Value Investing 3: Undervalued Balance Sheet Cash

 |  Includes: AAPL, CSCO, GOOG, MSFT, WDC
by: Philip Mause

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There has been a good deal of discussion recently about the enormous build up of cash on corporate balance sheets. Before going into the implications of this, it is important to define what we are talking about. Generally speaking, I will be focusing on net cash and liquid investments. Thus, on a balance sheet of a company like Microsoft (NASDAQ:MSFT) which has debt as well as cash, the debt must be subtracted to calculate the net cash. Secondly, I am including not just cash but also short term investments and long term liquid investments. The fact that some of the money is invested in 30 year Treasuries or corporate bonds does not really change the analysis materially. Finally, it is very important to distinguish companies based on the nature of their business. For example, insurance companies may have enormous amounts of cash and liquid investments but these must be analyzed in the context of the nature of their business. Insurance companies are required to establish reserves against future policy claims and these liabilities have to be set off against the investments to understand the company's financial situation.

I have written a number of articles discussing an alternate method of approaching a valuation for companies with net balance sheet cash. It is called "EPEE" and it is based on the isolation of the company's operations from its cash. Net cash is subtracted from market cap and net earnings on the cash (after tax interest income minus after tax interest expense) are subtracted from the company's earnings to calculate and "Enterprise Price" and "Enterprise Earnings." The EPEE is the ratio between these two numbers and should be more useful than the traditional price earnings ratio in determining how stocks are priced. The assumption is that the net cash is worth its face value and that the uncertainty in valuation is entirely connected with the business operation itself.

I will return to some of these basic assumptions but, first, here is the current analysis for 5 leading tech companies. In each case, I have set forth today's closing price, my calculation of net cash, the enterprise price per share, and my calculation of the 2011 EPEE using consensus earnings as adjusted for this analysis.

1. Microsoft (MSFT) (24,22) (204B) (49B) (18.42) (7.4)
2. Western Digital (NYSE:WDC) (35.03) (8.14B) (22.30) (7.4)
3. Cisco (NASDAQ:CSCO) (16.25) (27B) (11.25) (7.1)
4. Apple (NASDAQ:AAPL) (346) (66B) (275) (11.2)
5. Google (NASDAQ:GOOG) (528) (43B) (401) (11.9)

Ii is interesting to note that, if next year's earnings are used, the EPEE for GOOG is 10.2.

I have to say that the investment strategy implied by this analysis has not worked out well for me of late. I find it hard to believe that MSFT should be priced at less than 8 times earnings or that its pricing at an EPEE equivalent to that of WDC makes any sense. AAPL also seems to be getting cheaper and cheaper as balance sheet cash reduces EP, earnings keep going up, and EPEE falls below the level for electric utilities. Something seems off center, but that is the persistent verdict of the market.

I think several things may be going on here. The above analysis is really a subdivision of "sum of the parts" analysis where one of the parts is the net cash and the other part is the operating company. The analysis presumes that the net cash is worth its face value but this assumption may be questionable. Much of the cash is held overseas and taxes would have to be paid upon repatriation (however that is defined). Of course, a lot of the best investment opportunities are also overseas and the tax law may change so that simply discounting the cash by the "effective" tax rate is probably misleading as well.

There is also probably a sense that excess cash will "burn a hole" in the pockets of some of these companies as they go on spending sprees like "drunken sailors" and fail to reap returns on the cash for shareholders. In this regard, MSFT's recent acquisition of Skype has raised some eyebrows but the verdict on that one is not really in yet.

As we pulled out of the Panic of 2008, I had assumed that investors would fall in love with some of these stocks on the theory that the excess cash reduced risk. It certainly should be the case that MSFT's cash hoard dramatically reduces the risk of a dividend reduction. The cash also enables share repurchases which should tend to support share price and ultimately can increase per share earnings. In addition, a whole set of risks which bedeviled leveraged companies in 2008 and 2009 simply do not exist for these companies. Finally, there is in a sense a great deal of "pent up" earnings power in these stocks because the companies can leverage up by using their cash and unused borrowing power to buy back shares on a large scale and drive up per share earnings. Alternatively, these companies will get a significant earnings "bounce" when (more accurately, if) interest rates go up because they will earn more money on the balance sheet cash.

As these companies seem to pile up more and more cash each quarter, I am convinced that a turning point will be reached and market performance will begin to rebound (with a possible exception for WDC). At current prices, these companies each have significant opportunities to increase per share earnings by leveraging up (using cash and borrowed funds to buy back shares). Some of that appears to be commencing already as MSFT and GOOG have borrowed at ultra low interest rates and MSFT and CSCO are aggressively buying back shares. Value investments often emerge when investor revulsion is at its peak and that appears to be the case with MSFT and CSCO. AAPL and GOOG also look cheap based on this analysis although I realize that they do not fit the expected profile of a "value investment." In a sense, these companies are - from a leverage perspective - at exactly the opposite end of the leverage spectrum from the overleveraged mortgage REITs discussed in the first article in this series. And that is sometimes how it works - the two ends of the spectrum sometimes are where the value can be found. A lot of investors will probably disagree but my strong conviction is that MSFT, CSCO, AAPL and GOOG all qualify as value investments at current prices.

Disclosure: I am long MSFT, CSCO, AAPL, GOOG.