, we do believe they are immediate and significant competitors for display ads. Additionally, these firms undoubtedly will invest in search capabilities, and we could be wrong about their ultimate success. We also believe the returns on capital for the new businesses will be lower than the returns in its core search business. As many companies are investing heavily in content strategies, Google will have to continue investing in an attempt to keep pace in attracting more branded advertisers.

Valuation
Our fair value estimate is $744 per share, representing a 2011 price/earnings multiple of 27 and an EV/EBITDA multiple of 17. We forecast revenue to grow nearly 15% annually during the next five years, slightly ahead of overall online ad industry. Google reports its business in three market segments: Google websites, Google Network websites, and other.
Revenue driven by Google websites include its search engine and web properties such as YouTube and Google Finance. Although we expect minor short-term loss of market share in search, we believe that improvements in monetization (the conversion of a search to a paid click on an advertisement) and overall market growth will help drive revenue. Additionally, with additional investment in display revenue technology and content on YouTube, we have modeled Google websites to grow more than 18% per year. We also expect uplift from mobile search to support strong revenue growth in this core business. Excluding YouTube, search is the most significant cash generator and highest-margin business for Google. On the other hand, we are more conservative in our view of revenue coming from Google Network. Google Network represents revenue earned by the placement of ads on partner websites. We anticipate this growth will lag the market, growing at 8% per year through 2015.
While we believe Google could easily drive operating margins substantially above 40%, it would have to ratchet down its investment in R&D and its data centers to achieve these targets in the short term. We expect operating margins to stay below 30%, reflecting increased investment and higher personnel costs caused by the pay raise instituted in January. After this year, we forecast operating margins to begin expanding again and reaching 32% in 2015. Because Google is heavily investing in new markets, we still expect free cash flow to be depressed over the next few years. However, we expect growth in free cash flows to exceed 25% annually through our explicit forecast period.

Risk
Although we believe Internet search is habitual, explicit switching costs are relatively low. Fickle consumers may move to a competitor that is able to establish a stronger brand or a more useful experience. Google is investing in new businesses where it is less competitive, which may lead to a deterioration in its operating margin and return on capital. Advertisers may find new ways to reach their target audience in a cost-effective manner, like Facebook. Finally, competition in technology is fierce, and employee retention may become more difficult and cause an increase in operating costs.

Management & Stewardship
Co-founder Larry Page was named CEO in April, taking over from Eric Schmidt. Schmidt was CEO from 2001 to 2011, a period that saw Google define its business model, become a public company, and stay at the forefront of the Internet advertising industry as the largest company by revenue and enterprise value. Schmidt is retaining his position as chairman of the board and serving a more active role in lobbying Washington. With Schmidt as a key executive, the company essentially has been managed by a three-person team of him, Page, and co-founder Sergey Brin. The company's equity has a dual-class structure that concentrates the voting power in the hands of these three executives, who hold two thirds of the voting rights. They also have a significant economic interest in the firm at more than 15%, which helps to align the interests of management with the shareholders.
We are comfortable with management at the firm, but employee retention will be a continual challenge for Google. Page's style and efforts will not mirror Schmidt's and may cause some short-term disruption. In fact, the senior vice president of product management resigned the week that Page's new title became official. Although we don't view the move as emblematic of any looming management issues, we would not be surprised to see other similar moves as competition for personnel is ruthless in the technology sector. To address these concerns, the company is rumored to have given a 10% pay raise to every employee effective in January.

Overview

Financial Health: 
Google's balance sheet is flush with almost $35 billion in net cash and about $4.2 billion in short-term debt and long-term debt.

Profile: 
Google manages an Internet search engine that generates revenue when users click or view advertising related to their searches. This activity generates more than 80% of the company's revenues. The remaining revenue comes from advertising that Google places on other companies' websites and relatively smaller initiatives, such as hosted enterprise products including e-mail and office productivity applications.