Enron (ENE 9)
The management of a large corporation is a special
responsibility. It confers a fiduciary
duty to preserve jobs for employees, grow the wealth of shareholders, and drive
the growth of the national, if not world, economy. The potential of a corporation to outlive all its constituencies
makes top management a sacred trust.
Part of the reason for investing in major
corporations with long track records is that the probability of a management
failing in these responsibilities is smaller.
Enron, with a 20-year track record exceeding 15% average annual
compounded growth, has failed dismally.
In the first week of November, Enron admitted to filing fraudulent
financial statements over the past five years, overstating earnings by at least
half a billion dollars over that time period.
As we are painfully aware, this has destroyed the price of the stock and
led to the sale of the company to a smaller competitor, Dynegy.
Stories in various news publications preceded
Enron's admission. I failed to protect
us from losing money through a combination of stubbornness and excessive
loyalty. There are numerous examples of
distortions that start with an article in a major Wall Street newspaper and,
after being repeated on television all day, end up being accepted as fact. In the late 1990's, persistent mistruths
regarding QUALCOMM and CDMA depressed the stock price. The opportunity created to buy the stock
cheaply made many of us a fortune, as my untiring investigation of news article
claims proved them false. Enron was
different. The stories turned out to be
true, despite denial by the company. There
is a gray area between fortitude and stubbornness that I will be fine-tuning
for our future common benefit.
Fortunately, my valuation discipline protected us
from paying $80-90 for Enron when Wall Street’s enthusiastic consensus
peaked. Although we are wounded, our
basis in Enron is not a large enough percentage of account balances to do
serious damage. In fact, I expect to
get the money back in the form of Dynegy, which has agreed to offer an exchange
of its stock for Enron stock.
Dynegy is getting a phenomenal deal, and that is
already reflected in its share price.
Enron shareholders get 0.2685 shares of Dynegy stock in exchange for
each share of Enron. Although the
probability of closure of the acquisition is not 100%, it is high enough that
Enron shareholders might as well consider themselves Dynegy shareholders. Enron’s stock price will perform in line
with Dynegy’s, with a modest spread reflecting the estimated time and risk of
closure of the acquisition.
This acquisition should lead to exceptional
performance in Dynegy’s stock, and that will be positive for Enron
shareholders. In fact, Dynegy predicts earnings per share in 2002 should rise
35% due the acquisition alone. To put
this into perspective, most acquisitions cause dilution of earnings per
share. And, Dynegy was growing at a
rate of 20% annually before Enron came along.
Dynegy, trading at 43, has a 12.5 P/E on its $3.40 to $3.50 projection
of 2002 earnings on the combined companies.
Indeed, Dynegy emerges as a powerhouse energy
company from this acquisition, and I am evaluating it as a core holding.
QUALCOMM (QCOM 60)
"The largest profits in business accrue to the
company that supplies the key missing element that completes a commercial
system and ignites a new spiral of advance." Peter Drucker.
QUALCOMM may be the fastest growing major
telecommunications company in 2002, even though it reduced guidance for handset
sales, revenues, and earnings at a recent analysts’ meeting. Revenues are projected to grow between 15%
and 25%, based on the build-out of new CDMA networks in China and India and the
upgrading of CDMAOne networks to CDMA2000 throughout most of the world, other
than Europe. European wireless phone
companies such as Deutsche Telekom (DT) and British Telephone (BT) are going to
wait another year to see if promises from their traditional infrastructure
suppliers, such as Nokia and Ericsson, regarding GSM upgrades to GPRS, EDGE,
and WCDMA continue to be broken. So
far, GPRS is hindered by a lack of reliable handsets and a failure to scale
above glacially slow data rates.
Interestingly, GPRS is reportedly failing to carry on the major roaming
success of predecessor GSM networks.
In the WCDMA world, NTT DoCoMo’s network is not
supporting commercial numbers of customers.
This is both good and bad news for QUALCOMM. Bad, in that a royalty paying customer could be doing better and
paying more royalties. Good, in that
QUALCOMM’s competing CDMA2000 technology continues to prove superior.
Meanwhile, the world’s first CDMA2000 network in
Korea has 1.9 million users, and is growing rapidly. I do not believe the claims that the proliferation of 3G will be
driven by the emergence of a “killer app”.
Rather, growth will be driven by efficiency. There is just no way a wireless service provider whose GSM/GPRS
infrastructure supports 48 customer circuits per base station will compete with
a CDMA2000 infrastructure supporting 396 customer circuits per base station.
However, Korea is evidence that a “killer feature”
may be evolving. CDMA2000 phones have
become synonymous with “color phones” there, and phones with color displays
compose 70% of sales despite price tags two to three times that of black and
white phones. In fact, color phone
sales in Korea are exceeding the supply of color display parts, putting a
temporary constraint on sales. The
color displays are somewhat easier to read, like color TV versus black and
white, and I can hardly wait to buy one myself. Since color phones cost more and use more expensive QUALCOMM
chipsets, they generate more revenues for QUALCOMM, giving some upside surprise
potential to company revenue and earnings guidance.
The global roaming ”holy grail,” long promoted by
the GSM cabal will finally become a reality next year. Multimode chipsets, only available from
QUALCOMM, will enable a single handset to operate in GSM, CDMAOne, and
CDMA2000, transparently to the user.
In fiscal 2001, QUALCOMM generated $1.2 billion of
cash flow from operations. A portion of
this cash flow is invested in developing CDMA systems around the world. Two recent investments are quite
interesting. Vesper is a fixed wireless
carrier QUALCOMM is rescuing in Brazil, with the agreement that its license
will be expanded to limited mobility wireless and eventually to full
mobility. For a total investment of
about $500 million, QUALCOMM will own 86% of an existing system of 1000 CDMA
base stations covering 120 million “pops” (potential customers) over 70% of
Brazil. That works out to about $5 per
pop. I think this is an exceptional
bargain. In comparison, the stock
market values AT&T Wireless at $140 per pop and Sprint PCS at $110 per
pop. Although these systems deserve
higher values, because they are the leading US carriers, they make $5 per pop
look very cheap.
QUALCOMM is backing start-up Inquam’s build-out of
Europe’s first CDMA2000 network.
Starting with a mere foothold, Inquam will cover Romania with
exceptionally efficient CDMA2000 on exceptionally efficient 450MHz
spectrum. I am sure the DT’s and BT’s
of the world will be watching, just as I hear they are watching the success of
CDMA2000 in Korea. It will not go
unnoticed that CDMA subscribers in Korea will be watching the World Cup on
their cell phones, in real-time, and in color.
I believe QUALCOMM’s ignition of Peter Drucker’s “spiral
of advance” of wireless access devices will eventually propel a return of
the stock price to the levels we enjoyed before the NASDAQ sell off.
Pixar (PIXR
36)
Pixar continues to grow its franchise of being the
only source of animated feature films for the family audience. Pixar works long and hard to create
heart-warming stories that people of all ages can enjoy at different levels. Monsters, Inc., with over $100 million in
revenues over its first two weeks in the theatres, continues the string of
Pixar successes. The goodness of this
movie is especially therapeutic in periods of history that are highlighted by
man’s propensity to act in cruel and evil ways.
Pixar is striving to reach the critical mass
necessary to produce one feature film per year at its uncompromising standard
of quality. That is very important to
the sustainability of growth of the stock price. The company’s stock performance history is punctuated by strength
preceding the release of each picture followed by a decline due to the
anticipation of another long wait until the next release.
This tends to give the stock an aura of existing in
its own little world. The peaceful
escape attained while watching one of Pixar’s movies is reflected in the stock,
which is much more influenced by the movie release schedule than by the trend
of the stock market. Pixar's stock was
only briefly affected by the September 11 events, with the release schedule
soon regaining dominance over the stock price.
Pixar is building a movie library. First, a movie earns revenues from its US
release. Next come foreign release
revenues. About a year after initial
release, the movie is released for DVD and videotape sales, then Pay TV, then
pay-per-view, then regular TV showings.
And, don’t forget merchandise sales.
So, if Pixar can produce a feature each year, it will build up a very
nice earnings annuity.
It would feel rather nice to own a company that has
a stock that is sort of in its own world.
The eventual sustainability of growth, coupled with the unique long-term
franchise this principled company is building, places it on my targeted buy
list. Now, the stock just has to trade
at the right price someday so we can buy it.
I estimate the per share intrinsic value of Pixar in
the mid-20's, and consider the stock attractive at that price level.
Steven
L. Ré, CFA November
14, 2001
The above is for information purposes only and is
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reliable but is not guaranteed. It
should not be assumed that investments in any of the above-mentioned securities
will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets
don’t always go up. The employees and
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