The Internet Grows Up To Be A Gold Mine of Free Cash Flow

Round Mountain Gold Mine, Smokey Valley, Nevada, 2008, photo: Patrick Huber

This is a guest blog by Mycroft Psaras. It’s an edited version of a longer piece that can be found at The Free Cash Flow Analyst.

The internet is obviously an evolving and changing civilization with millions of new websites being created every day. As an investor though I have never been able to capitalize on Internet stocks in large numbers, because they have never been able to provide the price to free cash flow numbers that I look for when making an investment.

The formula I use is Price to Free Cash Flow (PFCF) or what maybe called “Owner’s Earnings” which is a special form of PFCF that I learned by studying Warren Buffett. Owner’s Earnings has been widely publicized but unfortunately little used by market participants. I say unfortunately because if more people used it they would not be like dogs chasing their tails and continue consistently buying at the wrong time and selling at the wrong time. By using owner’s earnings they could go a long way in understanding what they are buying. I find it very odd that the greatest investor in history has clearly described how he analyzes stocks and it has fallen on deaf ears.

Buffett’s formula in a nutshell: Net Income + Depreciation – Capital Spending = Owner’s Earnings. (All of those component numbers are usually readily available through Value Line and other sources.)

For those interested in seeing a complete analysis of Owners Earnings in action please read my article on Microsoft (MSFT).

From a stock picking point of view, Internet stocks really began showing up in the late 1990’s and became a popular trading vehicle for day traders and were extremely dangerous places to invest, as the dot com boom and bust clearly showed, and as an investor I have always stayed away. But that was then and this is now and since the only constant in the universe is change, I am overjoyed that I am finding intriguing Internet investment opportunities. The industry went from being a wild west day trading phenomenon, to a high beta growth play and has now just turned the corner and become a place to find consistent conservative growth/value opportunities. I of course am not talking about the entire industry and though there are many opportunities available, I have decided to limit this discussion to five key players.

When investing it is important to try not to follow the crowd, but instead to envision a potential future for the industry that you are analyzing and then try to find the key players that dominate through Economies of Scale, both now and in the future. (I learned the methodology of how to envision a potential future by reading the books of Alvin Toffler, which though outdated now, can still teach anyone to be a better investor). At the same time, though, you must also insist that each company is consistent and that you can buy them at very attractive valuations. This is not always so easy to do as most investors do little or no research and end up buying at the wrong time and selling at the wrong time.

This unfortunately is our competition and if you want to invest in the market, you need to deal with them. The best way to do so is to have a concrete game plan in place and set your parameters and always keep a large amount of cash on hand to take advantage of the mistakes of the crowd.

What I have attempted to do in analyzing the Internet is find what I call “the foundation stocks” in the industry that provide the services or platforms that allow people to do what they do on the internet seamlessly. I have done this because I relate the Internet to the “1860 California Gold Rush”. The people who made the money then were not those panning for gold, but were those who provided the tools, supplies and essential services to allow them to do so.

There are five key players that I see dominating the Internet in the future as ‘foundations stocks” and what I have done is divide the Internet into five sub categories;

  • Hardware
  • Software
  • Operating Systems
  • Search
  • E-Commerce

And in each of those categories I have found one dominant player that I bought at very attractive valuations.

These five stocks are:

  • IBM (IBM)
  • Oracle (ORCL)
  • Microsoft (MSFT)
  • Google (GOOG)
  • Value Click (VCLK)

IBM is a company that constantly adapts and for almost a century has dominated the hardware arena. Everyone talks about how cloud computing will change the world and how mainframes and servers will be a thing of the past, but the same thing was said when desktops computers and laptops first showed up, but they were wrong then and they will be wrong in the future as well because the Internet is basically a network of servers connected together that send data at the speed of light to one another. Without the hardware to store the data you have nothing. And I assure you IBM understands cloud computing and knows that it still has a long way to go. I remember in 2001 when the big talk around town was in how 3G wireless networks were going to go up within a year and everyone’s mobile experience would be amazing, but we are in 2010 and they have only now just gotten the kinks out ( don’t say that to an AT&T(T) Apple(AAPL) I-Phone User) and I also remember how Linux was going dominate the globe, but the Linux operating system, some ten years later, has only 2-3% of the global operating system market share.

Cloud Computing is still in its infancy and all cloud computing currently makes up about 2% of the combined IT Infrastructure. That means that 98% is still hardware based. Google, for example, buys used servers and mainframes and stores their information on them, so if Google is in no rush then cloud computing should be quite a ways off and should grow to a combined revenue of $3 Billion by 2013.

IBM makes its money from services and not just from the servers and mainframes they make. The real money in IT is in service contracts that are usually multi-year and fixed. Thus IBM can have a sustainable earnings stream that is very consistent. Their free cash flow generation is so powerful that they just announced that they will be buying $10 billion of their own stock back in addition to the $2.3 Billion that they announced previously. If you crunch the numbers and look out to 2011 you have IBM potentially earning $13.45 a share in owner’s earnings for that year and at today’s closing price of $140.67 you have IBM selling for 10.45 times its owner’s earnings estimate.

Oracle, our next pick, is the champion of the Software side of the Internet and provides the database software to store all the data that makes the internet work. It is amazing that the governments of the world have allowed Oracle to buy out their competition without charging them with being a monopoly, but if you look at the companies that Larry Ellison has bought and put them together, you basically have a monopoly. Oracle is also a service based company and signs multi-year contracts like IBM does and thus you have consistency and Economies of Scale and an incredible barrier to competition, as they have basically bought up their competition. By also by buying Sun Microsystems they have also got their hands on Java, which is a language that allows the user to interact with the Internet. Oracle in 2011 is expected to earn $1.95 a share in owner’s earnings, so at today’s closing price of $28.63 we are looking at a price to owner’s earnings of 14.68.

Microsoft is the world market share leader in operating systems for desktops and laptops and comes in with a market share of 90%. So 9 out of every 10 internet users in the world get to the internet from an operating system that was built by Microsoft. The Economies of Scale for Microsoft are just amazing and I feel very confident that when they report their earnings this week that they should surprise a few people. From what I have been able to determine they have sold over 240 million licenses of Windows 7 and 140 million of those were probably in this quarter. If you want to read my full analysis of Microsoft you can do so by going here. In 2011 we have Microsoft earning $2.50 per share in owner’s earnings and if we take today’s closing price of $25.90 we get a price to owner’s earnings of 10.36.

Google is my favorite stock as it totally dominates all aspects of the internet and gets more unique visitors and clicks than any other company. (See a chart of Google’s rising free cash flow below.) I can write volumes on Google but instead will let you read my article on it by going here. I bought Google in the $470’s and it has gone up considerably since then, but with expected owners earnings of $27.95 for 2011, I believe those estimates may be a little low and at today’s closing price of $618.60 it still may have some room to go at 22 times its owner’s earnings. In saying that I would assign a higher premium to Google than I would to other companies as their dominance in unmatched and their future so bright.

The last company on my list operates in a niche area of the internet and is the dominate player in that niche. The company is called ValueClick and they own this website or Commission Junction. The company only has a market capitalization of $1.12 Billion but is extremely profitable and very undervalued in my opinion. What they do is have an E-Commerce Network that has some 2500 clients who are advertisers and it acts as a go between them and tens of thousands of website publishers. I stumbled upon them only because I run this company as well and am a publisher client of theirs along with a dozen other affiliate networks.

ValueClick is the dominant force in the industry and in my opinion (along with other affiliate networks) will allow all kinds of entrepreneurs like myself to create store fronts to compete with the Amazon’s and EBay’s of the world, similar to how blogs compete with the established media and are slowly taking them down. Amazon (AMZN) and EBay (EBAY)are still the dominant players in e-commerce, but will eventually feel the heat as companies like Macy’s( M ), Wal-Mart (WMT) and Sears(SHLD) are joining up with ten’s of thousands of website designers to house direct link banners to their sites.

Amazon is smart as they have their own affiliate network, but since this article deals with companies that are market leaders but also have attractive valuations I don’t consider it a buy. Amazon’s owner’s earnings are too rich for my taste and I have never had the opportunity to own them, but I would at the right price. As for EBay their capital spending as a percentage of cash flow is too high for my tastes. I like to pick stocks where capital spending amounts to less than 15% of cash flow consistently over many years and EBay does not pass that test. ValueClick comes in with an estimated $1.13 owner’s earnings per share for 2011 and at today’s closing price of $13.74 is selling at 12 times its price to owner’s earnings. The company is very well managed and has a tremendous reputation in the affiliate marketing industry, is very profitable and if one includes the estimates for 2010 and 2011 into the equation, they have cumulative owners earnings for the years 2003-2011 of $7.78 a share or are basically selling for about 2 times their cumulative owners earnings, which makes it an amazing Main Street owner’s earnings generator.

In conclusion, I am sure that many of you may think that these stocks should not be classified as Internet Stocks, but remember that the Internet is actually a physical structured tool and the companies mentioned in this article are market share leaders in each of the categories that make up the internet and play a major role in allowing the user to access it.

Psaras’ Positions: Long MSFT, IBM, ORCL,GOOG,VCLK, WMT, T with No Positions in EBAY, AAPL, AMZN, M, SHLD

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.  Please note, investments involve risk and unless otherwise stated, are not guaranteed.  Past performance cannot be used as an indicator to determine future results.  Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.

Mycroft Psaras is Director of Investment Research for Geasphere and CEO of Mycroft Research LLC as well as CEO of Mycroft Mall LLC.

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