The Role of Relative Valuation Stu Linde November 1, 2006.

The Role of Relative Valuation

Stu Linde

November 1, 2006

Topics

The Broad Fundamental Analysis View

Financial Statement Overview

Relative Equity Valuations

CBS: A Case Study

Appendix

1

Topics

Information is Dangerous….

Knowing How to Apply is Deadly!

2

The Broad View

3

The Broad View

Common Analyses Elements

Revenues

– Drivers Of Business Model / Stress Test Against Industry Model

– Expectation Often Predicated On Recent History Rather Than Realism

– Industry Growth, Management Strategies And Comparisons Are Key Profitability

– Where Rubber Hits The Road….Is Revenue Growth Creating At Least Incremental Profitability

– Easiest To Play With – “One Time” Vs. Recurring

– Q To Q Volatility Cash Flow

– Measure Of Earnings Quality

– Measure Of Growth Capabilities

– Risk Of Over-Investment

4

The Broad View

Common Analyses Elements (cont’d)

Valuation

– P/E Most Commonly Used To Benchmark Against Market, Other Industries And Peers

– Cash Flow (EV: EBITDA);

– Enterprise Value (Debt, Book And Equity Measures)

– Dividend Yield

– Sales

– The List Goes On!

Expectations

– Greatest Opportunity To Enhance Risk Taking Broadly Is To Anticipate Expectation Embedded In Stock.

5

The Narrow View

Uncommon Analyses Elements: How Do They Affect the Model Levers?

Key Questions to Set Stage for Valuation:

– What are the Key Drivers of Growth?

– What is the Category Growth ?

– What Macro Variables Affect the Sector?

– Are There Sector and Company Specific Risks?

– What is the Geographic Scope?

– Does Scale Come into Play?

6


7


Income Statement Analysis

Revenues – Examine Growth Drivers

• Different for Every Industry

• Recurring vs Non Recurring

• Macro Drivers

• Example Cable Networks: Subscribers, Subscriber Fees and Advertising

• Example Hotels: Occupancy Rate, Price, RevPAR

Gross Margin = Revenues – COGS

• Impacted by Material & Labor Costs

Operating Margin/EBIT = GM – SG&A – D&A

• Impacted by All Operating Expenses/Run the Business

EBITDA = EBIT + D&A

8


Income Statement Continued

Below Line Items

• Interest Expense/Income

• Minority Interests

• Non Consolidated Investments

• One Time, Non Recurring Items

• Taxes

EPS

• Basic

• Fully Diluted – Options Included

• Operating EPS

9


Watch for Earnings Inflation

Quality of Operating Earnings is Critical!

– Analyze Earnings Release Carefully

– Remove Cheerleader Behavior

Watch for:

– Depreciation and Amortization

– Corporate Expense

– Interest Expense

– Minority Interests

– Lower Share Count

– Unexpected Tax Rates Changes

10


Balance Sheet – Understand Leverage Drivers

Liquidity = Current Assets – Current Liabilities

• Inventories, Receivables, Payables, ST Debt

• Burn Rates

LT Debt Analysis – Be Cognizant of Maturity Schedules

• Credit Crunch Could Impact Bank Rates

• Floating vs Fixed

• Cost of Debt Could Be Impacted By Ratios, Operations and Mkt Conditions

• Interest Rates Affect EPS

Key Leverage Calculations

Net Debt/EBITDA

Interest Coverage = EBITDA/Interest Expense

11


Cash Flow Statement – Direct Impact on Balance Sheet

FCF = Net Income + Depreciation/Amortization -

Changes in Working Capital and Capital Expenditures

Capital Expenditures = Maintenance or New Investment

• Recurring vs Non Recurring

• Depreciation vs Capex

The Cash Dilemma: What to Do?

• Management Needs a Well Thought Out Process for Assessing ROIC

• Stock Buyback is Easy Answer but is it Best?

• Buyback Often Signifies Slower Growth

• High Correlation Between Incremental ROIC and Multiples

• Common Stock or One-Time Special Dividend

12

Relative Equity Valuations

13

Equity Valuations

P/E Ratios

EV/EBITDA

FCF

Sum of the Parts

CBS: A Case Study

14

Equity Valuations

Growth

ROIC

Diversification

Leverage

Fundamentals

Complexity

Valuation

15

Equity Valuations

Things to Think About:

Think Before You Input; Watch for Straight Line Approach

Fundamental Analysis Key …But Do Not Forget Technicals

Keep Emotions Out of Equation; Let Data Speak

Fighting Tides is Often a Lost Cause; Watch Valuation Trap

- Find a Catalyst or Unlock the Value

Keep it Simple; Do Not Over Analyze

16

Equity Valuations

Relative Valuation

Define Companies in Universe

Understand Drivers of Business Model

Analyze Prospects for Growth

Financial Strength/Flexibility

Other Industry/Company Specific Dynamics

- Economic/Macro

- Product Risks

- Sales Concentration Risk

- Political Risk

- Management

- Return on Invested Capital

17

Equity Valuations

Understand Industry Drivers

Earnings Drivers Vary By Industry

- Retail – Comp Sales, Square Footage Growth

- Media – Advertising

- Banks – Asset Quality

- Energy – Commodity Prices

- Industrial – GDP

- Technology – Supply/Demand Cycle

- Healthcare – Regulatory

18

Equity Valuations

Excess Leverage Could Impact Valuation

Bankruptcy Risk

- Chapter 11 and Chapter 7

Decreases Financial Flexibility

- Shareholder Value

- M&A

Higher Borrowing Costs Equates to Lower Net Margins

Limits Reinvestment; Creates Asset Drain

Key Ratios

Net Debt/EBITDA

Interest Coverage = EBITDA/Interest Expense

Dependent on Industry Dynamics – Cyclical vs. Stable

19

Equity Valuations

Price/Earnings

Absolute Relative PEG TTM Versus Forward -- Must Normalize for One Time Items Normalized Earnings Fully Diluted

Variables Growth – Projected and Historical Industry/Sector Trading Liquidity Management Debt Complexity: Structure, Financing, Accting, Businesses, Control, 10k Thickness

20

Equity Valuations

EV/EBITDA

EV = MV of EQ + Debt – Cash – Non Consolidated Assets (Hidden Assets)

EBITDA = Earnings Before Int., Taxes and Depreciation

Variables Debt Levels/Balance Sheet Growth – Projected and Historical Industry/Sector/Risks Capital Intensity of Sector/Amount of Reinvestment FCF Complexity

21

Equity Valuations

Free Cash Flow

FCF = Net Income +Depreciation/Amortization -

Changes in Working Capital and Capital Expenditures

FCF Used to Determine Cash on Cash Returns• Cleaner than EPS/Measures Cash Creation

Uses Reinvestment/Acquisitions Debt Reduction/Stock Repurchase Dividends – One Time or Annual

Key Calculations

FCF Yield = FCFPS / Stock Price

FCF Conversion = FCF / EBITDA

22

Equity Valuations

Sum of the Parts

Break Up Value of the Company

Used in Complex Multi-Industry Situations

Accounts for Non Consolidated Assets

Assists in Measuring Franchise and Brand Value

23

Equity Valuations

Sum Of the Parts Example: AOL Time Warner

(US$ millions) OwnershipInterest 2002A 2003E Multiple 2003E

Consolidated Operations:Cable 2,745 3,047 EBITDA 11.0x 33,516Filmed Entertainment 1,232 1,387 EBITDA 12.0x 16,648Networks 2,032 2,265 EBITDA 15.0x 33,982Music 474 465 EBITDA 8.0x 3,717Publishing 1,155 1,172 EBITDA 9.0x 10,552Corporate (332) (363) EBITDA 11.7x (4,257)Intersegment Eliminations (47) (103) EBITDA 11.7x (1,213)Total $7,260 $7,871 11.7x $92,944

Unconsolidated Operations:Time Warner Telecom 44.0% 114 114 MM shs $6.80 per share 341Court TV 50.0% 75.0 80.0 MM subs $20 per sub 800Braves, Hawks, Thrashers 100.0% $725 $783 MM value 783Viva Media 30.6% $330 $363 MM value 111Cable joint ventures (a) 50.0% 1.5 1.5 MM subs $3,200 per sub 1,634Value of NOLs 2,784 2,575 2,575Total $6,244

Total Asset Value of AOL Time Warner $99,188

Less:Net debt $23,348Comcast's Minority Interest in TWC 5,337

Value to Common Shareholders $70,503

Total shares outstanding 4,555Value per AOL/ TWX share $15.48

24

Equity Valuations

CBS: A Case Study

Back Drop:

• Spin Off From Viacom

• Mature Assets

• High Free Cash Flow

• Strong Balance Sheet

• Complex Asset

How to Value?

25

Equity Valuations

Where Do We Start?

Determine Universe

Examine Business Composition

Analyze Growth Prospects

Are there Company Specific Risks? Industry?

What is the View of Management?

Should Brand Value be Taken into Consideration?

How Does the Economic Outlook Impact Fundamentals?

Is there a Dividend or Other Means to Enhance Shareholder Value?

How Does Leverage/FCF Compare to Peers?

Complexity/Accounting Concerns

26

Equity Valuations

Concluding Comments

Valuation Screens Often Precede Fundamental Analysis

• More Than One Methodology Usually Required

Relative Valuation Methods Vary by Sector

Stocks are Sometimes Cheap for a Reason

• Sector Driven

• Management Track Record

• Product Pipeline

Combining Fundamentals with Valuation Helps Minimize Risk

• Good Companies Make Great Investments

• Bad Companies Make Poor Stocks

27

Concluding Comments

Markets are Inefficient….

Valuation is a Key Investment Tool!

28

Follow-up Reading/Courses 1. Graham & Dodd Security Analysis

– The Bible!

2. You Can Be A Stock Market Genius, Joel Greenblatt

3. Stocks for the Long Run, Jeremy Siegel

4. Investment Valuation: Tools and Techniques, Professor Aswath

Damordaran

5. Think About Taking CFA

29

Appendix

30

Appendix

Consumer Discretionary & Staples

Energy

Financials

Health Care

Industrials & Materials

Info Tech

Media

Telecom

Utilities

Strategy / Converts

31

Consumer Discretionary & Staples

Consumer spending as a share of GDP is on the rise and near 70% Trend towards more durable goods purchases; sourcing is more

global Consumer credit up-cycles last 34 months on average Huge diversity in consumer proto-types Income trends impact decisions

– Inflation

32

Consumer: Retail

Very low margins and few barriers to entry Keeping customers from competing stores is a huge challenge,

long-term Unique products are hard to keep unique; so low price model often

wins out Category killers (HD, LOW, ODP, SPLS, WMT) achieve

economies of scale in traditionally mom and pop or regional businesses.

Move off the mall trend has hurt the traditional anchor tenants – duel income families don’t have time to find selection, quality, and reasonable prices at different places. They go where they get it all and get it fast (WMT, TGT, KSS)

33

Things to Watch and Monitor

Same store sales comps – investors often over-react to one month’s bad comps

Sales per square foot and inventory trends Valuation and macro trends since the strongest models are well known

Most have little debt on the BS but be mindful of off-BS obligations (leases)

Employee moral and culture (PT vs. FT workers) – they interface with shoppers

Cash conversion cycle trends: days inventory + days receivable – days payable

On-line competition

34

Consumer: Consumer Goods

Slow growth but very profitable, steady performers Scalable models Old, already largely consolidated industries Market share wars common (Coke vs. Pepsi) New products differentiate growth trajectory

(Gillette Sensor and Mach 3 Razor) Growth by acquisition Defensive investments

35


Slow growth means the focus is on costs and quality of acquisitions

Slow growth means international sales (and currency trends) are very important

Valuation and FCF Use of enormous CF – dividends and share repurchases Economies of mass scale Recurring charges after acquisitions Branding – is it being supported with adequate advertising? Increasing power of key retailers (WMT) Litigation risk – tobacco and high fat products

36

Energy

Mature industries; high CF Two thirds of the world’s energy is oil and gas Two thirds of known oil reserves are in the Middle East The U.S. imports 60% of the oil it uses Each $10 per barrel change in oil = 0.4% change in U.S. GDP Each $10 per barrel change in oil = 3.2% change in S&P 500 EPS Exploration and Production (E&P) firms are “upstream” Refineries are “downstream” The “upstream” is more profitable than the “downstream” because

OPEC maintains oil pricing way above production costs

37


Use of CF – dividends and share repurchases Reserve replacement ratio > 1.0 For Servicers & Drillers – Trend towards deep-depth drilling

should help an industry that has barely earned its COC over time Higher oil prices help E&P firms/hurt Refiners Lower oil prices help Refiners/hurt E&P firms Higher oil prices help overall industry profits Risks: OPEC losing its influence, regional instability, Russian

supply, and new fuels down the road (nothing on the radar screen)

38

Financials

Growing share of U.S. profits Share of S&P 500 index (22%) where past sectors have hit the wall Benefits from more trade, longer lives, older populations, and

rising affluence Has exposure to world growth no matter which sectors generate it Vital and strategic part of any developed economy for liquidity and

capital

39

Financials: Banks

Extremely capital intensive Regional oligopolies; high switching costs Not as rate sensitive as they used to be 10-20 years ago Net interest income (loan rates higher than deposit rates) Non-interest income (fees) – depositors literally pay banks for

liquidity Huge, diverse loan portfolios reduce risk and enable lower

capital costs FDIC guarantees over half the industry’s liabilities Key strategies include global reach (C), national reach (BAC),

attracting cheap deposits (WFC), right side of balance sheet focus (FITB), and location and customer service (CBH)

40


Strong asset base: equity–to-assets ratio of 8-9% (the level varies)

High levels of loss reserves relative to nonperforming loans ROEs of 14-20% (if its much higher, double-check the loss

reserves) ROAs of 1.2-1.4% or better Since bank assets are financial and liquid, P/B is the most

common valuation metric and a ratio under 2.5-3.0 often projects good value for a strong large bank

ROIC analysis is preferred because banks can quickly change their balance sheets, and this analysis is only published by Lehman Brothers, Inc. at present

DCF analysis is also preferred to P/B and is available at Lehman Brothers, Inc.

41

Things to Watch and Monitor (Continued)

Lending profitability: net interest margins of 3-4%: high end when rates are low and low end when rates are high

Fee income share of revenues and fee income growth trends Efficiency ratios of 55% or less (operating costs as a share of

revenues) Credit quality: BS, loan categories, nonperforming loan and charge-

off trends Risk: almost everything known about credit quality is after the fact,

sometimes fast growth signals riskier lending standards Portfolio diversity Aggressive collection procedures Asset (loans) sensitivity in a rising rate environment is preferred;

liability (deposit) sensitivity in a falling rate environment is preferred

42

Financials: Asset Managers

Wide margins and excellent economies of scale Stock prices reflect market optimism or pessimism (pays to be

contrarians) The most valuable assets are the PMs Diversity of assets and products helps weather various market

cycles and allows asset rotation to stick within the firm Assets held in tax deferred portfolios are sticky assets Reputation and regulatory risk

43


Assets under management (AUM) = cash flow Stocks have higher fees than bonds; bonds have higher fees than

cash Inflows in a variety of market environments

44

Financials: Asset Services (Custody)

High barriers to entry; size begets more clients Lower fees and more economies of scale than Asset Managers Frequently outsourced by Asset Managers Typically offers performance analysis analytics, pension

consulting, etc.

45


Assets under management (AUM) Economies of scale have lead to consolidation Generous lending to custody clients (BONY loans to Telecom

and Cable in 90s)

46

Financials: Life Insurance

Mature, slow growth industry with easy to substitute products Thin margin between ROE and cost of equity Best to adopt a value approach investing in these stocks Regulatory and huge capital requirements are only real barriers to

entry Complex products and financial statements Takes many years to know if a policy was priced correctly Claims normally 75% of premiums Extensive distribution system is a core asset; so biggest firms have

an edge Net income tends to revert to the mean over time, although

investment returns can vary greatly one year to the next

47


Near industry premium growth is preferred, as this is an industry where under-pricing risk to increase sales is bound to fail

Credit rating (AA or better) – people want to know their insurer will be around

Diverse investment portfolio and risk management culture (low junk bond to tangible equity or total assets ratios)

Since there is little detail on actuarial assumptions and returns are hard to predict, tangible book value ex-marked-to-market gains or losses on available for sale securities from shareholder’s equity (in the 10-K) is an important metric

48

Financials: Property & Casualty Insurance

Commodity business Thin net margins; low ROEs Low levels of pricing power; very hard to predict costs Claims normally 70% of premiums They invest the float (premiums received long in advance of

paying claims) Good management can often play the insurance cycle and

acquire poor performers when they are very cheap and turn them around

49


Make sure management has some skin in the game (owns part of firm)

Combined ratio is the key profit measure, less than 100 means profitability

Firms with a combined ratio over 105 for more than a short while typically have trouble recouping their losses via investment earnings

Unless Warren Buffet is the PM, look for a small equity share of investments

Investment ratio + combined ratio = operating profit ratio

50


Social trends: there has been a tendency for juries to award huge claims that were written years ago under more conservative judicial assumptions (Asbestos)

Regulation: insurance rates are often approved on a state-by-state basis and are often required to insure less profitable customers without charging them higher premiums as compensation. In many states, insurers are required to fund the losses of competitors who become insolvent

Voting mood: CA Prop 103, 20% cut in premiums. Customers can lobby states.

Best to invest with a value approach

51

Health Care

Strong growth characteristics: 9% of GDP in 1980 and 15% of GDP now

$5,444 per capita spending in 2002 in US, 50% higher than next closest country

60% of elderly in bottom 2 income quintiles; 75% of uninsured live in households of $50k or more in annual income

Aging population, longer life spans, desire to be active and healthy later into life

High barriers to entry: high start-up costs, patent protections, significant product differentiation, economies of scale, long drug development cycle

Intangibles: provider networks, clinical track records Pricing issues: costs paid by insurance plans limits consumer price

sensitivity

52

Health Care: Pharma

High margin, high FCF, near debt free, $500m and 10-15 yrs to make a new drug

Procedures are expensive and create demand for cheaper drug solutions. e.g. surgery vs. pill

Many new drugs are evolutionary rather than revolutionary

53


ROICs – look for mid 20%+ Gross Margins – look for around 80% Net margins – look for 25-35% Focus on high FCF - needed to fund R&D Political pressures Pipeline –new drugs to offset looming patent expirations Preclinical Trails – focus on potential toxicity Phase I – focus on safety and efficacy Phase II – how well the drug works vs. what’s out there Phase III – most costly trial. Focus on efficacy. Blockbusters need to be bigger to create meaningful percentage growth Greater specificity of future drugs means smaller target population per

drug

54

Health Care: Generics

Excellent growth outlook: half of all scripts are generics and the share is rising

Few pure plays After 180 day exclusivity the edge goes to the lowest cost producer

55


ROICs – look for around 10% Gross Margins – 40-50% Net margins – 15-20% 1st patent challenges Re-importation and foreign competition

56

Health Care: Biotech

Diverse industry with value drivers varying widely by company Highly complex and evolving industry Leading edge of molecular biology, IT, mathematics, quantum

physics, combinatorial chemistry, electronics and material science

Drugs and bilogics with greater specificity of action vs. Pharma Biologic process (cellular and molecular) vs. chemical process

of Pharma Many one drug or one technology companies; fewer well

diversified product suites

57


High FCF and cash on BS – needed to fund R&D Research productivity versus financial discipline EPS and sales growth Relative Valuation – volatile swings between optimism and

pessimism. Often pays to buy on big dips Script trends 10-Ks – often the best description of what’s going on Independent sales force – reduces dependence on partners Many late stage trials are the best assurance of forward growth

58

Health Care: Medical Devices

Excellent growth outlook – aging population that wants to be active

High switch costs with Doctors; sales force often assists in surgery

Switch costs lower with cardio devices than orthopedic devices Long clinical histories, patent protection, and economies of scale Patents protect devices and tools for their installation Most improvements are evolutionary rather than revolutionary

59


Product innovation and diversification (10-Ks best place to look) Strong margins and earnings trends Relative Valuation Excellent pricing power – Medicaid/Medicare reluctant to limit

brand choices Legal strategies often used as a defensive tactic vs. competitors

60

Health Care: Health Insurance/Managed Care

Litigation risks and regulatory pressure reduce attractiveness Insurance companies run the risk of under-estimating health care

costs Rising health care costs makes fee based businesses relatively

more attractive, such as claims processing or network access

61


Medical loss ratios (medical costs paid/premium revenue) of 85% or less w/trend in right direction

Minimal dual-options – more choice allows customers to shift costs based on asymmetric knowledge to the provider and creates more industry competition

Exposure to government accounts – reimbursements generally lag health care inflation rates

62

Industrials & Materials

Classic old economy: materials, machinery, equipment, etc. Long established replacement cycles Highly cyclical Huge operating leverage Many have financing subs (GE, CAT) Exposure to defined benefit (DP) pensions and Asbestos

63

Industrials & Materials: Materials

Simple financial statements Limited top-line growth; poor ROICs Low-cost producer wins in most commodity products (AA) Investments in technology can lead to low-cost status (electric

arc furnace in steel) Product innovation is still happening: AA is making lighter,

stronger aluminum products. However, the return on R&D often goes to the users not the

investors

64


Total asset turnover and fixed asset turnover Market share gains than come at the expense of asset turnover

often signals ill-advised price cutting Cash conversion cycle trends: days inventory + days receivable

– days payable Regular and growing dividends, which reduce some of the

cyclicality inherent in these stocks Debt levels – due to the cyclicality of these companies Acquisitions – are tempting due to slow growth of industry;

acquisition-associated charges often inflate future margins

65

Industrials & Materials: Industrials

Good companies in bad industries: MMM, UTX, PBI Finance subs are common: GE, CAT Low debt levels can make the difference in these very cyclical

industries (DE survived the early 1980s farm recession) Sector also includes people-based service businesses: CD,

APOL, RHI, MAN, MNST, etc. People-based services have more variable costs and are, thus,

less attractive than technology or processing based services (see Information Technology section)

66


Total asset turnover and fixed asset turnover Market share gains than come at the expense of asset turnover

often signals ill-advised price cutting Cash conversion cycle trends: days inventory + days receivable –

days payable Regular and growing dividends Cost leadership Debt levels – due to the cyclicality of these companies Acquisitions – are tempting due to slow growth of industry;

acquisition-associated charges often inflate future margins Organic growth, differentiation of services, and labor market

trends in people-based businesses

67

Information Technology

Growing share of equipment and total capital spending IT spending is influenced by the incentive to substitute capital

for labor Only true cyclical growth sector 64-bit generation of products in very early stages Most aggressive users of stock options as compensation Trend towards processing and technology-based outsourcing

services

68

Information Technology: Software

Intense competition but high customer switching costs Huge economies of scale High FCF; high ROICs Simple financial statements Excellent growth prospects High labor costs encourage the use of software for time-consuming

tasks Software helps companies grow in good times and cut costs in lean

times, but it is highly cyclical and depends on IT spending Many types: operating systems, database, enterprise resource

management, customer relationship management, security, video games, etc.

Back-end loaded quarters with majority of revenue booked in final days are the norm and this raises the odds of having big surprises

69


Network effects – people will create documents or files and use

software if they know the majority of PC users have the same

software (Acrobat Reader, Excel)

Branding –easier for small business or retail software

(QuickBooks, TurboTax)

Sales, EPS, and CF trends

Expanding margins over time due to scalable models

Large, stable installed client base

70


License revenue best reflects current demand for products and

leads service (less profitable) revenue

Deferred revenue shows cash the company has received before it

performs a service and is a good metric for gauging future

revenue

Days sales outstanding (DSO) – trend matters more than level

Watch out when a firm changes its rules for revenue recognition

Watch out when a vendor and customer simultaneously buy each

others products

They always look expensive

71

Information Technology: Hardware

Cost of computing and storage is going down Able to manufacture in low cost countries and sell in developed ones Highly cyclical industry Short product cycles, price competition, and technological advances

make it hard to sustain the lead, so distribution channels, scale, and broad product lines are needed to establish a more secure position

Key asset is the ability to innovate Switching costs are higher in telecom equipment Low cost model often wins Analog chips are highly proprietary and lack direct substitutes and

work on temperature, weight, pressure, and sound rather than 0s and 1s

72


Network effects – hardware needs to run on an operating system and be maintained by people who must invest time to operate the product

Market share Marketing focus Flexible models – since demand us so unpredictable Gross and net margins Intellectual property sales Best to invest with the cycle – very cyclical stocks often look

rich near the trough and cheap near the peak on valuation metrics

73

IT Services

B-to-B is growing faster than the overall economy Outsourcing trend apt to continue Technology and data processing services can spread systems

development costs over many firms Benefits from falling cost of technology Long-term contracts lead to recurring revenue Have earned above average returns Economies of scale prod acquisitions to achieve higher and

higher levels of volume: ADP, FDC High barriers to entry

74


Services vary a lot by company Service differentiation – needed to protect sizable investments in

software, hardware, and sales networks Sales, EPS, valuation

75

Media & Cable

CDs, movies, and books generate one time transactions and are dependent on stars and authors; costs precede revenue

Subscription-based models generate recurring revenue; revenues precede service costs

Advertising models have high operating leverage Intangible assets: licenses, trademarks, copyrights, and brands. Few cities can support more than one newspaper Cable faces challenged from satellites teaming up with RBOCs

76


FCF margins of 7-10% Deregulation: has lessened competition in broadcasting Recurring capital investment to fend off competition Transforming mergers (AOL/Time Warner) Family run firms Complicated cross-ownership structures Ridiculous CEO compensation

77

Telecom

Telecom looks nothing like it did 25 years ago and in another 25 years it will probably have little resemblance to what it looks like today

Long distance deregulated in 1984: AT&T break-up Local deregulated in 1996: Telecom Act of 1996 allowed AT&T and

WorldCom/MCI to lease networks at discounted rates Poor and declining ROICs; low asset turnover ratios Rural carriers least affected by deregulation Recurring expenditures and huge fixed costs to build a network Competition from cable and wireless networks Most of U.S. population has access to 1-2 local services 80% of U.S. population has access to 5 or more wireless carriers

78


ROICs – borrowing regulatory changes, firms may never earn their cost of capital again on long distance

Churn – firms need recurring revenue to pay for network costs Operating margins of 20-30% - below this level makes it hard to

provide customer service, maintain the network, and earn the cost of capital

EBITDA margin trends – as a guide to cash generation for capital spending needs and the ability to service debt

Operating CF – EBITDA can obscure accounts receivable Financial strength and flexibility to technological and regulatory

change

79

Utilities

Enormous operating and financial leverage Utilities generate, transmit, and distribute power Generation has the lowest barriers to entry; distribution has the

most (final mile of cable) Federal Energy Regulatory Commission (FERC) 1992 rule

changes started the deregulation process Deregulation is furthest along in generation Most recent focus of deregulation has been access to the grid or

transmission Northeast and Southwest are more deregulated than the Plans or

Southeast states

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Utilities are not the safe havens for widows and orphans they used to be

Debt levels – given the turbulent regulatory environment. Utilities often have 45-55% debt-to-assets ratios

Use of CF – dividends and share repurchases Northeast and Southwest are more deregulated than the Plans or

Southeast states Changing regulatory landscapes Rate cases in a still low interest environment. Many 10.5-12%

ROE situations could be reset to 9.5% or so

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The Role of Relative Valuation Stu Linde November 1, 2006.

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Transcript of The Role of Relative Valuation Stu Linde November 1, 2006.