ferrari at $23 b

Revenues for the year 2017 stood at Euro 3.4 b increasing 10% annually over the last four years. Over the same period, operating profits increased by 20% to Euro 775 m. Earnings increased by 22% to Euro 535 m; so did earnings per share. Operating margins were 22.68% (2017) compared to 15.59% (2013). Very high return on equity. Average free cash flows to firm were Euro 300 m. Not a bad performance for an auto business having sold only 8,398 cars in 2017. 

Sports V8 were in maximum demand. 

Ferrari sells a fair bit of engines too.

Now, how much should this firm be valued? It is currently priced by the market at $121.99 per share. That is $23 b or say, Euro 20 b in market value for the equity. Compare that to free cash flows to firm, and then consider Euro 1.8 b of debt; and there is cash of Euro 648 m. 

The market price appears a bit pricey. If that was the case, the equity was available for half the current price sometime in 2017 itself (its low price). In 2016, the stock sold at $32 per share when it was low. For someone who bought at that price, the increase in market value was nearly 4 times within a year. There is money to be made in every stock if you are good at market timing. Alas, isn't that difficult? Who knew it would be as low as $32 and as high as $122? Someone said it once, it is very hard to predict, especially the future.

Ferrari is a great franchise. But then every good business isn't a good buy; and at times, even a bad business can be a screaming buy. The game is between value and price; always.

The board is considering a share buyback program.

The number of shares outstanding (189 m) has not changed since 2013; and in February 2018, the Euro 100 m buyback initiative was announced by the company. In 2018, Ferrari bought 190,600 shares at $119.82 per share.

The management obviously considers that price is a bargain compared to its intrinsic worth.

To justify a buyback, two things have to fall in place: Excess cash, and price paid much lower than its value. Only time will tell whether $120 is a bargain. In the mean time, driving new Ferrari down the street is definitely red, faster than wind, passionate as sin.

invest when you have cash?

I hear some of the market experts saying, it is futile to time the market, so invest when you have cash, and sell when you need cash. I find this not only unwarranted, but also an incomplete advice. 

How can someone invest when stocks are priced at unprecedented levels compared to their intrinsic value? Do they mean to say, you have cash now, so buy Tesla? or Nestle? How about Valeant, or Rcom? I can list several stocks; but the point is, unless you have carried out some analysis of the business and its value, you cannot decide on buys or sells. It is fundamental to investing that you compare value with price. It will prove stupid if you go on a buying spree just because you have cash. You will have to wait for too long if you want prices at your levels, is again a remarkably unremarkable thought. It is better if we give these advices a pass.

There is only one occasion, and it is a powerful one, when you have to ignore market prices, and yeah, invest when you have cash. That is when you are investing in the market itself. That is say, S&P-500 index or Nifty-50 index. The index has to be a diversified market index, not a sectoral or thematic one. Three things matter then: Lower expense ratios; Higher liquidity; and lower tracking errors. Once the index is selected, go and invest when you have cash. In fact, invest periodically irrespective of the market prices. You don't have to compare intrinsic values and so forth. Over a long period, you will earn returns close to the market itself, which will not be too bad compared to other alternative investments available to you. This strategy is most suited to those who have no time or interest in analyzing stocks. 

I wouldn't recommend this strategy to any mutual fund investors making periodic contributions (systematic investment plans), especially for the US investors. Mutual fund managers can turn out to be idiots; and handing cash to idiots is as idiotic. In India, I would reluctantly approve since there are some mutual funds who can beat the market. Yet, this isn't my highly recommended strategy. I don't like to give cash to others to manage; therefore, I wouldn't advice other investors either. 

So you have two choices: Invest in the index irrespective of market prices, and carry on with your life; have fun. or 

Learn to play the value-price game, and pick stocks. Here you could have occasions when you have to sit on lots of cash. Invest when you have cash is a bullshit advice for stock pickers. They pick stocks when prices are cheap compared to value, and sell when otherwise. 

tesla, what's with it

Tesla may not be a pure auto company; With battery and solar energy embedded, it is electric cars, solar panels, and energy storage in one company. Does that mean it should be worth $50 b? Sure it was priced similar exactly a year ago.

One year market return isn't there. Yet in the last five years, it has marched forward in a way that has left some wondering, and a few more with aspirations.

How long can it go is in the story that is to unfold. You cannot sell less than 75,000 vehicles and say, you are worth $50 b, like it did in 2017. And you cannot sell about 100,000 vehicles and say, you are worth $50 b again, like it is now.

Of course, value of a firm has not much to do about its past. It is the future cash flows and growth that matter more. And then there are expectations of the rate of return to be earned based upon those cash flows. In present value terms, that is the intrinsic worth of the business underlying the stock. How many are willing to take the pain to assess this without much of a bias?

But for Tesla it is even more challenging: It has never earned operating profits so far; not even when we capitalize its large research and development spends. From 2009 to 2017, Tesla incurred cumulative operating losses of $2 b after adjusting for R&D costs. Positive net earnings have been out of reach so far. It had operating capital of $17 b as of December 2017. What it means is that this $17 b is not making any cash for its business. Consider this as the opportunity cost for the existing shareholders.

It also had $13 b of debt as of December 2017. When a business cannot earn consistent cash flows sufficient to service its debt, it has no business asking more from lenders. Funnily, it did; Tesla raised $1.8 b in August 2017; it had to offer higher yields of 5.30% making it sort of a junk bond offering.  

And now we find that Moody's has downgraded the corporate bond rating to B3, which means that it is speculative with high credit risk. Its junior notes maturing 2025 have been downgraded to Caa1, which means that they are of poor quality with very high credit risk.

Who are we going to blame? There is Tesla as business, there is its charismatic CEO, and then you have the lenders. If you believe in caveat emptor, like I do, your pick has to be the lenders. Look, lending is a serious business; I mean it is a skilled investing decision. You got to be able to receive back with profits what you have lent. 

Here's the summary of Tesla's cash flows for the last three years.

A casual look, and you will find that only positive cash flows are from financing. And here are its contractual obligations leading up to the next five years and later.

How Tesla is planning to come good on these obligations is the focus point of both the shareholders and lenders. Raising more debt? $500 m is not going to be enough, never mind the crazy rationale behind it. 

Tesla needs operating cash flows, and more of them for many years ahead, consistently. In the absence of it, there is no question of raising debt for it simply cannot afford it. It is surprising that both Musk and lenders did not grasp it. If there is some hope about the business as it should be for any entrepreneurship, the only recourse is raising equity. Musk and company might want to resist dilution, but it has become a survival issue now. Dilute the equity, and focus on Model 3 ramp up. 

With so much debt maturing in the coming years and along with other business commitments, it is a tricky math though. It is also a bit tricky to figure out at what price to issue equity, if at all. 

Is there still hope of hitting $700 b in market capitalization for Tesla? Well, only time will tell. In the mean time let's accept that hope is a powerful tool. So let's hope for the best.

mcdonald's drive thru

McDonald's Corporation is worth $125 b. 

At its high stock prices in 2007, it was valued $74 b by the market; and at low prices, $49 b. That means, if you had bought the stock at high prices, the annualized rate of return isn't much to date. Even at low prices, the return is not tempting. But then again, who is good at market timing? If you check the past five years, the story is similar.

This is what happens with an aging business. Consider this: McDonald's revenues in 2007 were $22 b; they were $27 b in 2012; and revenues were $22 b in 2017. There is no growth in revenues for this burgers-and-fries business. 

Reported operating profits were $3.8 b, $8.6 b, and $9.5 b in 2007, 2012, and 2017 respectively. When we adjust for leases and advertising costs, they change to $5 b, $9.5 b, and $10.1 b for the respective years. Adjusted operating margins look much better now (44%) compared to what they were in 2012 (34%), and in 2007 (22%). 

Return on equity also improved significantly. For 2017, return on equity becomes meaningless as the equity turned negative in 2016. This is not alarming because it was due to excessive stock buybacks rather than accumulated losses. McDonald's is profitable and has healthy free cash flows.

Earnings per share were $2.06, $5.45, and $6.54 prior to adjustments for leases and advertising costs. When you capitalize leases and advertising costs, the EPS changes to $2.83, $6.16, and $6.97 for 2007, 2012, and 2017 respectively. While the 10-year annualized increase was in double digits rate, the 5-year increase has been very low. This is despite McDonald's huge stock buybacks over the years. 

It repurchased 237 m shares in the past five years, and 465 m shares in the last 10 years. At the beginning of 2007, it had 1,203 m shares outstanding, which by the end of 2017 were 794 m. It is clear that if stock buybacks weren't carried out, earnings per share would have been lower, and of course, McDonald's would have retained its cash balance.

The future, though, doesn't look very bright for the business. Stephen Easterbrook surely has a task at hand. Where will he have to look?

Even the high growth markets aren't growing.

Free cash flows to firm were $2.6 b, $4.9 b, and $5.1 b for 2007, 2012, and 2017 respectively. Even if we consider $5 b as sustainable free cash flows to firm, we have debt to back out to arrive at equity values. 

McDonald's had $29 b of long term book debt as of 2017. It also has long term leases which make up almost another $10 b of debt in present value terms. That is $39 b of total debt. With cash and other operating assets of $3.5 b, the net debt value is about $36 b. 

To justify market value of $125 b for its equity, McDonald's operating assets will have to be worth about $165 b. With $5 b of FCFF, that implies a multiple of 33 times. And McDonald's isn't a growing business.

But then Tesla has never had free cash flows; it has never had operating profits; and had debt of $13 b as of 2017; yet, it's equity is worth $50 b. While McDonald's is aging, Tesla has survival issues to deal with.

Who are we to argue with the markets? We might as well profit out of their follies.

star india cricket rights

Star India won the rights for cricket for the next five years. And it has paid the price for it; whopping. It must have done the homework alright. But then people are asking whether it can recover its costs. And there are people who say it will be a goldmine for Star India. Who's right?

Let's check the math.

It's a total of Rs.353 b that Star India has contractually committed. That works like debt off its books; nevertheless a debt to be honored. 

Now, Star India needs not only to recover its costs, but also make some money. Contrary to this report which asks for recovery of Rs.65 b every year over the next five years to justify its price, Star actually has to earn more than that. How much more depends upon its opportunity costs. If we assume 15% rate of return, and further assume that both cash outflows and inflows are evenly spread across the next five years, Star has to make Rs.105 b each year. 

It looks like Star India has done its numbers.

I am not too sure how Rs.45 b each year becomes a breakeven point, though.

For 12% rate of return, cash earnings will have to touch Rs.98 b each year; and for 10%, they have to be Rs.93 b annually. Let's say Star India took the commitment for prestige, and expects to make only 7.5% like on the government bonds. Even then, it has to earn Rs.87 b each year to justify that price. Without any return, it has to earn over Rs.70 b each year as opposed to Rs.65 b suggested by this report. 

But then as in cricket, you never know until the last ball is bowled, and it ain't over until the fat lady sings. Heck, it's business after all, not sports. Who cares, let's enjoy the game.