Intel is trading off this morning, near $19, after closing yesterday at $19.59.  We believe INTC is a buy for accounts with a one year plus horizon.

Intel had $16 Billion in Net Cash as of June 2010.  Intel had generated $10.2 Billion in Free Cash Flow (by our calculations) over the past year.  As of this morning with a Market Cap of about $106 Billion, Intel’s Enterprise Value is about $90 Billion or less than nine times trailing Free Cash Flow.

With the MFE deal, Intel will have about $9 Billion in Net Cash, as MFE has about $800 million of net cash and the purchase price of about $7.8 Billion.  After the deal, Intel will have about $1.60 per share in Net Cash.  Even before adding in McAfee’s Free Cash Flow, Intel trades at 9.5x Free Cash Flow.  With MFE, this will be closer to 9 times.

The single biggest point is that Intel made a cash investment.  They had three choices: invest more in their current businesses, buy back stock or invest in a new business.  We would have preferred a stock buyback, but we’ll take a positive cash flow return, with growth, in a near-zero interest rate environment.  We grade the use of cash at Intel as a B-.

The real drivers of investment returns in the future will continue to be based on the same principles they have been based on over time.  They are unit growth, price changes, margin changes, re-investment opportunities, efficiency of transaction markets, and many others.  Collectively, they produce for an entity positive or negative cash flow and subsequent balance sheet adjustments.  Discounted free cash flow has been and will continue to be the true mechanism for determining value for a corporation, a government or any other entity or security.

All of the current issues, are just that, current issues.  We always have current issues.  They’re just different each month.  Here’s one example of a current issue that is bound to change.  Currently, new home builds are well below normal.  The April 2010 housing start data from NAHB is 672,000 SAAR.  The peak was in 2005 at 2,068,000.  Their is currently a great deal of excess inventory.  However, household formation is averaging about 1.3-1.4 million units per year.  This is due to population growth.  Which is why we have less excess inventory now than a year ago, than two years ago.  Current demand is well above current supply.  At some point, the excess supply will be gone and supply will have to equal demand.  Based on current supply and trend line demand, construction activity will effectively double.  This means roughly a doubling of current construction jobs – a sector which has one of the highest unemployment rates, somewhere in the high 20%.  Based on estimates, it would seem we are about one to two years away from this happening.  Stock prices can change all they want, but I doubt they are seriously going to effect household formation.

Governments that can print money to pay off excessive debts will probably due so to the extent they can.  Unemployment will stay high as long as people think that someone else will help them.  The best thing people can learn is that we are all self-employed.  The end of entitlements is a good thing.  Wealth creation takes work.

Note: This comment was posted today on the LinkedIn CAIA Association Discussions Forum started by Mark Jaeger.

There has been much debate over various proposals to change the tax treatment of “Carried Interest” that is generated by Hedge Funds and Private Equity or Venture Capital investment funds.  The basic structure of these investment partnerships is:  Limited Partners, who commit capital; General Partners, who commit capital and labor.  The General Partners invest in the partnership, but also receive a management fee for selecting, monitoring and providing guidance to the businesses who receive an investment from the partnership.

Over a period of several years, should the partnership have enough successful investments, the partnership should be profitable.  These profits are capital gains to the partnership.  Long-term capital gains that are created within these funds are subject to “favorable” tax treatment. Currently, most investors pay a 15% tax rate on these gains.

Carried Interest is when a long-term capital gain created within the partnership is re-allocated away from a limited partner(s) to the general partner.  Since this gain was a long-term capital gain to the limited partner, the general partner has typically filed this re-allocation on their personal tax returns as a long-term capital gain.  But is it a long-term capital gain to them?  The answer is no.  The explanation is below.

There are two inputs to Wealth: Labor and Capital.  From a tax point of view, labor is compensated via income in relation to time, effort or judgment exerted.  Capital is compensated by a return paid either thru a dividend or an increase in future sales price.  To generate a long-term capital gain, one must first commit capital.  The basis for a capital transaction is always assumed to be greater than zero.  The basis for labor, in comparison, is always assumed to be zero.

In the partnership described above, the General Partner is committing both labor and capital.  The General Partner has three wealth streams.  The first is the management fee paid to the General Partner by the investment partnership to evaluate and disperse funds into appropriate investments.  The General Partner is then to monitor and guide those investments.  The second wealth stream is the capital gain, usually long-term, on their invested capital into the partnership.  They receive this return, just like all the other Limited Partners.  The third wealth stream is the re-allocation from Limited Partners to General Partners.  If this wealth was not re-allocated, then Limited Partners would classify this as a long-term capital gain.  However, once it is re-allocated to the General Partners, it should no longer be considered a long-term capital gain.  The capital investment on this specific wealth payment was zero.  This wealth was created by the effort and judgment exerted by the General Partner.  This wealth was created by General Partner’s labor and not the General Partner’s capital.

A clearer example of this is as follows:

Suppose you own and build an office building.  You then need to rent out office space.  You decide to hire a leasing company to do this for you.  They will advertise and find the tenants; they will negotiate and sign the leases; they will take care of the property.  You pay them a management fee or a portion of the rental income as their compensation.  Since you want the leasing company, to have the same economic interests as you, you offer a 5% ownership to the leasing company based on the appraised value of the building before it’s leased.  The leasing company makes the investment.  The leasing company spends the next ten years running your office building for you.  After ten years, you decide to test the waters on what your building is worth.  You engage the leasing company again, this time as the selling agent of the building.  You offer them a bonus.  The bonus is 10% of the increase in value of the building at the sale price versus the initial appraisal value of their investment.  Again, you have aligned the economic interests of the leasing company with your own.  The leasing company comes thru and sells the building for much more than the original appraisal value.

Over the course of this entire investment period, the leasing company has made a capital investment in the building; the leasing company has received a management fee for operating the building and the leasing company has received a bonus for selling the building for far more than its original appraisal value.  How would each of these streams be taxed?

The investment in the building would be classified as a long-term capital gain.  The management fee earned yearly would be classified as income.  And the bonus would be classified as?  Anyone who thinks that the bonus would be classified as anything other than income is fooling themselves.  There was no capital ever committed to generating this return.  This return was generated entirely by someone’s labor.  The fact that this labor was performed over years (by keeping the investment quality of the building growing), but paid at the end of the relationship, does not in any way change the nature of the activity that generated the wealth.  There is no long-term capital gain to the leasing company.  Had you, the owner, not paid the bonus to the leasing company, you would have been taxed on that wealth payment at the long-term capital gains rate.  Since you chose, however, to forgo some of the investment return and instead share it with the leasing company, in the form of a bonus or whatever, they should not get to claim it as a long-term capital gain, nor would they under current tax law.  This is the same economics and structure as “Carried Interest” and yet because a General Partner in an investment partnership receives the re-allocation instead of a leasing company, they somehow get to receive “favorable” tax treatment.

Carried Interest is taxable income because it fails the capital test.  At some point, our tax code needs to be enforced or changed to achieve this result.

The purchasing strategy of the envelope is a simple way to explain some powerful investment concepts.  Another point of study is the concept of investment fraud.  What is an envelope?  It’s a piece of paper.  What’s inside it?  Something of value – in this case, money.  What is a corporation?  It’s a piece of paper.  What does a corporation own?  It owns things of value, like cash or real estate or patents.  Is there a way to check what’s in the envelope before you bid on it?  Well yes, an impartial outsider could open up and look in the envelope and verify that there is cash in it.  Isn’t that similar to the role an outsider accounting firm takes on when they conduct an audit of a corporation?  Strong auditing guidelines help to diminish the potential for investment fraud.

The key point of this entire exercise is to get you to understand the price and value are different when it comes to investing.  Price is easily determined.  In fact, it’s in overabundance. What’s important to always remember is that as Price alone changes, so does the entire Risk vs. Reward calculation.  What is valuable is to know what value is.  They key to investing is to spend one’s time focusing on finding Value first and then determining the appropriate bid Price.

Before we get to the answers, let’s recap a little on why this is so important and valuable to investing.  Warren Buffet, the famous investor of Berkshire Hathaway, is often quoted as saying that the best investing book ever written is “The Intelligent Investor” by his mentor, Ben Graham.  Two of those chapters are essential reading.  They are chapters 8 and 20 – Mr. Market and Margin of Safety.  Mr. Market teaches the reader to ignore the hectic price movements of stocks on Wall Street.  Margin of Safety is about buying assets for well below their intrinsic value.  The less you pay for that value, the lower your risk is and the higher your potential return.

So now, let’s get back to our three questions.

The First Question is a self-reflection question.  The whole point is to help you determine your risk vs. reward comfort-ability.

The Second Question highlights Mr. Market – and the limits of his usefulness.  Mr. Market provides you with opportunity, but very little value.  Imagine if there were 10,000 other people looking to also buy “the envelope”.  That’s 10,000 pieces of data.  Are they really useless?  Basically, yes.  Why?  Because wouldn’t you rather have one data point of exact value instead of 10,000 data points of price?

The Third Question is about Margin of Safety.  If you purchase “the envelope” for $1, your risk is zero.  Your potential return is up to $19.  If you purchase “the envelope” for $20, your risk is $19.  Your potential return is zero.  So low risk can lead to high return and high risk can lead to low (or negative) returns.  But isn’t it conventional wisdom that “low risk = low returns” and “high risk = high returns”?  This is why the conventional wisdom is frequently wrong.  Usually, low prices have less risk than high prices.  Unfortunately, most investors think with their emotions instead of their analysis and buy high priced investments and sell low priced ones.

We call this “The Envelope”.

Imagine we have an envelope.  In the envelope, we’ve placed between 1 and 20 dollars.

First Question:

What is the most you would feel comfortable bidding for the envelope?  The key to this question is “most”.  You need to think about the highest number you’re comfortable with.

Now suppose there are other people also present.  They have also decided upon a “most” number to bid for the envelope.  Assume everyone has made their decision privately.

Second Question:

I offer you the following two choices of information:

Choice A) We can tell you what everyone else’s “most” number is

OR

Choice B) We can tell you exactly how much money is in the envelope.

Which do you choose?

Third Question:

If you buy the envelope for a price of $1, what is your risk?  what is your potential return?
If you buy the envelope for a price of $20, what is your risk?  what is your potential return?

Every economic transaction conducted every day, everywhere is based on one thing.  This one thing is the “Price-to-Value Relationship”.  The buyer is willing to pay a certain price for perceived value.  The seller believes they own or have created something of value and is willing to sell it for a certain price.  Homes and autos are bought for a certain price because of the value they will bring the new owner.  Similarly, stocks, bonds, investment real estate and commodities are bought because of a belief in their value.  Whether the eventual value of the item purchased is less than or greater than the initial price paid, is something that isn’t determined until some period of time has elapsed.

We will discuss this further in the next few blog posts.

HPQ reported revenue growth of 13%  and earnings per share of $1.09.  Total Net Revenue was $30.849 billion.  Cash flow from Operations was $3.384 billion for the quarter.  That was calculated using Net Earnings and Depreciation and Amortization.  We don’t add back items like stock-based compensation or bad debt provisions or restructuring charges.  Gross PPE expenditures was $950 million.  We use gross cap ex, and not maintenance like some analysts.  Thus Free Cash Flow was $2.434 billion for the quarter.  Annualized this is $9.7 billion.

HPQ’s Balance Sheet has about $4 billion in Net Debt.  The current Market Cap is about $110 billion.  The Enterprise Value is about $114 billion.

The valuation of $114 billion divided by Free Cash Flow of $9.7 billion leads to a multiple of 11.7x for HPQ.

Our Client Commitment:

Communication
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In detail, they are:

Communication – Open, Honest and often Frank. You’re hiring us for one reason: Investment Performance. We know how to do it and will tell you when you (yes, you the client) is getting in the way of yourself.

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Confidentiality – Your personal information is kept in complete confidentiality. We respect the trust you bestow upon us.

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