#9 IMS Review

IMS also reported earnings last week. The results were in-line with expectations. IMS noted that business was being impacted by the macro slowdown, as well as f/x drags. Management also acknowledged that large clients were cutting back on spending, the consultants were operating at just 66% utilization and that there are few levers they can pull (besides hoping the economy gets better) to drive performance.

We had previously noted that we enjoyed paying a low p/e (<7.5x presently) on a great operating model (19% ebit mgn), but we also decided to consider other (like book or asset based valuations) metrics. Whereas in COT for example, we compared the value of the equity to the replacement value of the company, it took a little more work with IMS. IMS has a shareholder deficit of $255m; however, this includes share buybacks of 153m shares for $3.5b. Admittedly I need to get a second opinion on this, but I added back the bought back shares in Treasury to the share count, and added back the monies spent on the buybacks to shareholder equity; this would give me an idea of what the balance sheet might look like assuming they did not do a single share repurchase. I then calculated TBV, BV and ROE. This exercise does assume you can magically cancel the sharebuybacks (done at an average share price of $23, which considering the stock trades at $12 wasn't a smart move in hindsight).

IMS reported in line results for the quarter as well. There are no red flags to sell, but on second thought there may not be compelling must-have reasons to own the stock. IMS noted that business was We had previously noted that we enjoyed paying a low p/e (<7.5x presently) on a great operating model (19% ebit mgn), but we also decided to consider other (like book or asset based valuations) metrics. Whereas in COT for example, we compared the value of the equity to the replacement value of the company, it took a little more work with IMS. IMS has a shareholder deficit of $255m; however, this includes share buybacks of 153m shares for $3.5b. Admittedly I need to get a second opinion on this, but I added back the bought back shares in Treasury to the share count, and added back the monies spent on the buybacks to shareholder equity; this would give me an idea of what the balance sheet might look like assuming they did not do a single share repurchase. I then calculated TBV, BV and ROE. This exercise does assume you can magically cancel the sharebuybacks (done at an average share price of $23, which considering the stock trades at $12 wasn't a smart move in hindsight).



If we add back the $ amount of bought back Treasury shares, we get shareholder equity of $3.3b. Likewise, we'd have to adjust for those shares in the share count, which would rise to 334m. This gives us a BVps of $9.94, meaning RX shares trade at 1.3x book. Since IMS Health has grown over the years through acquisitions, we decided to calculate TBV by eliminating the goodwill. This gives us an almost $8 book value and 1.6x P/TBV multiple. Assuming it was fair to do this, we need to figure out whether 1.6x P/TBV is cheap, fair or expensive. (The only other industry I am familiar with where people try to justify P/BV valuations are in insurance, where they justify it based on how good the ROE is. In our case, it would appear the ROE on tangible equity is 12%. I think an insurance analyst would suggest that an ROE of 12% merits only a 1.2x P/BV multiple, 13% merits 1.3x, and so on.) . So I guess the applicable questions are (1) is the book value representative of the value of the business and (2)how much above book value might we be willing to pay?

The hard thing for me to figure out about IMS Health is what the intrinsic value of the business is. On the one hand, there aren't hard assets like factories or land or equipment that can provide us a floor. This business's main assets are the data gathering and analysis they do--their employees do this based on the company's corporate partnerships are relationships. During tough economic times, the fact that a company's main assets are people and relationships is not such a good thing; I would much rather prefer something tangible like a plant. During boom times though (when you hear about things like the war for talent), these people and relationships get valued much higher. I would argue that IP tends to be undervalued during bear cycles and overvalued during booms. We are clearly in a bear period now (debatable as to whether a bull cycle is beginning) so my inclination is to not to fight the macro and put too much value on the IP (intellectual property). This increases my inclination to sell should a better opportunity arise. For the time being though, I am comfortable owning the stock ($12.33 at Fri's close) near where we bought it ($12.50 ish). It does appear cheap on a multiple basis, but it is hard for me to tell whether it is a steal based on asset value.

#8 Earnings: UNH and MSFT

United Healthcare reported earnings 13 cts ahead of consensus ($0.81 vs. $0.68) on Tuesday am. However the company maintained full year EPS guidance of $2.90-$3.15, thereby implying that quarterly eps for each of the remaining three quarters this year would be lower than consensus. This, I think, is why the stock ended the week down 5%. Likewise, Wellpoint, THE largest managed care company (I had earlier written UNH was), also beat earnings this week but guided to lower targets for teh remainder of 2009, and it finished 2.5% lower on the week. Overall, the op mgns of 7.6% weren't the greatest (they've been 100-200bps higher in the past), but it appears there could be room for improvement. Both UNH and WLP suggested that the medical loss ratio (percentage of premium revenue spent on medical care) would rise in the coming quarters as members on high deductible plans work through their deductibles and the costs for the companies begin to rise. Nonetheless, using $3 in 09 eps, the stock continues to trade at just over 7x p/e ratio, well below historical norms (see the graph previously posted). We believe the low multiples are a result of market concerns over healthcare policy and we are comfortable making the bet that (1)profitbaility is stable and may eventually improve and (2) large managed care players like UNH are more part of the solution than part of the problem in addressing the healthcare needs of the United States.

Microsoft also reported in-line numbers this week. The stock reacted positively to cost control initiatives which could help drive profitability in future quarters. The company has a fiscal year end in the June quarter. MSFT's 2009 eps estimate is $1.72, compared to $1.86 in FY08. Consensus for FY10 is $1.84. Assuming flat (ie, 12cts lower than consensus) FY10 eps of $1.72, MSFT presently trades at 12.2x p/e, compared to 14.9x (866/$58) for the S&P500. Considering the proftiability of MSFT's business model (30%+ op mgns) and stable revenue outlook (supported by upcoming releases of Windows 7, Office 10 and other products), we believe it makes sense to continue to own MSFT here. Considering we initiated the position slightly higher than $16/sh and are now up 25% on the position, we do ask ourselves at what point we'd sell. So far our answer is: at a slight discount (14x) to the SPX: 14x p/e on $1.72 (flat eps) = $24.08.

#7 A little more on Cott

Last night PEP announced an offer for two of its bottlers, PBG and PAS. This is a change in direction for the industry as previously separating the relatively asset-lite brands (KO, PEP) from the asset intensive, low ROE bottlers (CCE, PAS, PBG) was thought to be a more efficient capital structure. These separations haven't been without their anxieties for the siblings because of concerns over pricing and marketing strategy between brand and bottler. Now PEP is proposing to bring everything (at least 80% of its distribution) back under one umbrella. My gut says these deals should close although one potential pitfall could be the cross-conditionality of the deals (ie, both must close else neither will) and I am not sure what the reaction of each board will be with respect to price and valuation. This complication could make it take slightly longer to negotiate what is effectively a three-way deal.

It will be interesting to see what KO's take is on this with respect to its own bottling operation. Also, the valuation offered for the bottlers (about 12-15x p/e) should help provide a decent valuation support for DPS (which has already rallied from $12 to $20 since early March (what a miss on my part!)). DPS or Dr Pepper Snapple Group, is the only one of the three main soda companies to have both brands and bottling under one umbrella. This had arguably caused a watering down of its valuation--brands like KO and PEP would trade at 15x+ p/e, bottlers would trade at 10x p/e, and DPS would trade 10-12x despite deserving a valuation between a bottler and a brand. One can argue DPS continues to be cheap here at roughly 12x 09 eps but I am staying on the sidelines as (1) i dont want to chase this after a 75% rally and (2) i am not sure what multiple DPS deserves as the #3 bottler. After all it isnt really a takeover target (at least not by KO or PEP for antitrust reasons) and we've seen lots of consumer/retail related companies struggle even from the #2 position (think home furnishings and home electronics as an example).

All this brings me to Cott. I really am not sure what the impact of this would be. Cott should benefit from the recession as there is a shift to private label. However the KO and PEP brands are so strong that in no way am I betting there will be a massive improvement. So, I wanted to illustrate below why we own Cott: (1) attractive on asset (pp&e) value basis (2) cheaper than peers on ev/ebitda and p/e, and (3) could actually make money this year provided we dont get into a summer price war in sodas. If i had one hope re: this PEP-PAS-PBG deal, it would be that we are less likely to see soda pricing wars, which would be immensely helpful to Cott as it tries to regain its footing.

#6 Recent addition (4/8): TBT

The SPX has had a big runup since the March lows (up 27% by my calculation). It is nice to have made money during that time, but the big runup also makes it hard to find new investments. It is hard to know if we are out of the woods yet. It is encouraging that home sales are starting to improve and that banks feel good enough about contemplating a return of TARP money. On the other hand, I do still worry about the non-security assets on banks' balance sheets (ie the loans) which are probably being marked at generous levels. Quite frankly if there was a way to put on a trade where you were long marked down assets and short assets as yet to be sufficiently marked down, i think that'd be a good trade. Maybe that is a GS or MS vs. the commercial banks.

Anyways i am getting off track. There are two reasons for our purchase of TBT (200% inverse of the 20yr treasury):
(1) There has been a flight to quality in Treasuries, and I think the Fed has been buying too (albeit more of the shorter term bonds); however as sentiment improves, and inflation becomes more of a concern, Treasuries won't be as attractive.
(2) The size of the Obama budget and prospective deficits should make people relatively less optimistic about the US being able to pay its debts in 20yrs. The TARP and other bailout measures are effectively a transfer of toxic assets from the banks to the taxpayer, so why not short the taxpayer.

There are only 2 short ETFs on US bonds. One is PST, short 7-10yr, and the other is TBT, short 20yrs. We shorted the 20yr.

#5 Recent addition (4/1): RX

The other addition we made in the healthcare field is IMS Health. Here is how the investment came about:

I like cheap stocks (i admit there are many metrics but the two i most commonly use are p/e or ev/ebitda and book/replacement value). In the case of p/e ratios, I prefer to own companies with low p/e's but high operating margins. I figure why should I pay up to own a company with low margins? If I can own a company at 8x p/e and it has 30% ebit margins, shouldn't that be preferable to buying a company at a 15 p/e with 20, 30 or even 40% ebit margins? I have decided to call this idea a PEBIT (pee-bit) ratio. It is kind of like PEG (in which you conceptually are willing to pay a higher p/e in exchange for growth), except here you are willing to want to buy the stock that gives you the best operating margin bang for your valuation buck.

I ran a quick screen for US companies with p/e<20,>20% ebit mgn and EV>1000. Three hundred companies fit the bill and the top 1/3 had PEBITs of <0.3. A lot of these were financial names, commodity oriented names, or levered radio/broadcasting companies. However a few stood out (I was happy to see MSFT which we already owned came out on the list at a 0.25 PEBIT--8x p/e and 32%+ ebit margin), one of which was IMS Health. For a frame of reference, less than 1/3 of the companies in the S&P have a PEBIT of <0.5.

IMS is a medical sells market research for otc and prescrpition pharmaceutical products. Basically they sell prescription data. I was familiar with IMS Health from a previous investment project. In 2005 IMS Health had tried to merge with VNU, a Dutch company that also was in the measurement/data business--it owned Nielsen (the Nielsen ratings). The deal was blocked after shareholders of VNU argued they could gain a better return if the company were more efficiently run. It was a big Event driven idea in 05-06 (as arbs tried to reverse the deal and load up on VNU stock. The company was eventually sold to a consortium of private equity investors). During that time i was lucky enough to meet with IMS's management. Although I knew VNU shareholders weren't crazy about the deal with IMS, it was mostly because of their dislike for VNU management more than anything wrong with IMS. In fact i actually thought the IMS management seemed pretty good. I have to admit i didnt follow IMS much after 2006, but when i came across it a few weeks ago, the name did ring a bell. Plus, I figured good data helps companies make better decisions, so there may be something to their business. The stock was trading at $12.50, on eps estimate of $1.70 for 2009, or 7x p/e. I read the most recent earnings transcript for RX and the $1.70 seemed doable. Even more attractive was the company's 12mo trailing operating margin of 20-25%. paying 7x for 20% ebit margins in a business that I hope is not cyclical (like commodities) and should have a good macro trend seemed reasonable.

#4 Recent addition (3/23)-UNH

Two of our last three additions were in the healthcare sector. Before going into a brief description of those names, a few words on our investment philosophy. While we do not aim to achieve particular targets in terms of industry representation (ie, set percentages of the book in healthcare, tech, consumer), we do try to think from a macro perspective what sectors should outperform the market. We like to think of our approach as bottoms-up, but it is almost as necessary to have a good world view. It is foolish to think that one can do such good bottoms up analysis so as to overcome any macro challenges, so a basic tenet for us is that it is easier to make money with tailwinds than in headwinds. The problem with the current environment is that it is hard to know if we are in the midst of tailwinds or headwinds.

I am not a healthcare sector experts by any stretch. I have looked at pharma and biotech names from time to time, but still need to refresh the basics of CMS policy and Medicare Part D every time I start looking at a name. From a macro perspective, it appears that a few things are going on:
-patent cliff expiration for big pharma after 2010 (which is driving M&A)
-general concern that Obama's plans for healthcare (which I am not full aware of) will squeeze profits out of the industry
-general acceptance/expectation that healthcare needs to modernize which is a boon for healthcare IT.

I first started to look for healthcare IT names. One I came across was Athenahealth (ATHN) which provides internet-based services like billing and customer management for physicians. From a macro perspective this seems like a business I would really want to own, but the valuation (over 30x 2010 eps) seemed richer than I was willing to pay at the time. I think there is a good GARP (growth at reasonable price) story here but that requires more work. So, I moved along to low p/e names with decent ebit margins.

The first name I bought was United Healthcare (UNH). It is the largest managed care provider in the US. The sector has been hit hard over concerns about the new Obama administration and its yet unannounced healthcare initiatives. Other metrics worth watching are enrollment figures and operating margins. I admit that I need to do more work on this name (in particular operating leverage and book value) but when we added the position on March 23, the stock was trading at around 7x 2009 earnings. Incidentally, the consensus estimate for UNH appears to be around $3 in 09. Although that is slightly higher than 2008 (in today's environment it is important to do a gut check on whether you think consensus 09 ests make sense compared to what the results were over the past 5 years), I did like the fact that the 2007 eps appeared to be $3.50. Basically I don't think I am buying a business at peak profitability so I think the 7x p/e is a legitimate calculation. I took this 7x multiple and compared it to historical p/e for UNH. Again, it appeared to be closer to the low end rather than high end. (the green line below represents historical p/e). All in all, it seemed I could buy a key healthcare player on relatively conservative earnings at a conservative valuation. If (1) the earnings exceed expectations, (2) the market decides to value these companies at a higher p/e or (3) it turns out companies like UNH are more a part of the solution than a part of the healthcare problems in the US, this investment could make money.

#3 March and April breakdown

As you can see above, we increased our investments significantly in March and April. Cash went down from 48% of our holdings to less than half that amount by mid-April.

BRK/B: Berkshire Hathaway Class B (1/30 class A): I will not profess to be an expert on Berkshire. The majority of the business is an insurance business. There is also a utility (Mid-American), several wholly-owned subsidiaries (such as See's Candies and NFM) and the portfolio of securities (KO, etc). I read Warren Buffet's annual letter and gained comfort from a few things: (1) it didn't seem there were toxic investments in the insurance company's portfolio (unlike its peers) yet the stock had gotten hammered along with the peer group, (2) the underwritten equity puts had a little likelihood of causing damage and even in that case, damage would be manageable. In early March, the company was trading at close to book value, with the A shares were at $72,000 (book value) when I bought B shares at the equivalent $2400. I figure paying book value for a great insurance company with no toxic investments was worthwhile enough, and to have Buffett's expertise on top of that was a nice bonus.

COT- Cott is a Canadian based private label bottler of carbonated soft drinks (csd). I think their 10k says they produce roughly 60% of the csds in the US. I became familiar with the company in 2008 when I researched the Cadbury-Schweppes demerger. At the time there were rumors that Blackstone wanted to buy Dr Pepper Snapple Group (which later IPO'd as DPS) and combine it with Cott. A few things stood out to me. First, DPS spent a few billion dollars building a bottling plant in California (where it was under-distributed). To me, this means that the PP&E at Cott must be worth something. Second, Cott stock got crushed in 08 after Walmart said they wanted to end an exclusive relationship with Cott on private label csds--this would have a direct impact on Cott volumes. However to my surprise, in reading the transcript of the YE call, management indicated that volumes were holding up well and actually clarified that the WMT relationship wasn't dead, but that Cott would just need to compete for business rather than just be guaranteed it. i thought this was somewhat comforting. The recent price collapse of aluminum also was good for COT as it is the primary input cost. The negatives are that the co is still not out of the woods and probably needs to renegotiate with lenders in the next couple of years. I actually tried to buy the COT bonds (at 51) through Fidelity but alas Fidelity did not trade that issue. So my next choice was to buy the equity. Here is the quick math I did (although i lost the piece of paper where I actually did the math): the co has gross PP&E of X. I use the gross and not the net because i am choosing to believe the facilities (10 bottling plants i think) are still worth close to what they were booked at originally. The co has debt of Y (using par for Y, not the 51 level where it was trading). I got something like (X-Y)/shr count = $2.20. The stock was at 65 cents so I started buying. Added some more later around $1. Now at $1.23.

DEI-Douglas Emmett is an office REIT. I must have been crazy to have bought this stock--after all why in the world would you want to buy offices in a recession! Here was my rationale: the entire market was on sale during the first 2 weeks of March. During this time I decided to look up my mental list of "best in class stocks I would like to own but are too pricey for my tastes at the moment" and recalled DEI. I first came across DEI during the EOP (Equity Office Properties) days. Sam Zell was selling his office REIT, and a bidding war ensued among Blackstone and Vornado. Ultimately BX won, but I remembered from researching that situation, that VNO's geographic preference was in LA office property (not Orange County, else it would be interested in MPG); in trying to learn more about the LA office market, i came across DEI, the #1 landlord in LA, specifically West LA. Since then I have always looked at the price an valuation from time to time.

Assuming 3000 apts are worth $300k each (Hawaii, Los Angeles) = $900m. 13.3m sq ft of W LA office at $400 psf (vs Manhattan close to $600)= $5.2bn. Manhattan psf rents are $50/yr, or $600 at an 8% cap rate (cap rates had been as low as 5%, so I am being conservative); using 2/3 of that value in LA I figure might be ballpark. Another way to calculate is W LA rents are about $3.25/month, or $40 per year. Using a cap rate of 8% gives a property value of $4.8b. Assume a Total value is $$5.6-6bn. Less debt of $4.1b (incl minority interest), gives an equity value of $1.5b, divided by 122m shares = $12.25 per share. We began accumulating in the $6 range and last purchase was around $8. Plus most of the debt is recourse to property owned, rather than a claim on the entire company.

MSFT-bought around $16, then trading at a sub 10x p/e and ~6x ev/ebitda. This compares to the SPX trading at around 680 (during early March), assuming SPX eps of $60, or an 11 p/e. We liked the prospect of owning MSFT better than buying SPX--after all it has a 30%+ EBIT mgn.

Last 3 additions were UNH, RX and TBT. More on those another time.

#2 Position breakdown, Jan and Feb

I am going to discuss Jan and Feb first because (A) the inflection point in the market occurred in March and (B) I cannot figure out how to fit Jan-Apr charts together so I have to do two months at a time.

The most notable aspect to Jan-Feb is the vast out performance over the SPX (almost 20%%). We were able to preserve capital during January and February primarily due to the fact that (1) we were 48% cash, and (2) some longs, such as SBB (short S&P600) and DNA were able to offset losses in GENZ. The remainder of our positions were flat over this time frame, resulting in a net 1% gain through Feb 27.

To give a little more color:
OGZPY (Gazprom) was a position we had held for some time (over 2 years I think). The basic bull thesis is that the company is a monopolistic gas supplier to Europe, which gets 40%+ of its nat gas needs from Russia. The downside is that most of the Gazprom sales within the former USSR are at below market rates and unprofitable (a point of consternation over recent winters as the Russians have threatened to shutdown gas pipelines during the cold winter months). We were lucky to have sold 40% of our position during the energy peak in mid-08 at substantial profit. In 2H08-Feb 09, the price of OGZPY declined substantially owing to the fall in nat gas prices (caused by the global recession) and the collapse of the Russian ruble. We probably could have sold earlier had we not been complacent and distracted in our investment approach at YE08 when I lost my job. However, we decided to sell the rest in early March as we decided to refocus our efforts and to run our PA with a more professional approach rather than one consisting of whimsical trades. The decision to sell was not based on a particular bull/bear view of OGZPY but rather a reflection of trying to build a new PA with well thought out ideas supported by the type of valuation work I had done as a buyside analyst.

GLD (gold etf)-we put this position on in late 2008 as the markets melted down. At the time, equities provided little safehaven or comfort, and I thought the injection of money by the Fed and the US government would have inflatrionary effects. The trade worked well Nov through December and was flat afterwards through February. At the beginning of March, I thought the trade had become crowded, and I thought the macro environment had stabilized enough to the point where equities had more limited downside (owing to their 20% drops since Jan 1). Additionally, the recession appeared deep enough to make me worry about deflation rather than inflation so GLD was not as attractive. Overall I think GLD is a good investment when you fear infation and when you are afraid in general (too afraid to put on stock trades); by late Feb I thought these conditions were about to reverse.

DNA- was bought by Roche for $95. We sold the stock in March before the tender was announced. Had I not sold this position, I estimate performance would be better by 3%! What a miss! Still I have no regrets. This position was an event-driven position and I made a conscious decision that although I liked the deal as an arb, I did not want to trade too many arb-like positions in our PA as there were better risk/rewards out there. Despite missing out on DNA, we have still managed to significantly outperform the S&P thus far.

SBB- short S&P 600. Speaks for itself. Reflects bearish view we had at the beginning of the year. Sold this position at the beginning of March, a few days before the big meltdown. Still I don't regret the early timing as we raised cash and promptly used it to buy stocks during early-mid March.

TRV- legacy holding (10 shares) from the Citi-spin years ago. Because i am too lazy to figure out my basis (for tax purposes) I am just holding onto it until I do.

GENZ-sold in March. Owned for 2+ years probably and ended up being flat on the trade. At times we were up significantly, at other times down notably. I liked the protected nature of their business (many drugs have orphan drug status). I first became familiar with GENZ when I owned Shire in 2006 (a good trade for us). I had become familiar with Shire because I did extensive work on TKTX (Transkaryotic) which Shire bought in 2005 (an arb deal I participated in at work). I frankly just became frustrated with the stock and sold it to move on to something else.

#1 YTD performance of our PA

Welcome to the blog of our PA (personal account). I decided to keep this diary to help track the performance of my investment decisions. I have indexed the returns to a benchmark of 100 beginning Jan 1. Above is the ytd (year-to-date) performance. Note that the performance figures are based off of a 0/20 fee structure. The next post will have more detail on the portfolio of the breakdown.