In fact, Microsoft’s balance sheet has over $22.7 billion in short-term investments listed in the most recent 10-Q. For the most part, those short-term investments are the equivalent of cash since they are primarily invested in fixed income securities that are investment grade and easily sold for cash. Taking these short-term investments into consideration, I really should have determined that net cash for Microsoft is currently $31.8 billion.

Using $31.8 billion in cash instead of $9.1 billion, my intrinsic value estimate rises to $27.39 per share versus my initial estimate of $25.  I knew something was amiss with my original estimate, but I did not see the omission until I received the comment about net cash.

Receiving comments on one’s investment analysis is one of the great benefits of posting research online for other to review and provide comment. I’m amazed at how often I receive insightful comments on my posts. Just look at the great discussion occurring on my original Microsoft Price Watch post. This is also one of the reason why I have shared my Fat Pitch Finder Spreadsheet here. 

Speaking of the Fat Pitch Finder spreadsheet, I need to update it now to better address short-term investments in determining net cash. Expect an update on this spreadsheet here at Fat Pitch Financials within the next few days.

Full Disclosure: I own shares of Microsoft

I originally determined that MSFT had an intrinsic value of at least $30. I provided my calculations along with those shared by some of my readers in a previous post about Microsoft’s value. Today, I decided to run another discounted free cash flow model to determine if I need to update my intrinsic value estimate.

I once again ran a linear regression on the past 10 years of Microsoft’s free cash flows but this time it included 2006 numbers as well as the trailing twelve month free cash flows.  Then I projected out the next ten years of free cash flows. The results are shown in the chart to the right.

I then discounted those future free cash flows using a 10% discount rate. After the tenth year, I assumed a 3% stable growth rate.  That resulted in a present value of the enterprise of $242.3 billion.  To determine the market capitalization, I added in $9 billion in cash.  Then I divided by the diluted average number of shares outstanding and determined an intrinsic value estimate of $25. Uh oh, this is significantly lower than my previous estimate of over $30.  What is going on here?

There are couple of things I noticed.  First, if you look at the graph above, the most recent year’s free cash flows and the trailing 12-month cash flows are below the trend line.  If you were to mentally draw a line, it would likely have been above this one and a bit steeper (i.e., higher growth rate). From the R-squared in the graph, you can see that only 59% of the variation in free cash flow growth is explained by the trend line.  I prefer to see at least an R-squared of 0.75 before I am comfortable with the model’s results.

I checked in with the analyst estimates for MSFT, and they forecast next years earnings to grow by 16.6% and to average 12% over the next five years.  The linear regression I ran only grows at 5% over the next five years.

I also noted that Microsoft’s business is at a major inflection point. The company has just launched several major product upgrades including Vista, Office 2007, and XBox 360. They have also launched an upgraded online presence called live.com and their own portable music and video device, Zune.  Each of these products and service have the potential to deliver significant long-term earnings.

If I substitute a 12% growth rate (a less conservative estimate) instead of using my linear regression estimate of future growth, I calculate an intrinsic value of $36.  I am not as confident in this estimate, but it is useful to create and upper bound on my estimate of Microsoft’s intrinsic value.

Given my uncertainty regarding Microsoft’s intrinsic value, I am going to stick my original estimate of at least $30 per share.  With the market’s rich valuation currently and the potential for a serious correction building, I am going to implement a stop at $30 for Microsoft. If shares drop back down to $30 or lower, especially on bad performance news, I will likely sell my shares of Microsoft. I will be closely watching Microsoft at this point and I will be updating my intrinsic value estimates as new information becomes available.

Full Disclosure: I own shares of Microsoft.

What do you think of UFI a textile company selling at approximately 0.36 times book.  Current price is $2.55 wit 0.69 in cash.  Assets are mostly tangible with recent divestment selling for more than 70% of cost.  Mgmt is trying to unlock value.

I took a few moments today to look into Timm’s question regarding Unifi Inc. (UFI). The first thing that caught my attention was the fact that Timm mentioned that UFI is a textile company.

A textile company to me signals that this is likely to be a commodity producer. Commodity companies tend not to have economic moats and end up facing heavy competition. The only way a commodity producer can build a moat is to become the low cost producer. Without a moat or a special situation opportunity, a fat pitch investor should wait until a better “pitch” comes by since there are no strikes called in investing.

Unifi Inc is a producer of yarns. It sells its products to other yarn manufacturers, knitters and weavers. The company has tried to brand its premium products but none of the name were recognizable to me (however, I don’t use yarn).

In its 10-K, Unifi mentions that it uses advanced production processes to manufacture its high-quality yarns cost-effectively. Even given that, if I’m not mistaken, many foreign companies in the textile industries often receive support from their governments in order for them to remain competitive enough to continue to provide jobs. As I continued to read the 10-K, Unifi confirmed my suspicions that they are facing intense competition when they stated, “The North American synthetic yarn market has contracted since 1999, primarily as a result of intense foreign competition in finished goods on the basis of price.”

Let’s take a look at Unifi’s financial numbers to further see what is going on with this company.  Sales have gone down from $1.1 billion in 2001 to 739 million in 2006.  Net income has been negative over this whole period.  Gross profit margins were less than 6 percent last year. None of these numbers look good.

It is interesting to note that the company has been free cash flow positive over the past five years, but free cash flows have also been declining.  It looks like the only reason that Unifi has been free cash flow positive is that they have been spending much less in capital expenditures than they are depreciating.  This might mean that their equipment is getting old. There might be a need for major capital expenditures to replace plants and equipment in the next few years.

The company only has a market cap of $137 million but it has long term debt of over $200 million. Even if the company has lots of valuable assets that could be sold off, if it takes too long to realize the value of those assets and its business continues to deteriorate, the debt holders could end up owning those assets. (Hmm… maybe this company’s debt is worth looking into.)

Without going any further into this company, this stock looks like a “cigar butt”.  Just like Buffett, I tend to shy away from cigar butt opportunities.  Benjamin Graham was a big fan of cigar butts, but Buffett moved away from these type of stocks after working with them for several years early in his career when he worked for Graham. As Buffett learned, there are often much better opportunities in excellent businesses and short term special situations.

While I wouldn’t short Unifi’s stock, I am definitely not interested in researching this company any further.

In terms of what the analysts had to say, I found it interesting that the analysts’ value targets ranged from $30 to $33. I reported back in early May that I estimated that the intrinsic value of Microsoft’s stock was about $31.  I took some heat for that estimate but it doesn’t look like I’m too far off from the professional analysts for whatever that’s worth.  Rick Sherlund of Goldman Sachs came in at the lower end with a target of $30 and the UBS analyst, Heather Bellini’s target came in at the high end of the range.

Brendan Barnicle of Pacific Crest Securities noted it looked like work on Office was going better than Windows Vista. I did not realize that another version of Office was already in the works. If it does a good job in facilitating online collaboration, I think a new version of Office could help add to revenue growth.

There is a lot of change underway at this giant wide moat tech company. I think if they can turn this ship in the right direction, there will be a lot of value generated by this stock.

[Full Disclosure: I own shares of Microsoft (MSFT).]

However, I think Robert Peck of Bear Stearns is jumping the gun here.  I ran a quick and dirty discounted cash flow model using the past five years of free cash flows and I project out the next five years of free cash flows using a linear regression.  After discounting everything using a 10% discount rate, I came up with an intrinsic value of $28.75 per share for eBay (EBAY).  I believe eBay would need to drop down to at least $21.50 before I would get excited about it.  Ebay shares closed yesterday at $24.66 a share.

Peck mentioned a few positive trends for eBay, including partnering with Yahoo (YHOO) for advertising revenue.  Too bad he didn’t mention that the Yahoo advertising system upgrade has been delayed.  The also did not mention the waste of money on the acquisition of Skype.  I also don’t think eBay Express is going to really help increase shopper demand.  What Ebay really needs is a complete overhaul of their online customer interface.  The website is getting way to complicated and cluttered.

Ebay is definitely worth watching, but I think a cheaper price is needed before I take any action.

I discussed some of my valuation rationale for the Microsoft purchase decision in the comments section of my previous post. Let me republish it here:

I took a linear regression (i.e., a fancy way of drawing a line on a graph) of the past 10 years of Microsoft’s free cash flow. I then used that regression to project the next 11 years of free cash flow. The regression was able to explain 90 percent of the past trend in the data. I then took the present value of the first 10 years into the future and the discounted perpetual value of the 11th years estimated free cash flow estimated to maintain a sustainable growth of 3%. I selected a 10 percent discount rate for the calculations. I then added in cash to get the intrinsic enterprise value of Microsoft and then I divided by the diluted average number of shares. My final result was $31 dollars per share.

From Magic Formula Investing I found that Microsoft Corp (MSFT), Market Cap of $248,365.25 ($ Millions), pre tax earnings yield of 8% and a pre tax return on capital of greater than 100%. Microsoft was in the top 100 MFI stocks with over $1 billion market cap.

Steven of ValueBlogReview is apparently thinking along a similar line. In his comments regarding “More Microsoft”, Steven wrote:

Even assuming growth of 10-11% (which I would give a50-50 chance) you get to just about a 45% MOS with the stock at $24.50.

Another reader, Max, came to a similar finding in regards to valuation. He wrote:

Microsoft as a huge moat, but not too much growth, so I’m going to put it at 20x EBIT, which for a DCF calculation means I am assuming a 10% RROR and 5% growth in perpetuity.

Enterprise Value = 20 * 14B = $280B
$280B + $34B (cash) = $314B
$314B / 10.33B outstanding = $30.4 / share

I agree that at minimum MSFT is worth what it’s selling for today, as no matter what calculations I do the lowest # I come up with is around today’s price. So, that’s some downside protection, plus MSFT’s current moat on operating systems keeps that cash coming in.

Sam Adams had a different opinion. Sam commented:

What you have here is an investment with all themarket risk and a very limited reward. You might make some money here, you might lose some.

If you want low risk, buy a CD.

If you want to invest , find something with some mojo

Jim Chan from Collecting Wealth thinks I jumped the gun on purchasing Microsoft. He writes:

While I don’t think MSFT is a bad investment opportunity (not a particularly exciting one for me, even at this level), I think you might have jumped in a little early. Purely technical (read, short term) prospect calls for a further decline. At the very least, you probably should’ve waited till the volume has subsided. Back to the “not so exciting” part, before the slide, my calculation (there seems to be quite a few Buffett followers read your blog) showed it was trading at fair value. So the drop represents the discount that (30%) you can Steve and other have discussed. To me, that margin is still too shallow.

Looking in the rear-view mirror, I think Jim Chan makes a valid point. I don’t normally look at the technicals when buying a position in a stock. However, since reading Phil Town’s Rule #1, I’ve been considering using technical analysis in a very limited way to enter and exit positions. Maybe I should review Phil Town’s “tools” and see how they could have helped me in deciding when to buy Microsoft.

Finally, Chris from InvestorGeeks agrees with my valuation but writes:

My sticker is about $31, which gives me a MOS of 30%, however, given that the stock has traded between $24 and $29 for the last 3 years, I’m thinking the market knows something I don’t, which furthur hurts my MOS.
If you have the time to do the research, I think this is too risky for the potential reward.

In response to Chris’ comment, I don’t think that Mr. Market knows something that we don’t know about Microsoft. I just believe Mr. Market is sort sighted and gets easily depressed when major product release dates are missed. I agree with Mr. Market that Microsoft is going to have tough year, but I believe in the long run they are setting themselves up for some major improvements in the long-term.

I’m sure there are other opinions on whether Microsoft is currently a buy. Please feel free to share your thoughts and analysis either back on the original thread or down below.

I took advantage of the opportunity. I put in a limit order earlier this morning for $24.25 a share in one of my accounts and with Marketocracy. I received the following confirmation from Marketocracy:

Your ticket to buy 4120 shares of MSFT at $24.2500, created at 13:27 May 01 completed at 15:45 May 01. 4120 shares were bought at a net average price of $24.2994 including commissions and fees.

I reran my intrinsic value spreadsheet for Microsoft this morning, and I still get at least $30 per share in value. Given that finding, I decided to pull the trigger and add to my Microsoft position. I don’t normally buy a stock a second time, but I just couldn’t pass up buying some more of the widest moat stock at a discount.

A proxy statement details the corporate governance issues that are going to be discussed at a company’s annual meeting. This includes information about when and where an annual meeting is going to be held. It also lists the issues to be voted upon at the annual meeting and details what those issues are. Those issues may include:

• Capital structure
• Management compensation
• Insider ownership
• Election of the board of directors
• Conflicts of interest
• Takeover defenses
• Corporate structure

Given all these issues, proxy statements are often very long and complicated. Until I ran across an article on AAII by John Deysher entitled, “The Proxy Edge: Exercising Your Shareholder Rights “, I did not have a good systematic way to review the proxy statements that I received and those of companies I was interested in investing. I now use the shareholder scorecard at the end of that article as a framework to focusing my research efforts when reviewing a proxy. To better explain how I review a proxy, I’m going to walk you through one of my recent reviews.

Microsoft Case Study
If you are a frequent visitor to Fat Pitch Financials, you probably know that I recently purchased shares of Microsoft. As part of my decision to make that purchase, I reviewed the recent Microsoft proxy statement.

Finding the Proxy
The first step I took was to find the most recent proxy statement for Microsoft. I called on my good buddy EDGAR and I clicked on Search for Company Filings and then Companies & Other Filers. On the Companies & Other Filers page I filled in “Microsoft” in the company name box and I clicked the exclude button under “Ownership Forms 3, 4, and 5″. After clicking the Find Companies button, I scanned down the results page for form DEF 14A, which is the definitive proxy. Filings are listed in order by date with the most recent filings listed first. If I want to look at older proxies for previous years, I just continue reading down the list.

Sometime there are also amendments added to the proxy, and they are reported as from DEFA14A. You can see an example of an addition in the Microsoft filings list. It is worth the effort to quickly click on these additional proxy material filings to make sure nothing important is hiding in these additional documents. The recent Microsoft DEFA14A is just an email sent to Microsoft employees encouraging them to vote in the their proxy.

To view a form, click on the “[html]” link next to the form you are interested in viewing. When I clicked on the DEF 14A “[html]” link I get a long list of links. The important link is “1 DEF 14A ddef14a.htm“. The other links are just supporting graphics.

Annual Meeting Information
Information about Microsoft’s annual meeting is listed just below the regulatory filing information. It states:

The Annual Meeting of Shareholders of Microsoft Corporation will be held at the
MEYDENBAUER CENTER
11100 NE 6th Street
Bellevue, Washington
on November 9, 2005, at 8:00 A.M.

Voting instructions follow this information. I also noticed that Microsoft is providing live coverage of the annual meeting on their site and a transcript along with video and audio of the entire annual meeting. That type accessibility is very shareholder friendly and a plus in my book worth 2 points.

Capital Structure
Microsoft has one class of stock that has gives owners 1 vote for 1 share, so I give Microsoft a score of 10 points. The questions to ask about Microsoft’s capital structure include:

• Is there a non-transferable super-voting common class of stock? No.
• Is there a widely held class of stock that gets 0 votes? No.
• Are there any additional classes of shares owned by insiders only? No.
• Is there non-cumulative voting of directors? No. I believe you can cast your all your votes for one or two directors, but it’s not clear to me.

Management Salary Compensation
Salary information is listed in the “Summary Compensation Table” on page 5 of the proxy. Given the massive profits of Microsoft, I am impressed that none of the salaries of top management exceeds $1 million. Bill Gates and Steve Ballmer both earned $600,000 in base salary for 2005. Microsoft definitely deserves a score of 10 points in this category. The questions to ask about Microsoft’s managment salary compensation include:

• Is there minimal disclosure in the proxy statement of how salaries are determined? No. On page 7 the “Compensation Philosophy and Practice” and “Components of Executive Compensation” discuss the basis of how salaries are determined.
• Are salaries higher than for executives running similar-sized companies in similar industries? No. A good source for quick executive salary information can be found at the AFL-CIO’s Executive Paywatch. It is pretty common to find technology executives making more than $1 million in base salary in much small and less profitable companies.
• Are past increases in salary not in line with company performance? No. Salaries appear to have only increased moderately over the past three years.

Compensation: Bonuses & Cash Incentives
Ideally, a company would base its incentives on the companies return on assets or return on capital. If Microsoft had such an incentive system, I would give them a score of 10 in this category. However, Microsoft’s compensation incentives have some flaws. The questions to ask about Microsoft’s compensation incentives include:

• Are vesting periods short (less than three years)? No. The stock award and options seem to vest over five years according to the footnotes in the “SUMMARY COMPENSATION TABLE ” on page 5 and 6. In 2005, no stock options were granted to any of the executive officers. I believe Microsoft is phasing out the use of stock options.
• Are incentives based on non-return measures like earnings per share, sales levels or stock price? Yes. According to page 7 of the proxy, “The performance-based commitments used to determine bonuses will vary for each executive based on his/her responsibilities and may include financial or strategic measures, including but not limited to: revenue, contribution margin, innovation, product development and implementation, quality, customer satisfaction, or developer community satisfaction.” I’m subtracting 2 points for this vague set of measures that includes sales.
• Does the proxy lack a disclosure of how bonuses are determined? No. Page 7 and 8 give some information on how bonuses are determined. I would like to have seen more detail on exactly what metrics are used, however.
• Are there any Golden Parachute agreements? No. I did not spot any in this proxy.

Microsoft gets a total of 8 points for compensation incentives.

Compensation: Stock Options/Restricted Stock
If a company does not have a stock option or restricted stock incentive plans, I give them 10 points for this category. However, Microsoft does have a restricted stock incentive plan, so I ask the following questions:

• Are the restricted stock issued in modest quantities? Yes. However, given Microsoft’s shift from stock options to restricted stock it is a bit difficult to analyze this. Plus 2 points.
• Does the company treat option exercise as a compensation expense? Yes. Microsoft has started expensing all stock-based compensation. (I didn’t spot this in the proxy, but I found it doing a quick Internet search.) Plus two points.
• Is the option/restricted stock strike price at or above the stock’s price at the time of grant? Yes. The value is based on the closing price on the date of grant according to a footnote on the “SUMMARY COMPENSATION TABLE “. Plus two points.
• Is the vesting period greater than three years? Yes. The vesting period is over five years according to a footnote on the “SUMMARY COMPENSATION TABLE “. Plus two points.
• Are the restricted shares “funded” with shares repurchased on the open market? Not clear. I do not believe Microsoft’s proxy addresses this issue.

Given the above, I give Microsoft 8 points in this category.

Insider Ownership of Shares Outstanding
According to the table titled, “INFORMATION REGARDING BENEFICIAL OWNERSHIP OF PRINCIPAL SHAREHOLDERS, DIRECTORS, AND MANAGEMENT” on page 5, executive officers and directors own 13.79% of the outstanding shares of Microsoft. That gives Microsoft a score of 4 point out of 10 in this category. To earn ten points, insiders need to own more than 40% of outstanding shares.

Board Composition & Board Committees
I ask the following five questions regarding the Board:

• Are at least 2/3 of the board outside directors? Yes. Only Gates, Ballmer and Jon Shirley are obvious insiders. Plus 2 points.
• Is each outsider truly an outsider? Yes. According to what I read in the proxy I believe so. If I was concerned about the number of insiders, I would research each Board member more thoroughly. Plus 2 points.
• Is the Chairman of the board an outside director with no ties to management? No. Bill Gates is the Chairman.
• Are any insiders on the audit, compensation, governance, or nominating committees? No. I checked the table on page 2 of the proxy to answer this question. Plus 2 points.
• Are votes/seats held by insiders commensurate with shareholdings? No. Insiders hold three seats or 30% of the seats. Insiders only own a bit more than 13% of shares.

Microsoft gets a total score of 6 points for this category.

Conflicts of Interest & Related-Party Transactions
Page 9 of Microsoft’s proxy lists any potential conflicts of interest and related-party transactions in the section titled, “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS “. I asked the following questions regarding conflicts of interest:

• Does the company occupy a building leased from management or an affiliate? No.
• Does the company engage in business with another company owned or controlled by management? Yes. Microsoft does business with Corbis Corporation, which is solely owned by Bill Gates.
• Did the company buy real estate or businesses from management or affiliates? No.
• Did the company make loans to management on generous terms? No.
• Does management receive excessive perks? No.

I give Microsoft a score of 8 in this category.

Takeover Defenses
I do not belive Microsoft has engaged in any takeover defenses, so I give them a full score of 10. Some takeover defenses include, staggered board of directors, poison pills, restrictions to call special meetings, ability to issue unlimited preferred stock, and super-majority voting requirements.

Governance Statement
Microsoft details much of their corporate governance in their proxy and they also provide a link to a more comprehensive governance guidelines. I give Microsoft a full score of 10 in this category.

Re-Incorporation Strategies
Microsoft has no re-incorporation strategies, so I give it a full 10 points for this issue.

Conclusions

Microsoft appears to have fairly good corporate governance, which is shareholder friendly now. If I did the math right, Microsoft gets an 86 in my review.

There are a lot of details buried in these filings. If you would like to get a sampling of what can be unearthed, I recommend visiting Footnoted.org. Michelle Leder is a pro at reviewing these documents and she reports on her interesting findings daily on her site.

Like everything, it takes a bit of practice to review proxy statements efficiently and thoroughly. Start by going through all the current proxies of the companies you own. Hopefully, you won’t find anything too shocking and new to you in your search. If you do, it might save you some heartburn in the future. After you go through a few of these proxies, you will get a lot more efficient at it and you will be prepared to start reviewing proxies of companies that you are potentially interested in investing in the future.

There are not many companies out there that have been accused of being a monopoly the way Microsoft has. Microsoft had created such a deep broad moat around its core operating system, Windows, and its Office software suite that it actually resulted in a dangerous legal liability. I remember at one point there was talk that Microsoft might need to be broken up like AT&T.

During Microsoft’s antitrust litigation, an interesting email from Warren Buffett to Jeff Raikes of Microsoft was revealed. Shai Dardashti just uncovered a copy of this email message on CNET’s servers. This email message written by Buffett in 1997 provides an amazing peak into Buffett’s thought process in this candid and unguarded message. Here is what Buffett wrote about Microsoft:

“In effect the company has a royalty on a communication stream that can do nothing but grow. It’s as if you were getting paid for every gallon of water starting in a small stream but with added amounts received as tributaries turned the stream into an Amazon. The toughest question is how hard to push prices and I wrote a note to Bill on that after our December meeting last year.”

Wow, I never really thought of Microsoft as having a royalty on electronic communication. I especially like the notion that the hardest question facing Microsoft (at least in 1997) is how high to raise prices. I guess the danger in increasing their prices too high is that it will push people into using and developing other alternatives, such as open source software.

Buffett goes on to compare Microsoft to Bell and Coke. Buffett notes, “Bill [Gates] has an even better royalty-one [compared to Coke's royalty on swallows] which I would never bet against but i dont feel i am capable of assessing probabilities about, except to the extent that with a gun to my head and forced to make a guess, i would go with it rather than against.” So according to Buffett, the real question with Microsoft is how sustainable into the future is their competitive advantage. Will Microsoft still be the dominate software powerhouse in 20 years? I am confident that they will be for the next 10 years, but 20 years it is a bit harder to predict. I think the key for tracking my investment in Microsoft will be to closely monitor its competitive position even more than its financial performance. In the near future, I think Google is the only significant threat to Microsoft but they have a long way to go before they can actually threaten to breach Microsoft’s moat.

Warren Buffett is the ultimate fat pitch investor. In this same email he goes on to say, “… I prefer to structure investing as a no-called-strikes game and just wait for the fat one.” Buffett draws on the wisdom and writing of baseball superstar Ted Williams and his reference to his batting “happy zone”. “Your happy zone, because of the business experience you have had, what you see every day, your natural talents, etc. is going to be different than mine,” notes Buffett. This makes me feel a bit better about my Microsoft decision. However, I still wish I could have the opportunity to ask Buffett what he now thinks of the future of Microsoft’s competitive advantage.

I strive to develop the same discipline that Buffett has to let decent pitches go past him and to wait for that perfect fat pitch before swinging.

You can follow the performance of my model portfolio (FPF Value) by visiting Marketocracy. You can review my past purchases in this long term model portfolio by visiting my FPF Value archives.

According to AP, the jury wanted Merck to listen and that larger studies are needed for drugs. Would they also like to pay more for their drugs too?

Derek Lowe over at Corante’s In the Pipeline made a great comment on the size of the award. He commented, “If you’d like a strictly utilitarian, economic response to that award, start by pricing out what $253 million dollars of life insurance will cost – that is, if you can get anyone to not hang up the phone on you.” I thought that was a fairly insightful way of looking at the economic reasonableness of the damage award.

Another way to look at this is to consider that there about 4,200 additional claims against Merck. If each of these claims resulted in similar damages to those for the death of Robert Ernst, the total liability resulting from Merck’s Vioxx debacle would reach over $1 trillion dollars! Looking at that total potential liability, you would think Merck caused a nuclear meltdown disaster in a major city. I understand that the purpose of punitive damages is to send a message to the company that it should be more careful before it releases a potentially lethal drug. However, this measure of damages goes above and beyond this message. The repurcussion of this financially crippling award (not to mention the attorneys’ fees Merck will have to shell out over the next few months/years) may very well be that the cost and availability of other life-saving drugs will be put in jeopardy.

Imagine if Carol Ernst actually got 66 percent of that award, or $152 million. She would instantly become a member of the top 1 percent of the wealthiest people in the U.S. She would also have a heck of a time managing her money to avoid buying Merck stock, since Merck is standard component of many stock indexes and mutual funds. Every scam artist, charity, and financial planner will be hounding her day in and day out for the rest of her life. Even if she gets a smaller award, I hope she and her family are prepared for tremendous stress and turmoil that any windfall will cause them. God forbid that she or her family members will ever be in need of any Merck drugs. This includes any drugs that they could have been able to produce had they not faced tremendous financial liability.

I know it is likely that on appeal the damage award will be reduced substantially or even thrown out. However, the jury’s verdict does affect my estimate of the potential total financial liability Merck will face as a result of Vioxx. I originally felt that it was very unlikely that the total damages from Vioxx could exceed $10 billion; however, I’m not so confident now. I will also be a lot more cautious in the future when looking for value investments in companies with medical liabilities. I think I remember Charlie Munger also recently warning of the dangers of huge legal costs associated with medical liabilities. I should have taken his warning a bit more seriously. Maybe that is why we haven’t seen Warren Buffett and Charlie Munger investing in depressed stock of drug companies. For now, I will be holding on to the Merck stock I purchased last year, and I’ll be waiting to hear how the appeal of this case turns out.

I learned a few other important things from this event. These include:

1. If I need an attorney for a jury trial, I would hire a Christian minister or reverand like Mark Lanier, who is an ordained Baptist minister. (Now if I could only invest in a law firm specializing in providing attorneys that are Christian ministers. Now that is a competitive advantage that would give a firm a wide moat.)
2. I need to learn how to make PowerPoint presentations as effective as Mark Lanier using the techniques he used that are detailed in the book Beyond Bullet Points written by Cliff Atkinson.
3. Never underestimate the power of persuasive speaking even when the facts do not appear to support an arguement. Emotions are often much more powerful than reason. As value investors, we want to focus on rational reasoning, but we have to remember that emotions play a much larger role in the decision making of many around us.

The interesting item of note was that the article pointed out that Unilever trades at a discount of as much as 30 percent compared to Procter & Gamble, Danone and Nestle. That is similar to my finding as well. I’ll have to keep on eye on Unilever’s moves over the next couple of months. Unilever’s value may start to attract attention and it might be unlocked in the near future.

Recently, things have started to change. Online advertisement expenditures have been increasing, and it looks like some of those old Golden Age business plans are getting dusted off. Yahoo! Auctions recently announced that it will no longer charge sellers listing fees or closing costs. In addition, I noticed Yahoo! Classifieds, an old favorite of mine before Craig’s List grew, is also providing free listings again. It will be interesting to see if they will be able to revive their markets.

This development will be a direct challenge to Ebay. It currently has a massive competitive advantage with its large network of buyers and sellers, its rating system, and its brand name. Having a large concentrated market of buyers and sellers increases the overall auction experience, since it is most efficient to list items for sale where the most buyers will be looking to bid on items. Sellers with high ratings also face high switching costs, since they have to rebuild their reputation if they move to another auction provider. It will be interesting to see if Yahoo! Auctions will be able to attract enough users to make its auctions worth while.

I don’t think there is an investment opportunity here, but if Yahoo! Auctions gets enough traffic, it might be a money saving opportunity to list your “junk” for free with them. I’ll have to check on how close the closing prices on Yahoo! Auctions compares to those for similar items on Ebay.

Merck was proactive in informing the FDA of its research concerning the increased risk for cardiac problems associated with Vioxx. I believe Merck made the right decisions in voluntarily removing Vioxx from the market even though it will cost the company in the short term. I believe the market has over reacted to this setback, and I don’t believe the loss of Vioxx will impact the long term value of Merck. I agree with Barron’s assessment this weekend that investors have clearly overreacted. Vioxx only accounted for 11 percent of the company’s sales this year, so a 27 percent hit that Merck’s shares took is a bit excessive.

However, there is some danger that lawsuits will cut into future earnings. However, given Merck’s proactive measures and the fact that it had earlier put a warning label on Vioxx warning of cardiac risk, I think Merck will be able to manage the lawsuits. There is also the issue that Merck’s drug pipeline seems rather thin. I think the struggles that Merck has faced this year will cause the company to focus on new product development and strategic partnerships.

Looking at Merck’s free cash flow, I find that using fairly conservative estimates that Merck shares have an intrinsic value between $40 and $50. Given Merck’s 4.6 percent dividend that should be safe for quite some time, I am interested in buying Merck at this time with all of its warts and bruises. I will patiently await better days and new drug discoveries in the future while collecting a handsome dividend now.

I’m adding Merck to my Marketocracy fund Monday morning, so we can track the performance of this analysis.

To determine intrinsic value, I often like to know how much cash the company is generating for me. Unilever reports what they call “ungeared free cash flow“, and I give them points for using this metric as a target to maximize their value. The ungeared cash flow is equal to the cash flow from operating activities less capital expenditures, less taxation on profit, and taxation on interest and financing income from pensions and similar obligations. Basically this is free cash flow free of tax benefits.

In 2003, Unilever generated €3,939 million in ungeared free cash flow. I estimate that the company will safely grow 3% to 5% in the long term. Assuming a 4% growth rate and using a 10% discount rate, the present value of free cash flows is €65.7 billion. Adjusting for cash and long term debt, the total value to shareholders is €59 billion.

Since Unilever has two classes of shares (PLC and NV), the intrinsic value for PLC shares must be calculated by dividing total value by 6459.4 million combined PLC shares as stated in the Unilever FAQ. Each PLC share is equal to 4 UL ADR shares and the Euro currency needs to be converted to US dollars (1€ = 1.2US$). After crunching these numbers, I get $44 per share as the intrinsic value of UL stock. Using a 25% margin of safety, I am comfortable buying UL at $33 a share.

I actually purchased UL on Tuesday at $33.58 per share. I set up a Marketocracy fund to track this purchase and any future purchases that I make at Fat Pitch Financials. Sorry about the delay in getting this posted, but I’ve been tight on time this week.

Business Basics
My first stop was over to Unilever’s investor relations center to learn a little more about this large European consumer products conglomerate. I was a bit amazed at the number of high quality brand names in Unilever’s stable of products. Here are a few of their many (400 plus) high quality brands:

• Hellmann’s
• Knorr
• Wishbone
• Bertolli
• Becel
• Country Crock
• Slim*Fast
• Lipton
• Breyers
• Ben & Jerry’s
• Klondike
• Popsicle
• Birds Eye
• Snuggle
• Surf
• Dove
• Pond’s
• Suave
• Close Up
• Calvin Klein fragrances

Many of these strong brands dominate their product sector and command premium prices. Unilever’s global brands provide the company a major competitive advantage against new entrants in the market.

The company appears to be free of any major legal problems.

Unilever does have substantial pension obligations. They are accounted for using reasonable assumptions. There is also the accounting of stock options, which thankfully have been expensed and are fully included in the financial statements. This is a good indicator that the company practices good conservative accounting.

Return on invested capital has improved from 2002, where it was 9.8%, and in 2003 was 12.5%.

There is still quite a bit more to write about, but I’m out of time. I’ll continue the discussion later today. However, I plan on buying this stock this morning while the price is still a bargain.

To better understand how the longest bull market in history has severely change the expectations of Coke investors look at it this way: if you had invested $1 in Coca-Cola in 1983 you would have purchased a company with 54 cents/share in net equity and you would have earned 9 cents a year in earnings. For a $1 investment today you get 13 cents in net equity and 4 cents/share in earnings annually.

My general speculation is that at 15 times earnings Coke is an excellent stock to look at. At $30/share this would only bring the price to free cash flow ratio on Coke down to 23 times. However, remember that dividends will continue to be dolled out by the company.

I tend to agree with Brady’s analysis. We’ll have to wait and see if Coca Cola presents itself as a real fat pitch in the coming months. For now, it’s time to move on and look at other opportunities.