Monday, June 18, 2012

The 10% FCF yield club

When a company's business is easy to understand, offers a 10% FCF yield, provides steady and predictable profit year-in-year-out without oversize Capex, I get excited. If it can grow its cash flow in line with nominal GDP growth, it can easily offer 15% p.a. return. 15% has been Buffett's hurdle rate throughout his investing life. This is the "good enough" mentality that both Warren Buffett and Ben Graham advocate. If it's good enough for Buffett, it should be good enough for me.

What's interesting here though is I started looking at one company which led my thoughts onto another company which led me onto another one... And I ended up indecisive....

Let's start with Lamar Advertising.

Lamar Advertising
  • Company: Lamar Advertising (NASDAQ:LAMR)
  • Market Cap: $2.55B
  • TTM FCF yield: 9%
  • Business: The 3rd largest billboard advertising provider in US
  • Moats: Nothing can replace billboards for brand-awareness advertising. Highway Beautification Act (1965) limits the number of billboards that can be built. This is pretty close to Buffett's "toll booth" type of business.
  • Positives: A gradual recovering US economy will improve both occupany and rates. LAMR will also be able to refinance some of its debts in the coming years with lower interest rates.
  • Negatives: Cyclical business. Very high debt. FCF interest cover is only 2.2x. But the mgmt has been prudently using all of the FCF to pay down its debts in the last 3 years. Yet, there is no gaurantee the mgmt won't do another debt-fueled acquisition in the future.
My biggest hesitation here is the 2.2x interest cover. It is quite a stretch on my comfort level. While LAMR's cashflow was pretty stable through the GFC, considered that its advertising contracts are typically less than a year long, I'm not sure how much shock such a highly levered balance sheet can take. My issue here is safety.

While I was thinking about LAMR's advertising business, I remembered another advertising related company.

Omnicom Group
  • Company: Omnicom Group (NASDAQ:OMC)
  • Market Cap: $13.2B
  • TTM FCF yield: 10%
  • Business: Advertising agent
  • Moats: Ad agent is a service business.When marketing campaigns get more and more complicated, the value of an Ad agent increases. Its moat resides in its sticky customer relationship. (e.g. Apple has been staying with one agent since Jobs returned. You can't say that for its semi suppliers. Btw, Apple's ad agent belongs to OMC.)
  • Positives: Although debt/equity is ~1.0, interest cover is a comfortable 10x. 
  • Negatives: This is cyclical business and profit moves in tandem with the economy. OMC has significant exposure in Europe. This is both a plus and minus. When Europe's problems fade, we shall see growth. But it may take years.
Next, I remembered Dun & Bradstreet Corp, which was beaten down badly in May after it released its disappointing FY2012 guidance.

Dun & Bradstreet Corp
  • Company: Dun & Bradstreet (NYSE:DNB)
  • Market Cap: $3.22B
  • TTM FCF yield: 8.75%
  • Business: Data provider of business records and credit history
  • Moats: When the database you provide is essential to other people to conduct their businesses and when its size gets to a certain critical mass, its economics benefits from a form of network effect and becomes self-sustainable. This is the kind of business an idiot can run.
  • Positives: But DNB's mgmt are not idiots. They don't chase unattractive growth for the sake of it. They return cash back to investors in the form of share buybacks.
  • Negatives: Business isn't growing in the recent years. Can it really grow in line with the economy?
At this point, I asked myself, why all these troubles? Why don't I just add more to my existing Microsoft position?

Microsoft Corp
  • Company: Microsoft Corp (NASDAQ:MSFT)
  • Market Cap: $252B
  • TTM FCF yield: 11%
  • Business: software
  • Moats: MSFT has 2 undeniable franchises: Windows and Office. Both are essentially annuity kind of business.
  • Positives: Truck load of cash. ROE in the range of 40% without using debt. Growing steadily 8-12% p.a. over many years. On the corporate front, Windows 7 upgrade cycle will accelerate in these 2 years. On the consumer front, Windows 8 sales will provide additional revenues.
  • Negatives: Given its size, growing will become harder and harder. Cloud-based computing and mobile computing both threaten MSFT's franchises. There is also the risk the mgmt will destroy value on poor acquisitions.
I'm pretty comfortable MSFT can defend its turf. It may even be able to leverage its dominance into offering more cloud-based solutions and mobile solutions than everyone can imagine.

No matter how I cut it, MSFT looks like a superior investment to the rest. My conviction is high.

Charlie Munger always says diversification is diworsification. My dilemma here is whether I should diversify in order to reduce my exposure to one single company. No matter how high my conviction is, there are always "unknown unknowns". There is also this unhelpful thought urging me to divest: "Earning outstanding returns requires hardwork. If I keep on adding to just the same old position and not spending time to dig deep into other companies, I'm not working hard enough." (I haven't yet done in depth analyses of some of these other companies. If I end up staying with MSFT, this won't be the best use of my brain power and time.)

I'm really interested in your thoughts!

 (Disclosure: Long MSFT)


  1. your biggest problem will come this Xmas when Xbox ain't doing so hot. Why?
    1. Ninendo Wii U
    2. Apple TV + Games
    3. Xbox 360 is end of life
    Then on top of this little problem, you'll enjoy declining sales in operating systems, office (the cloud-based competition is getting better and better), as well as enterprise software.
    So in general, all you have is that dividend and some hope.
    You and the "value" army that are invested in MSFT, are going down by hook (deflationary evironment plus declining importance of msft products) or by crook (money printing will reduce the value of your stock thanks to rise in commodity prices).

    1. I'm not sure about your description of 'hook' and 'crook':

      1) hook: You mention "deflationary environment" but you don't explain yourself. Are you referring specifically to MSFT products?
      2) crook: You make a few massive assumptions here, including that 'commodity prices' are going to rise (do you know what MSFT does? If you do, please explain to me their exposure to "commodity prices"?) Also, you assume that MSFT can't push through those higher "commodity prices" AND it also seems that you assume that this "money printing will reduced the value of your stock" is specific to MSFT? which you might know, is not true as different companies react differently to "inflation", which by the way is a very vague word because not every product and service out there reacts the same toward the devaluation of a currency.

      Overall, I grade your comment D-

    2. Do you have scuttlebutt or statistics to share that can shed lights on MSFT's declining businesses you mentioned? I'll be interested to hear them.

  2. I just wanted to comment on the issue with inflation. I don't think that the value of microsoft stock will be hit by inflation. If the value of money declines, they can easily raise prices (yes, they still have pricing power). So profits will rise in line with inflation. Assets will also have to rise with inflation, so there is additional money to invest and free cashflows will decline. Luckily I don't see much tangible assets on microsoft's balance sheet.

    It is true, that most companies are hurt by inflation. Microsoft is not one of them.

    About the Xbox: what is the share of Xbox-Profits in Microsoft's overall profits? So if they fall to zero, you can estimate, how small the effect on the value of microsoft stock is.

    About declining sales in msft's core businesses: everybody has to form his own opinion. I see people talk about decline since years, and everything that happens is a further rise in revenues and profits. But contrary to the other two points, this point has at least a relevance for the value of the stock.