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.
Feb 24, 2012
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.
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.
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.
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.
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.
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.
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.
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