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.

A trusted brand and an unrivaled product and services portfolio hold IBM in good stead.

IBM's technological leadership and sticky products and services will enable the company to deliver steady recurring revenue for a long time.
IBM's offerings cover a wide swath of the technology industry, including hardware, software and services. The company faces different competitors in each segment, but maintains a leadership position in most areas through a combination of investments in research, worldwide distribution, and a respected brand.
IBM's hardware product portfolio is composed mainly of proprietary mainframes, industry-standard x86 servers, storage systems, and proprietary microprocessors. Despite decades-old predictions of the death of the mainframe, these systems continue to generate profitable recurring cash flows as some customers are reluctant to port legacy applications to newer systems. Additionally, mainframes perform very well for certain high-end applications, though this market is a small fraction of the overall server market. The firm also has substantial market share in the x86 server market, but the economics of this segment are less attractive than proprietary servers because of greater competition from rivals such as Hewlett-Packard HPQ and Dell DELL.
IBM's software business is mainly focused on operating systems, infrastructure management for data centers, and application middleware for software development and deployment. IBM's z/OS mainframe operating system is provided to customers on a rental basis, thereby generating recurring rental revenue for the life of the mainframe. Infrastructure-management tools and application middleware tend to be very sticky and generate recurring maintenance revenue from annual support contracts. IBM's ownership of the mainframe platform and wide distribution through its services organization enable the firm to effectively compete with HP, CA CA, and BMC BMC in the infrastructure-management market, and with Oracle ORCL and Microsoft MSFT in the application middleware market.
IBM's services organization offers a wide variety of services: managing the day-to-day operations of large data centers, business process outsourcing, and developing custom systems to address customer needs. Outsourcing contracts are sticky and generate annual recurring revenue over the contract duration, typically five to seven years. Although the company competes with several large service providers such as HP, Accenture ACN, Computer Sciences CSC, and Infosys INFY, the addressable market is very large, and IBM's trusted brand and strong product portfolio give it an edge in winning new services business.
Although each of the above businesses is an industry leader in its own right, the combination of these products and services provides IBM with an unrivaled solution creation and delivery ability that is the key to its wide economic moat.
However, new challenges are on the horizon. The advent of cloud computing could throttle demand for IBM's high-end hardware products, slowing down the company's virtuous hardware-plus-software-plus-services cycle. Oracle's acquisition of Sun is an attempt to create a competing integrated hardware and software stack and could reduce demand for IBM's system-integration services. Despite these developments, IBM's product development and distribution scale and entrenched customer relationships position the company well to respond to competitive threats and maintain its leadership position for a long time.

Valuation
Our fair value estimate for IBM is $182 per share, which implies forward fiscal 2012 price/earnings of 12.8 times, Enterprise Value/EBITDA of 9.3 times and a free cash flow yield of 8%. We are maintaining our revenue growth forecast in the low-  to mid-single digits during the next five years. We expect operating margins to remain flat as benefits from strength in high-margin software sales will likely be offset by a rebound in personnel costs in the global services businesses. If management is able to increase operating margins in the global services business while software sales outpace lower-margin businesses, our fair value estimate would rise to about $214 per share. On the other hand, if global services operating margins decline to prerecession levels, our fair value estimate would retreat to about $135 per share.

Risk
IBM's high-end computing hardware business (namely mainframes and power systems) faces ever-increasing competitive pressure from commodity x86-based servers. Cloud computing makes vast computing capacity available on-demand and could lower revenue and profit opportunities for IBM's high-end hardware business. IBM's custom, best-of-breed approach to meeting customers' needs is being challenged by Oracle's potentially cheaper integrated solutions that aim to meet 80% of customers' requirements without expensive customization. The firm's limited application software portfolio places it at a competitive disadvantage, relative to Oracle, in delivering integrated business solutions.

Management & Stewardship
Virginia M. Rometty took over as CEO of IBM on Jan. 1. Rometty was formerly senior vice president and group executive for sales, marketing, and strategy and has been with the company since 1981. Former CEO Sam Palmisano is the chairman of the board. We are glad the firm used Palmisano's retirement as an opportunity to separate the CEO and chairman roles. Palmisano's total 2010 compensation was about $31.7 million, which was reasonable for his stewardship of the firm, in our opinion. Executive compensation is heavily weighted toward short- and long-term incentives that are well-aligned with creating shareholder value. Board members receive the majority of their compensation in the form of stock, which is good for aligning their interests with those of outside shareholders. Our overall positive view of the firm's management is slightly colored by the use of retention packages awarded to some senior executives.

Overview

Financial Health: 
IBM has nearly $17 billion in cash and equivalents, and about $31 billion in debt. The firm generates adequate cash from operations to cover its debt obligations while continuing to invest in growth opportunities.

Profile: 
IBM is one of the largest information technology companies with an array of offerings, including system hardware, infrastructure software, outsourcing, and systems integration services. The firm has operations in more than 170 countries and generates about 65% of revenue from abroad.

Coke's thirst for emerging market expansion has yet to be quenched.

For the full year, Coca-Cola's KO global volumes climbed by 5%, driven primarily by continued growth in emerging markets as well as still beverages. This volume growth helped the firm's comparable EPS to increase 10% to $3.84 during 2011. Going forward, we expect that Coke's investments in emerging markets will continue to stimulate volume growth and global market share gains; additionally, we believe that Coca-Cola's broad portfolio of still beverages will continue to grow faster than the company's carbonated soft drink brands. While we expect that the firm will continue to methodically execute on its 2020 vision to grow system volumes and company profits, we believe the shares are fairly valued.
In the quarter, many emerging markets continued to achieve meaningful volume growth; including 20% volume growth in India, and 10% in China. However, growth was flat in Brazil and down 3% in Russia as rising food inflation tempered demand in those regions. Meanwhile, volumes climbed by 1% in Coke's more mature markets of North America and Europe. In the quarter, Coke's still beverages increased volumes by 6% and we expect that in the coming years, Coke's bevy of juices, sports drinks, and waters will grow slightly faster than the firm's iconic carbonated beverages.
Coca-Cola also announced a new "Productivity and Reinvestment" program that targets an incremental $550 million-$650 million in annualized savings by the end of 2015. The first portion of this new plan targets $350 million-$400 million of productivity initiatives; and the second part of the plan steps up the expected productivity savings from Coke's North American bottler acquisitions from an initial $350 million of annual synergies to $550 million-$600 million of annual cost savings. As Coca-Cola embarks to achieve these cost reductions, it expects to incur $800 million of cash costs while implementing the plan and plans to earmark these productivity savings to be reinvested into brand-building investments and to offset commodity cost inflation.

Thesis 01/11/12
Coca-Cola's wide economic moat is bolstered by its extensive distribution network, which enables the company to deliver its products to consumers in more than 200 countries, as well as its bevy of powerhouse brands. While declining consumption of carbonated beverages in North America will serve as a near-term headwind for Coke, we believe international markets will provide plenty of growth opportunities over the long term. Absent any strategic missteps, we view Coca-Cola as a safe haven in an uncertain economic environment given that the firm has one of the widest moats in our consumer coverage universe.
Even though Coke's existing distribution network spans the globe, the company continues to invest for international growth. The company and its bottling partners intend to invest billions over the next few years in countries such as China, Russia, and Brazil, where per capita consumption is increasing in light of the burgeoning middle class. For example, annual per capita consumption of Coca-Cola products in China is just 34 servings, versus eight servings in 1998, and versus 394 servings in the United States. We think that these investments will build out the firm's manufacturing and distribution footprint to such an extent that it would be too costly for a new entrant to duplicate, further solidifying the sustainability of the firm's competitive advantages.
Over the last decade, tastes have changed in mature markets as consumers have shifted from purchasing carbonated soda to still beverages such as juices, ready-to-drink teas and coffees, and enhanced water. To mitigate this falling volume and maintain share, Coca-Cola has been forced to broaden its portfolio deeper into various still beverage categories, which has enabled the beverage giant to leverage its vast distribution system and marketing might to continue to grow its worldwide volumes.
The pressure on bottlers' margins and the demands of the syrup makers for distribution and production flexibility have been sources of conflict for many years. Consequently, Coke followed PepsiCo's PEP lead by acquiring the North American operations of Coca-Cola Enterprises CCE. This acquisition is intended to eliminate these conflicts and to make the firm more responsive to changing customer demands. Although Pepsi was the first to control its North American bottlers, Coke's copycat move less than a year later shows that there is little that one of these beverage juggernauts can do that cannot be duplicated by the other. We think that Coke's strategy will nullify some of the competitive advantage that Pepsi had hoped to achieve in its route to market.
We believe that Coke's extensive distribution network and strong brands in almost every nonalcoholic beverage category should allow the firm to successfully generate excess returns on invested capital for years to come. We recommend buying the stock at around 14 times forward earnings, and thanks to its strong competitive advantages, we think that Coke should trade at a premium to other consumer staples firms.

Valuation
As we transfer coverage of Coca-Cola to a new analyst, we are increasing our fair value estimate to $69 from $68 per share. Our fair value estimate implies fiscal 2012 price/earnings of 17 times, enterprise value/EBITDA of 12 times, a free cash flow yield of 5%, and a dividend yield of 3%. We believe that Coca-Cola's wide economic moat and opportunities for continued growth merit above-average valuation multiples.
Volume and pricing are key drivers of our valuation model. We forecast Coca-Cola's top line to grow roughly 5% per year over the next decade driven by roughly 3%-4% volume growth and 1%-2% pricing growth. Additionally, we believe that the company's operating margins should range between 25% and 27%, in line with Coke's average adjusted operating margin during the last five years. From our perspective, EPS growth should outpace top-line growth going forward as the firm utilizes the substantial free cash flow it generates to reduce debt and repurchase shares.
Our estimates for the Coke's revenue growth and EPS growth are within the range of the company's long-term targets of 5%-6% CAGR for the top line and 7%-9% CAGR for long-term EPS growth. For 2012, we expect Coca-Cola to generate about $48 billion in revenue and earn slightly more than $4 per share.

Risk
Coke's sales and profitability could be negatively affected beyond our forecasts by greater-than-expected increases in commodity prices, particularly for raw materials such as sugar, cocoa, and oranges. Ownership of the company's North American distribution platform will increase Coke's exposure to other commodities such as aluminum and plastic resins; and the deal is not without integration risk. With around 70% of revenue being generated outside the U.S., the firm is subject to currency and geopolitical risks in the overseas markets in which it operates. Sales of Coke's carbonated drinks could be hurt by negative publicity regarding the health concerns associated with drinks with high sugar content, and volumes of Coke's sugary drinks could be constrained should governments look to increase taxes on soda.

Management & Stewardship
Coca-Cola generally has a high standard of corporate governance. We attribute the firm's consistent execution during the difficult operating environment over the past several years to strong leadership from the top and a very deep bench. We are also impressed with management's focus on the company's 2020 vision, which emphasizes making the best decisions to grow the business over the long term, not just the next quarter.
Muhtar Kent is currently Coca-Cola's CEO and chairman. In general, we prefer to see these roles separated. Executive compensation is generous, but incentive-based pay does appear to be aligned with the long-term interests of shareholders. While six of Coca-Cola's 15 board members have sat on the board for more than two decades, the firm has recently added some high-profile new board members, including Howard Buffett (Warren Buffett's son), Evan Greenberg (CEO of ACE Limited ACE), and former Chicago mayor Richard Daley.
We applaud the firm for its adoption of majority voting, allowing shareholders to vote against the election of a director, but we think that allowing cumulative voting would further enhance the rights of the small shareholder.

Overview

Financial Health: 
Coca-Cola is financially healthy. Although the acquisition of CCE's North American bottling business measurably increased the firm's debt, interest expense, and pension expense, we believe that the firm's strong cash flows will enable the company to meet all of its financial obligations, invest for future growth, and grow its dividend. We forecast EBITDA to cover interest expense more than 40 times, on average, over the next decade, and forecast the firm to generate free cash flow of around 19% of revenue over our 10-year explicit forecast period. We currently assign Coke an issuer rating of AA-, implying very low default risk.

Profile: 
Coca-Cola is the world's largest nonalcoholic beverage company. The firm, which sells a variety of sparkling and still beverages, generates 70% of its revenue and about 80% of its operating profit from outside of the United States. Coke's core brands include: Coca-Cola, Sprite, Dasani, Powerade, and Minute Maid. Following the asset swap with CCE, Coke now owns around 80% of its distribution in North America.

E.ON looks outside of Europe for growth in post-nuclear age.

E.ON's EOAN earnings continued their nose dive in the third quarter but remain on track to meet our full-year expectations. We are reaffirming our fair value estimate and long-term outlook.
It came as no surprise that the nuclear plant shutdowns earlier this year and the unfavorable gas marketing conditions weighed heavily on third-quarter and year-to-date profits. Divestitures, particularly the sale of its U.K. distribution utility, also hurt year-over-year comparisons. Adjusted EBITDA has fallen 39% year over year through the first nine months of 2011 to EUR 6.6 billion, and net earnings are down 64%. Management attributed EUR 2.3 billion of lost EBITDA to the nuclear plant shutdowns, slightly more than we expected, but not material enough to change our long-term assumptions or fair value estimate. Its growth investments in renewables, Russia, and upstream natural gas production are offsetting its Central Europe challenges, and its cost-cutting program should right-size expenses with its lost profits elsewhere.
Management affirmed its 2011 EBITDA guidance at EUR 9.1 billion to EUR 9.8 billion and maintained its EUR 1.00 per share dividend for 2011, a positive sign that the recent turbulence in its business at least could be stabilizing. If conditions remain stable or even improve, we expect E.ON could raise its dividend as much as 10% for 2012 and continue with 5% dividend raises in 2013 and beyond. Although this won't come close to bringing the dividend back to its EUR 1.50 rate prior to 2011, it does offer an attractive yield and growth prospects at E.ON's current stock price as of early November.

Thesis 08/12/11
Nationalist protectionism and political meddling in European energy markets constrain E.ON's ability to create value from its attractive asset portfolio and have forced management to look beyond its core region for growth opportunities. Still, management has shown strict adherence to return-on-investment hurdles and free cash flow generation, both key metrics for investors. Even with the coming nuclear phase-out in Germany, we think it could be a good long-term investment for those seeking European diversification.
Founded in the 1920s as Germany's national power company, E.ON today has more than 28 million customers in 30 countries. It ranks among the world's three largest investor-owned utilities, along with France's Electricite de France EDF and GDF Suez GSZ.
Acquisitions since 2000 enlarged E.ON's international footprint to include the United States, the United Kingdom, Scandinavia, and continental Europe. Its largest was the EUR 11.5 billion purchase of Enel and Endesa assets in June 2008. E.ON also acquired stakes in U.S. renewable energy, a Nordic utility, power plants in Russia and Turkey, and an Italian utility in 2008-09. It continues talking with Russian gas giant Gazprom about joint energy projects.
However, management recently changed course and is more than halfway through its 2009 plan to divest as much as EUR 15 billion of assets. Part of this was due to a November 2008 settlement with the European Commission that required E.ON to divest certain power transmission and generation assets by December 2011. Although the timing is particularly bad with energy prices at cyclical lows and asset prices depressed, E.ON has been able to execute swap deals for most of the EUR 3 billion of required divestments, preserving shareholder value. It also recently sold regulated utilities in the U.S. and U.K. at what we consider premium valuations.
In addition to the divestments, E.ON also has moved to refocus operations by selling its minority interests in German municipal utilities (Thuga), its U.S. utilities, its U.K. distribution utility, and its 6% stake in Russian energy firm Gazprom. The U.S. sale brought in about EUR 5.7 billion (roughly $8.0 billion) and the Gazprom sale brought in EUR 3.4 billion net of its share swap for the Yuzhno-Russkoye gas field in 2009. With these divestments, E.ON has cut EUR 7.4 billion from its four-year, EUR 63 billion investment plan announced in 2007.
We believe management has shown good discipline to protect its industry-leading 11% returns on capital. Such returns could be more difficult in a challenging economic environment. In Germany, E.ON faces growing discontent from customers and regulators who pay some of the highest energy prices in the world while facing supply shortages. Legal battles in Germany following the nuclear shutdown legislation passed in mid-2011 likely will drag on for years. Political pressure also could jeopardize cost recovery in distribution rates. Politicians in Italy, Spain, and Russia concerned with challenging economic growth prospects continue to meddle in energy markets with mostly negative implications for E.ON.
If European markets stabilize and E.ON's investment plan continues, shareholders should see strong returns for many years.

Valuation
We are reaffirming our $31 per ADR share fair value estimate after adjusting our projections following management's mid-year operating update. We recently cut our fair value estimate 27% to reflect the impact from Germany's decision to retire its nuclear power plants. We estimate phasing out the 60 terawatt hours of nuclear generation E.On owns in Germany results in a EUR 4.0 billion cut in annual revenue by 2015 and a $24 per share reduction in our fair value estimate. That is offset by $6 per share of benefits from lower operating costs, higher margins for its fossil fuel and renewable fleet in Germany ($3 per share), and the phase-out of nuclear fuel tax payments as plants close ($4 per share).
Lower energy prices in Europe continue to have a significant impact on near-term profits. After incorporating Germany's nuclear fuel tax and plant retirements, we expect earnings to bottom in 2011 near EUR 1.10 then climb above EUR 2.10 by 2015 as a energy markets rebound and investments drive strong earnings growth in its non-European operations. A EUR 1.1 billion of increased costs from carbon credits in 2013 offsets the earnings from our projected EUR 19.5 billion of capital investment between 2011 and 2013 and our assumption that management achieves its EUR 1.5 billion of cost cuts proposed in mid-2011. We do not assume any divestitures beyond mid-2011 although management has said it would like to sell an additional EUR 6 billion of assets by 2015.
In our discounted cash-flow valuation, we use current market credit spreads and an 11.0% cost of equity to produce a 9.4% cost of capital. Our fair value estimate is based on an exchange rate of $1.40 per euro as of August 11, 2011.

Risk
Our medium fair value uncertainty rating stems from the sensitive political environment throughout Europe and increasing earnings exposure to volatile energy commodity prices. A key uncertainty was resolved in mid-2011 when the German government passed legislation to shut down all of the country's nuclear plants and impose a tax on nuclear fuel until the plants retire. Although the outcome was a significant negative for E.ON, it allows the company to move forward with its post-nuclear strategy. Government-imposed limits on power prices in Germany and elsewhere are another recent concern. E.ON also could have trouble continuing to invest its large amount of capital at value-creating returns, especially given the influx of cash it has received through its divestures. For U.S. investors, appreciation in the dollar relative to the euro will depress the ADR shares.

Management & Stewardship
The German corporate governance structure includes a board of management, which oversees day-to-day operations, and a supervisory board, which acts like the board of directors for a U.S.-based company. E.ON's supervisory board has 20 members, each with five-year terms. Shareholders elect 10 members, and E.ON employees elect 10. The strong employee presence is common throughout Germany and all but eliminates shareholder activism. U.S. investors should be comfortable with this power-sharing before investing. E.ON's 10 shareholder-elected supervisory board members read like a Who's Who of German industry executives, with ties to Deutsche Bank DB, Siemens SI, Allianz, and other large German firms. Chairman Ulrich Hartmann, 72, who has been chairman of the supervisory board for the last eight years and was CEO and chairman of the board of management for the preceding 10 years, retired in May 2011. The supervisory board approved Werner Wenning, 64, to succeed Hartmann. The loss of a long-time insider could be good or bad for shareholders, but we don't  expect any significant change in strategy under Wenning.
The board of management has seven members, appointed to five-year terms by the supervisory board. CEO and chairman Johannes Teyssen assumed the role from Wulf Bernotat in May 2010 after Bernotat passed the standard retirement age (60) and his contract expired. Teyssen has held key management jobs at E.ON for many years, including COO since 2004, and we expect a smooth transition. We like that compensation for the supervisory board and the board of management includes variable components linked to dividends, earnings before interest and taxes, return on capital, and stock performance.

Overview

Financial Health: E.ON's strong balance sheet has allowed it to re-sign credit agreements and issue debt through the credit crisis. The EUR 9 billion of divestments during the last two years have allowed it to cut its net debt nearly in half, supporting its premium credit rating even through trough earnings period. If energy prices rebound from recent lows, we expect interest and dividend coverage to remain strong. We were not surprised that management decided to cut the 2011 dividend to EUR 1.00 per share from EUR 1.50 per share in 2010 given our projections for its payout ratio to fall below management's 50%-60% target range. In August 2011, management guided toward a EUR 1.10 per share dividend in 2012 with a potential increase again in 2013 depending on commodity market moves and investment opportunities.

Profile: E.ON is one of the world's largest integrated power and gas companies. It generates, transmits, and distributes electricity and natural gas in 30 countries, primarily in Europe. As of 2010, the firm was the largest German gas company and generated one third of Germany's electricity, sourcing about 40% of this with nuclear power. However, the country's nuclear shutdown legislation will reduce its power generation share significantly.

ConocoPhillips plans to spin off its downstream assets.

ConocoPhillips' COP earnings report was largely in line with expectations, as the benefit of higher oil prices offset lower production volumes and flat refining and marketing earnings. Fourth-quarter adjusted earnings were $2.7 billion compared with $1.9 billion a year earlier. The conditions that had boosted refining earnings throughout the year largely evaporated during the quarter. While refining adjusted earnings, excluding the benefit of asset sales, were essentially flat with the fourth quarter of 2010 at $201 million, they fell from $1.2 billion in the third quarter as market conditions weakened significantly. ConocoPhillips' realized refining margin fell more than $6 per barrel from the third quarter, to $7 per barrel in fourth quarter. However, conditions have since improved somewhat, which we expect will be reflected in first-quarter earnings.
Exploration and production fourth-quarter adjusted earnings rose to $2.3 billion  from $1.9 billion a year earlier. Total production for the quarter averaged 1.60 million barrels of oil equivalent per day, down from 1.73 mmboe/d during the same period a year ago, reflecting lost volumes from Libya and China, asset dispositions, and natural field decline. Full-year production averaged 1.62 mmboe/d compared with 1.75 mmboe/d in 2010. With domestic natural gas still contributing about 16% of production, we expect ConocoPhillips will be stung by the recent swoon in natural gas prices. Increased production from oil and liquids dominant regions--Canadian oil sands, Eagle Ford, Bakken--should help to somewhat offset the effect, though. The company continued to make progress in its returns improvement plan by generating $2.7 billion in cash from asset sales to fund the repurchase of $3.1 billion in stock. For the full year, ConocoPhillips sold $4.8 billion of assets and repurchased $11.1 billion worth of its own shares.

Thesis 12/28/11
Faced with a tightening resource market, ConocoPhillips made significant acquisitions over the past decade to boost reserves and increase production. The ensuing fall in commodity prices made those acquisitions appear poorly timed, however. As a result, management changed course last year by selling assets and reducing investment. Now it is taking another step by spinning off the downstream assets into a separate company.
For a supermajor oil company, increasing production has become challenging because the project size required to significantly boost output is quite large and becoming harder to find in OECD countries. As a result, majors must engage in riskier exploration projects, partner with national oil companies, or acquire independent producers to support growth. Although ConocoPhillips pursued exploration and partnerships in recent years, acquisitions dominated its strategy. While ExxonMobil XOM and Chevron CVX sat on the sidelines, ConocoPhillips acquired North American natural gas assets (Burlington Resources), Russian oil supplies (20% stake in Lukoil LUKOY), and stranded gas in Australia (Origin Energy). Even though the deals added reserves and production for the company, the subsequent drop in commodity prices calls the timing into question. In fact, these higher-priced deals culminated in a $34 billion goodwill-impairment charge.
With its acquisition strategy failing to deliver returns, ConocoPhillips decided to  embark on a new strategy that included asset divestitures and share repurchases. Through year-end 2011, the company has divested about $10.5 billion worth of assets and is committed to is selling another $5 billion-$10 billion worth of underperforming assets during 2012 in an effort to shore up the balance sheet and improve returns. Divestitures will occur across its upstream and downstream asset portfolios. Cash generated from operations and divestitures to date have supported a share repurchase program that should result in buybacks of about $11 billion in 2011, with potentially another $10 billion worth in 2012.
Despite the success of this plan, management has decided to go a step further and spin off the refining and marketing assets into a separate company. The decision comes in light of the share appreciation Marathon saw when it announced a similar move earlier this year. However, the shares have faltered somewhat after the spin-off, particularly at the upstream company. Given the success ConocoPhillips' improvement plan was showing, we are a bit puzzled by the announcement. Because the company had closed much of the valuation gap with its peers, exceeding it in some cases, we think any more appreciation will be limited.
The newly created downstream company, to be called Phillips 66, will hold ConocoPhillips' refining and marketing and chemical assets. We think given the collection of some well-positioned refining assets, divestment or closure of poor performing facilities and an attractive chemical and midstream business, Phillips 66 should stack favorably to its new peer group. We think the remaining upstream business may have a more difficult time as its new peer group will include much smaller competitors who have better growth prospects. Additionally, the challenges ConocoPhillips faced as an integrated firm are likely to persist once the spin-off is complete. However, like Phillips 66, we expect ConocoPhillips will likely offer the highest dividend yield in its peer group, which could attract yield hungry investors in search of commodity exposure.

Valuation
We are maintaining our fair value estimate of $85 per share, which is about 4.4 times our 2012 EBITDA estimate of $29 billion. Our valuation is based on a discounted cash flow model of the integrated ConocoPhillips. Because the cash flow of the company's individual segments is unlikely to change once the downstream is spun off, we see no reason to alter our valuation at this point. A sum of the parts analysis validates our DCF valuation.
Our initial analysis suggests after the upstream company is worth about $70 per share, while Phillips 66 is worth about $26 per share. Based on the anticipated capital structures of the two companies and the split ratios, the SOTP analysis implies a valuation of about $83.
We continue to believe reliance on natural gas production and refining will drag on results until ConocoPhillips completes its divestitures. However, additional Canadian production should result in a greater portion of oil volumes in the coming years. Also, in the near term ConocoPhillips should benefit from its international (about 50% of total) and Alaskan (about 25%) crude production, which is tied to more attractive Brent pricing.
In our discounted cash flow model, our benchmark oil and gas prices are based on Nymex futures contracts for 2011-13. For natural gas, we use $4.04 per thousand cubic feet in 2011, $3.34 in 2012, and $3.99 in 2013. Our long-term natural gas price assumptions for 2014 and 2015 are $6.50 and $6.70, respectively. For oil, we use Brent prices of $110 per barrel in 2011, $102 in 2012, and $99 in 2013. Our long-term oil price assumptions for 2014 and 2015 are $95 and $98, respectively. We assume a cost of equity of 11% in all scenarios.
Refining staged a recovery in 2010 that has continued into 2011, sustaining downstream profits. Meanwhile, natural gas prices face the headwinds of high inventories, adequate supply, and reduced demand. A collapse in refining margins would provide downside to our valuation, while higher natural gas prices would offer upside. We anticipate share repurchases to continue in 2011 and explicitly model about $11 billion worth for the full year.

Risk
Persistently low oil and gas prices would hurt cash flow and force ConocoPhillips to reduce its capital plans or raise debt to fund growth. The company's large projects run the risk of delays, cost inflation, and falling commodity prices, which could ruin their economics. Global operations and partnerships with national oil companies expose the company to the threat of expropriation of assets and modification of contract terms by governments.

Management & Stewardship
James Mulva has been chairman and CEO of ConocoPhillips since the 2002 merger of Phillips Petroleum and Conoco, adding the chairman role in 2004. Before 2002, he held the same positions at Phillips Petroleum, among other executive management roles in his 25-year tenure with the firm. Under his leadership, the firm undertook a growth by acquisition strategy that failed to deliver returns. Recent efforts to implement a shrink-to-grow strategy while refocusing on shareholder returns have so far been successful. Execution of the new strategy will probably be Mulva's last major initiative before stepping down sometime in 2012 after completion of the spin-off.
Ryan Lance, current SVP of E&P, International, will assume the chairman and CEO role of ConocoPhillps, the upstream company. Greg Garland, SVP of E&P, Americas, will become chairman and CEO of Phillips 66. He will be joined by several other senior executives from ChevronPhillips Chemical.
Mulva is paid rather well, with $24 million in 2008, $14 million in 2009, and $18 million in 2010, though most was incentive-based and in line with the company's peers. Incentives are based on a variety of company metrics including shareholder returns, returns on capital, and income per barrel produced all relative to its peer group. We like the fact that compensation is primarily performance-based and that the goals are tied to shareholder returns.

Overview

Financial Health: 
In the past year, ConocoPhillips applied proceeds from asset sales toward debt retirement, lowering its debt/capital ratio to about 26% at the end of the third quarter. Further debt reduction is unlikely as the company aims to improve shareholder returns with share repurchases and dividend increases. Operating cash flow should be sufficient to cover the capital plan at current commodity price levels.

Profile: 
ConocoPhillips is an international integrated energy company. In 2010, it produced 913,000 barrels per day of oil and natural gas liquids and 4.6 billion cubic feet a day of natural gas, primarily from the United States, Canada, Norway, and the United Kingdom. Proven reserves at year-end 2010 stood at 6.7 billion barrels of oil equivalent (plus 2.1 billion for equity affiliates), 44% of which are natural gas. With refining capacity of 2 million barrels of oil a day, it's the second-largest refinery operator in the U.S.

Interview Between Porter & Marybury (S&A Digest)

Porter's note: In today's Digest, we make a departure from our usual fare of stocks, bonds, and commodities to bring you one of the most important interviews you'll read this year. It's with our friend Richard Maybury…
For those who are unfamiliar with Maybury's work, it's important to know his Uncle Eric book series is one of the best educations on history, liberty, personal responsibility, and the idea of America that you can find anywhere, for any price. If some bizarre stroke of fate put me in charge of the American educational system, I would stay on the job for less than one day. That day would consist of me flushing the whole corrupt system, mandating every child study and understand the Uncle Eric series, and retiring before lunch.
If you have children who you'd like to see grow up right – or if you want to learn more about the subjects above – the Uncle Eric series is a must-read.
Maybury is also the editor of the U.S. & World Early Warning Report, an investment newsletter so highly regarded it's read by Congressman Ron Paul and officials at the Pentagon and CIA. Put simply, Maybury is a legend in our business…
You'll find Maybury and I share many ideas on the "End of America" – that our country has completely abandoned the ideals of our founding fathers… ideals that made the U.S. the richest, freest nation the world has ever seen. That's why today, we're publishing a recent interview our news and insight "aggregator" The Daily Crux just conducted with Maybury. You won't find the ideas below in any mainstream publication or television program… which is why they are so important.
The fall of the American Empire has begun: An interview with Richard Maybury   The Daily Crux: Richard, you've long said the collapse of the American Empire would be the central issue for Americans, with regard to money, investing, and life in general.
In your recent issue of Early Warning Report, you said there's now a very high probability this collapse has already started. Can you talk about why you think that is?
Richard Maybury: Let's start with a little history: All empires eventually fall. No one in Washington will admit it, but the U.S. has been an empire for decades now, and there has never been any reason to believe our empire would be immortal.
People who are power-seekers want more power, and they'll sacrifice other things in order to get that power. One of the things power-seekers in a large government almost always sacrifice is the financial integrity of the country. They will bleed the whole economy dry just to increase their power. That's a main reason empires fall.
We see it all through history. You can look back to any of the ancient empires… They're forever wrecking their economies in order to increase their political power. So it's no brilliant prediction to say the U.S. Empire is going to fall. Anyone who has studied much history should have been able to predict this mess was going to arise… and here it is.
It's fascinating to me. I talk to all sorts of so-called ordinary people, such as dentists, barbers, and taxi drivers. Most have no understanding of what's actually happening to America, but they all know deep in their hearts something has gone terribly wrong… and it's not going to end anytime soon. This is an interesting condition that has arisen recently.
Americans, up until the last year or two, have always been optimistic. They would say things like, "Yes, hard times come along, but this, too, shall pass." They aren't saying this anymore. They're beginning to figure out that America's troubles aren't going away this time.
You can see these problems in the financial markets and elsewhere… unemployment, bankruptcies, mortgage defaults, poverty… These are all just symptoms of the fall of the empire. Let me quickly point out, however, that the fall of the empire is actually a wonderful thing. Empires are cancers, and it's a good thing to excise them as fast as possible. But the surgery necessary to do it is awfully painful.
If you look at any previous empires I write about – the French Empire, the British Empire, the Russian Empire – these countries are all much better places today than they were when they had empires. America will be too. But we've got to get from here to there… and the process is very, very painful. We're going to experience an awful lot of trouble because of it.
Crux: For many years, you've also been writing about the problems in the Middle East. In the past few months, it seems many of those problems are coming to a head. Can you explain how the troubles there – part of the area you refer to as "Chaostan" – are related to the troubles we're facing here at home?
Maybury: Sure. For those who aren't familiar, "Chaostan" is a term I coined for the area from the Arctic Ocean to the Indian Ocean, and Poland to the Pacific, along with North Africa. This area includes the Middle East.
In Central Asia, the suffix "stan" means "the land of." For example, Afghanistan is the land of the Afghans. So in 1992, I coined the term Chaostan to mean "the land of great chaos."
The reason this area is so often in chaos is a conversation of its own, but here's a quick summary.
All religions teach that there is a higher law than any government's law, and they all teach two fundamental laws: Do all you have agreed to do, which is the basis of contract law, and do not encroach on other persons or their property, which is the basis of tort law and some criminal law. Each religion expresses these laws in different ways, but they all teach them.
These principles are the basis of the old British common law. It was called common law because it grew out of principles common to all.
In a book called The Ideological Origins of the American Revolution, historian Bernard Bailyn pointed out that the American Revolution, the Constitution, Bill of Rights and Declaration of Independence all sprang from the common law.
In the decades following the revolution, other people saw America's new liberty and prosperity. They wanted the same thing, and the American philosophy began to spread around the world. The areas where it took root became known as the "Free World."
Then in the mid-1800s, socialism began to spread, and it nearly killed off the American philosophy – a philosophy that I believe is now being rediscovered.
Chaostan is the most important area where the principles of liberty never got a chance to take root. From the beginning of history, most parts of Chaostan have been a sea of blood and destruction because they never had rational legal systems… and still don't.
The turmoil is greatly aggravated by the interference of European regimes during past centuries.
When you look at this area on a map of the world, you see all these countries are delineated by borders drawn by Europeans. Very few Americans understand this. Practically every border in the world was drawn by the European governments as they swept over the globe conquering one country after another.
European rulers would draw the borders in locations that were convenient to them. And so there are very few borders in the world that were drawn by the people who are native to those areas.
This means what we regard as a country when we look at a map usually isn't really a country at all. It's a collection of tribes cobbled together by the Europeans for the convenience of the Europeans.
In each of these so-called "countries," there are some tribes that are either dominant or want to be dominant. And the way they achieve dominance is by acquiring money, weapons, and other resources from outside powers, which were originally the Europeans.
A good example is Saudi Arabia. The Saudi tribe was one of many that lived on the Arabian Peninsula. The British government essentially created Saudi Arabia by giving money and weapons to the Saudi tribe and helping them take control of the other tribes.
This would be akin to China or some other foreign country coming to the United States and choosing single families or neighborhoods to rule over entire states. These families would have all the wealth, all the power, and would make all the rules. And just in case anyone got any ideas, the Chinese government would keep a few battleships and aircraft carriers parked near our shores.
Crux: We're huge fans of your Uncle Eric books here at The Crux, and I remember being blown away the first time I read that example. We're not taught these things in our schools… But when you look at it from that perspective, it's not surprising there's so much anger toward Western governments.
Maybury: Exactly… and this is the case all over Chaostan. None of those nations are what you and I would regard as natural countries. They were artificially created, and the rulers of those countries were propped up, in nearly every case, by the Europeans.
Keep in mind that except for five countries — Iran, Thailand, Afghanistan, most of China, and Japan — every country in the world at one time or another was conquered by the Europeans. So the political structures we see in these countries — nearly all countries — are either creations of the Europeans or outgrowths of those creations.
During and after World War II, some of these tribal leaders wanted help maintaining their power after the Europeans departed. The U.S. was the top dog at that time, so they said to Washington, "We will do your bidding – we will be your surrogate here – if you do what's necessary to keep us in power."
That's the deal that was made with dozens of regimes around the world. That's the U.S. Empire, and that's what is falling apart now. The people who have been dominated by tribes backed by Washington are sick of it, and they're starting to overturn the existing political matrix.
So the troubles in the Middle East are to a large extent part of the collapse of the empire. For instance, Hosni Mubarak in Egypt was one of Washington's closest surrogates… and he was a nasty guy. He's out of power now, and Egypt is in great turmoil. Nobody knows who's going to take over the place.
That's just one example out of many. The whole thing is beginning to crumble. Egypt was one of the early cases, and I think there are going to be a lot more.
Even nations that were not part of the U.S. Empire are being thrown into chaos, as the spirit of rebellion spreads.
As of a couple weeks ago, I think there are now 11 countries over there experiencing uprisings of one kind or another. I expect this is going to continue to spread.
It's very possible Egypt will wind up being the model for what happens in many of those countries… where you have a U.S.-backed dictator who is overthrown and then so-called Islamic fundamentalists come in and take over. That's very likely what's going to happen in Egypt.
Obviously, I don't know for sure… no one should be certain about these things. But I'm inclined to believe the Egyptian government is going to be replaced by something that will not be friendly to Washington.
Again, however, we're really on thin ice when it comes to making predictions about these sorts of things. Egypt contains many millions of people, each with his own agenda. Predicting how all that's going to go is very, very problematic.
What I can say with confidence is the political matrix Washington put in place during and after World War II is now crumbling. I think that's pretty clear. And again, I return to the point: This is ultimately a good thing. The U.S. Empire should never have existed in the first place.
Crux: Why did the U.S. get involved in Chaostan to begin with?
Maybury: I believe it really just goes back to the lust for power. That's one thing the mainstream news media is absolutely derelict about… They say practically nothing about political power.
Crux: Could you define political power for us?
Maybury: Perhaps the simplest definition is "the legalized privilege of using brute force on persons who have not harmed anyone." This privilege is what sets governments apart from all other institutions. No church, charity, fraternal organization, or any other institution can legally send people with guns to your home to force you to buy their services or obey their rules. Only the government can do that. And whether they realize it or not, it's this privilege – of using force on persons who don't deserve it – that a power-seeker wants.
Crux: Is that related to the old saying that power corrupts?
Maybury: Very astute of you to make that connection. If the American founders were here today, they'd tell us political power is poison… Stay as far from it as you can… It's evil stuff.
But the media have bought into this assumption that political power is good, it's the solution to our problems, and a world full of political power is a good place. They almost never look into the psychology of it… What causes a human being to want to force his will on other people? Because that's what political power essentially is – the ability to bend other people to your will. And the media just don't look at that at all.
There's this assumption that the people in the federal government are a whole lot of nice individuals who have good intentions, and it would never occur to any of them to get a thrill out of forcing their plans onto somebody else.
But that's what it's all about, and that's what it's been about for thousands of years. Government is brute force. Coercion. Chains. Prisons. Follow our plans or else. The political mind is the mind of a bully.
Crux: We often hear the U.S. is involved in the Middle East because of oil… How big a role does oil actually play?
Maybury: I think oil is an excuse. I don't think it's a reason for the empire. Whoever owns the oil has to sell it or it's worthless.
They may not want to sell it directly to us, but they're going to sell it to somebody. This will increase the total world supply of oil, and the price of oil from other suppliers will go down.
So the idea that this is all about oil… that's just a smokescreen. It's about power. It's about the thrill that these people in Washington get out of meddling in other countries.
Crux: You mentioned before that it's very difficult to make predictions. But what do you see happening next in the region?
Maybury: As far as that's concerned, I refer to Egypt again. The friends of Washington are widely hated by their own people, and they will be coming under pressure to hit the road.
Look what happened to the Shah of Iran back in the late '70s. I think it's going to happen to pretty much all of Washington's surrogates. Like I said, it's a fool's game to try to predict these things, but that's the direction events are going now, and that's the direction I've been predicting since the early 1990s.
Before the Soviet Empire fell apart, the Soviet Union sat on Chaostan like a lid on a pressure cooker. One of the forces at work there was the individual tribes that ruled these countries did not want to be conquered by the Soviets, so they formed alliances with Washington as a protection against the Soviets. When the Soviet Union fell in the early '90s, this essentially removed the lid on the pressure cooker. The explosion began, and now it's escalating.
In the 1990s, the rest of the world was cheering a new era of peace and brotherly love… and I was saying, "That's ridiculous. The whole place is going to blow up." Everybody said I was crazy, and I kind of wondered if maybe I was.
But it turned out that by the year 2000 – a mere 10-year stretch of the new era of peace and brotherly love – more than 100 wars broke out and more than 5 million people were killed.
I think what's happening today is just the beginning of what will turn out to be even more violent than the '90s. There are literally hundreds of millions of really angry people over there, and a rebellious momentum is growing.
Again, I'm really reluctant to make specific forecasts on this kind of thing. All you can say is governments have been creating empires since the beginning of history, and empires have been falling apart since the beginning of history… We're in one of those "falling apart" periods now.
Crux: Do you think the individuals in power in Washington realize the empire is crumbling? Do they even realize it's an empire?
Maybury: Well, it's official U.S. policy that Washington does not have an empire. Everybody is taught that.
But just a couple months ago, President Obama phoned up Mubarak in Egypt and fired him. If that's not an empire, what is it?
Now, Obama has decided the Libyan government should change, too. These people in Washington seem to think they're ordained by God to somehow make the world better.
I think it's amazing they believe they're intelligent enough to be able to do that. It's actually pretty hilarious.
Crux: So as the empire begins to crumble, how do you think Washington will respond?
Maybury: I think we'll see more examples of Washington trying to steer events in directions favorable to Washington. Notice I'm not saying favorable to America. I'm saying favorable to the U.S. government. They are two entirely different things.
Of course, the people in Washington are all individuals. They all have their own agendas. They can't even agree on what's favorable to the government.
So they're all grasping at straws. They have no idea what they should really do in a situation like this. There are no guidelines. And since they don't even want to acknowledge they have an empire, they don't understand what it is they're trying to save.
I mean, talk about a bunch of lost souls. They seem to think being elected means they have some sort of special ethical position in the world. They have no idea what it is they're trying to defend. All they know is they're trying to defend it.
Typically, in every empire, it all continues until one day somebody looks at the books and says, "Gee, we're broke. We can't do this anymore." That's when it all starts to come apart.
One of my favorite stories is about William Gladstone – the prime minister of England in the mid-1800s – and that's essentially what he did. He just said, "Look, we're going broke trying to prop up this empire. This is ridiculous."
He started dismantling the British government's power. He probably made more progress in abolishing political power than any other lone individual in history. It's an amazing story.
Gladstone is one of the few peaceful examples of how all empires go down. They eventually realize they can't play the game anymore. They realize they've exhausted their resources… They've bled the population dry.
Humans can only produce so much wealth, and the government is consuming this wealth in order to prop up the empire. Eventually, it all just goes under.
Incidentally, we're talking here today about the federal government's empire abroad… But America itself, internally, is part of the federal empire, too. There are no less than a quarter-million federal bureaucrats making and enforcing regulations on us. And each of these regulations is backed by guns, chains, and prisons. It's not much of an exaggeration to say the whole world – including America itself – has been conquered by the federal government.
Crux: How close do you think we are to the point where the empire collapses the economy?
Maybury: My best guess is we're in the process of going under now. That's the economic trouble the average American is noticing… the unemployment, the business failures, the financial crash, the real estate collapse… plus the mental and emotional strain – the psychological depression, marital problems, divorces. It's the process of the empire going under. The economic problems are symptoms of the manipulation of the currency, and all sorts of other economic tomfoolery, to try to keep the federal bureaucracy well fed at the expense of the rest of us.
The absolute best thing Washington could do for the American people – if the folks in Washington were honest – is just announce that the empire is over. "It's finished, we quit." We're going to withdraw our troops from all those countries around the world. We're going to bring them home to defend America. We're not going to meddle in other countries anymore.
After all, this attempt to keep the Empire alive is just squandering blood and treasure for nothing. We're bankrupt. We can't do this anymore. The attempt to preserve the empire – which means, largely, the attempt to keep Washington's surrogates in power – is just dragging out the whole painful process and making it all the more expensive and hopeless.
If they'd just give it up, that would be the first big step in triggering the economic recovery. But they're not going to do it. They're power junkies. They'll drag this thing out until – in the words of political philosopher Howard Kershner – the last bone of the last taxpayer has been picked bare.
Crux: So what are the personal and investment implications of the fall of the American Empire? How do you recommend people prepare for what you see coming?
Maybury: First and foremost, you should have a good stash of emergency equipment and supplies. Everybody should have these things anyway, because you never know what's going to happen, be it earthquakes, riots, hurricanes, riots, epidemics, riots, blizzards – did I mention riots?
Life is full of really nasty surprises. Everyone should have the ability to be completely self-sustaining for at least a month. Three months would be better. You want food, water, all the necessities of life, plus the ability to defend yourself and your loved ones.
As far as investing, my approach in Early Warning Report is to try to identify long-term trends that are very solid, and invest in things that will benefit from these long-term trends.
If you look at history, you'll find there are two carved-in-granite long-term trends that never seem to change. The first is war. The second is currency debasement. So what I do is suggest investments that will benefit from these two major trends.
The obvious winners from war are the defense giants: Northrop Grumman, Lockheed, General Dynamics, and Raytheon. If you want to just buy a collection of defense stocks, the Fidelity Select Defense & Aerospace Fund contains those four and a lot more. Its symbol is FSDAX.
The major beneficiaries from currency debasement are raw materials, because they cannot be created in unlimited quantities on a printing press… especially precious metals. So I recommend everyone own some gold, silver, and platinum bullion coins. These have been doing wonderfully, and I think they'll continue to do so because the fiat paper currencies are dying. Beyond those, you can also consider some of the top commodity and energy producer stocks. To find a list, just look at "Track Record" on the home page of our website.
For an investor who's just starting out in this area, FSDAX and the coins are good ways to go. Get into those first, and as you learn more, you'll find other ideas you'll want to follow. You can find many more in my letter as well.
Crux: You mentioned earlier that the fall of the empire – while painful – will ultimately be a great thing for our country. Can you talk about what you see for the future of America?
Maybury: Many people misinterpret me as a "doom-and-gloomer." But let me tell you, for the long term, I'm unimaginably optimistic. I am more optimistic now than I have ever been in my entire life, and I'm 64 years old.
I fully expect to live a healthy life until at least 140 because I believe technological breakthroughs are coming so fast now that Ray Kurzweil is right – a healthy 140-year lifespan is plausible. And before I die I expect to see the beginning of the civilization that is depicted in the Star Trek stories. Not the whole Star Trek civilization, but the beginning.
I believe the next great civilization will begin almost instantly, as soon as we get the present statist nightmare out of the way. But getting from here to there is going to be really hard. For the short term and medium term, it's going to be really awful, I'm afraid for quite a few years.
I hope things in America and Western Europe don't get as bad as Russia was in the 1990s – when the Soviet empire was falling – but it's definitely a possibility in some places, especially the major cities. I encourage everybody to be ready to ride through some very hard times, because empires almost never fall quietly.
Once the U.S. Empire does go down, though, I expect we'll see a new prosperity. I'm very optimistic about this, because the world is now learning what statism is really all about… what political power really does. It's not theory anymore… We're experiencing it every day.
The true nature of statism is an extremely painful lesson to learn, but once it's learned, the decks will be clear to produce a truly healthy, advanced civilization. When that happens, hold on to your hat… Things are going to be wonderful, and it will happen fast.
Crux: Could you define statism for us?
Maybury: Statism is the belief that political power does not corrupt, and government is a good thing, the solution to all our problems. This is what is taught in the government-controlled schools. If Jefferson and the other American founders were here, they'd fall down laughing at such a notion. But what else would a government-controlled school teach?
Crux: Why wasn't that lesson learned after the fall of the Soviet Union?
Maybury: Well, the economic side of it was learned to a large extent. The world saw what central planning did to the Soviet economy… So even communist China has embraced free-market economic principles, to some extent.
But you still have seen practically no focus on the dangers of political power itself… on the fact that political power is evil and treacherous – it corrupts.
That lesson has yet to be learned… or re-learned. The early Americans understood it well. But most people today have this attitude that the reason things are bad is the wrong people are in power, and if we somehow put the right people in power, everything would be okay.
There's little appreciation for the fact that political power itself is the problem. It corrupts morals and the judgment. And no matter who you put in there, he or she will likely end up making a mess.
So that lesson has yet to be learned. Once you see discussions about political power itself – about what it is and what it does to a person's mind – appearing in the news media, we're going to be well on our way to where we want to be – a new world of liberty, peace, and abundance.
Crux: That sounds great. Thanks so much for talking with us, Richard.
Maybury: It was great speaking with you. Thanks for having me. Take care.

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