Some Observations on the FDIC

There has been a lot of press today in the wake of yesterday's failed bailout vote in the House about possibly raising FDIC deposit insurance limits from $100,000 to $250,000. When the FDIC was created in 1933, it had deposit insurance limits of up to $2,500. This ceiling has been raised over the years. The most dramatic increases were from 1966 to 1980, when the limit was hiked three times, taking it from $15,000 to $100,000, its current level. Since there hasn't been an increase in nearly 30 years, it's arguable that raising the limit is not only reasonable, but long overdue.

So with the proposed bigger backstop along with the recent rise in bank failures, the question becomes can the FDIC actually afford to do all of this? Evidently, the answer is yes they can. There have been so many wrong reports that the FDIC is "running out of money" that the FDIC issued a press release addressing the issue. They basically have two options: (1) they can raise premiums for banks with riskier portfolios to replenish the fund's current balance of $45 billion; and (2) they can borrow whatever they need from the Treasury whenever they need it, and the borrowed sums must be paid back through "industry assessments." Thus, the FDIC, in the case of insuring deposits, isn't really a separate entity from the U.S. government. Rather, it acts as a conduit for the U.S. government to provide whatever funds are needed to make good on the deposit guarantee. In the event that the FDIC needs to tap its Treasury credit lines, however, I'm not sure what happens if it turns out the "industry assessments" are insufficient to repay the borrowed amount. It's probably not very likely as the FDIC imposes liquidity and reserve requirements and maintains a watchlist of banks that are in danger of failing. The bottom line is that the FDIC will stand by the deposit guarantee.

The other question that comes to mind is how many banks are at risk of failing? The FDIC does keep a "problem" list of banks, but it wisely does not share this list as doing so could cause a run on those banks. There are some 3rd party services that attempt to rate banks for a fee, but only Bankrate offers some limited services for free. The FDIC does put out a Quarterly Banking Profile, with the latest for June 2008. This is a lot of data, so I looked for another source to analyze it. The most eye-popping stats are that the FDIC's reserve ratio is now 1.01% ($45.2 billion to cover $4.5 trillion of insured deposits), down from 1.19% in the prior quarter and the 1.2% to 1.3% range since 2004. There are also 117 "problem" institutions representing $78.3 billion in assets, up from 90 institutions and $26.3 billion in the prior quarter. Those numbers don't sound too bad, but who knows how many more banks should be on that list. Indymac, which has $32 billion in assets and failed in July, didn't make the list until June.

For what it's worth, Forbes ranks the FDIC chairwoman, Sheila Bair, as the 2nd most powerful woman in the world in 2008. That's right, number 2 in the world, right behind German chancellor Angela Merkel and well ahead of other more recognizable ladies like Condoleeza Rice (#7), Nancy Pelosi (#35) and Oprah Winfrey (#36). The FDIC chairman is appointed for a five-year term by the President and approved by Congress. Bair was appointed in June 2006, so she'll be in the position till 2011, which is a lot more than what some of the other officials that have been prominent in this crisis can say. It's a big mess to clean up, and it would make anyone nostalgic for a past life as a professor and part-time children's book author.

Things certainly don't look good, but they can get worse. To put things in perspective:

• 4,004 banks failed in the first 2 months of 1933 during the Great Depression; 13 banks have failed in 2008.
  
• The Dow dropped 777 points yesterday, but that represented only an 8% decline. The New York Stock Exchange has "circuit breakers" in place that halt trading after significant drops to prevent market crashes, but these are triggered only after a 1,200 point decline. Given all of the uncertainty in the market, it looks like we're heading to the point where trading will be halted one of these days.
  
• The carnage occurred despite the SEC's ban on the short-selling of "financial" stocks, which began on September 19. By the way, unless the SEC extends the ban, it is supposed to terminate at the end of October 2. The SEC does have the option of extending the ban through October 19. Who knows what happens after the ban is lifted?

As highlighted in prior posts, there will be a number of bargains out there, but I think it would be wise to see how some of these larger issues play out before committing too much capital.

What Do You Buy in this Market?

What do you buy in this market? With the outcome of the bailout plan still up in the air, it looks like there will be quite a bit of uncertainty in the days ahead. While most would advise caution in this environment, there may be an opportunity to jump in on some quality companies.

The key is quality. But what is considered quality, especially in today's markets? Here is what I would be looking for, which would be on top of solid free cash flow generation. I covered some of my technology sector ideas earlier this month, but really the same principles described there can apply to just about any sector.

1. Strong balance sheets

No matter what fiscal or monetary assistance the government will ultimately provide, it looks like we should expect some lean years ahead. These are the times when the weaker companies fail and the stronger companies take market share. Having a strong balance sheet will be critical to tie companies through these tough times.

That basically means cash is king, and short-term debt is undesirable. Let's just say it would be preferable to not have to raise money (debt, equity, whatever) in the next few months or even years. To have a lot of short-term debt coming due is probably not the most desirable position to be in right now. Not that long-term debt isn't worrisome either, but I'd like to indulge in some wishful thinking that market conditions will eventually be much more favorable than the current environment. It would be less than ideal for a company to take desperate action now to meet short term commitments by raising money at unsavory terms. This basically rules out substantially all financial stocks, retail stocks, industrial stocks, etc.

It's also why technology companies look pretty good right now. Here are a couple of well-known names, with their latest cash balance, short-term debt and market cap:

• Apple (AAPL): $20B / - / $117B
  
• Cisco (CSCO): $26B / $500M / $138B
  
• Dell (DELL): $9B / $129M / $33B
  
• Google (GOOG): $12B / - / $138B
  
• HP (HPQ): $14B / $4B / $117B
  
• Intel (INTC): $12B / $175M / $104B
  
• Microsoft (MSFT): $23B / - / $243B
  
• Nokia (NOK): $17B / $2B / $75B
  
• Oracle (ORCL): $13B / $1B / $105B

Considering the price Goldman Sachs just paid for their cash infusion, and considering what some financial firms would give for just a fraction of this cash, I'd have to say these balance sheets look pretty valuable. The sum of these cash balances is almost $150B, which is over 20% of the proposed $700B bailout package.

Of course, this isn't limited to just technology companies. Here are a handful of other well-known companies with a high ratio of cash to short-term debt. They do seem to be confined to pharmaceuticals, energy and technology, however.

• Chevron (CVX): $8B / $1B / $180B
  
• Exxon Mobil (XOM): $40B / - / $419B
  
• Johnson & Johnson (JNJ): $13B / $5B / $194B
  
• Merck (MRK): $10B / $1B / $69B
  
• Nike (NKE): $2.7B / $0.2B / $32B
  
• Pfizer (PFE): $27B / - / $126B

It's kind of strange that these companies are trading at such low multiples. I think traditionally higher multiples have been reserved for high growth companies. I'm not sure whether those expectations for growth would still hold in the environment we are facing. I would think the safety of these balance sheets would eventually be valued more.

2. Safe dividends

An online savings bank like HSBC Direct pays 3.25% currently. However, that interest is taxed as ordinary income, while dividends, for the time being, are taxed at a more favorable 15% rate.

Companies that have the cash balance and free cash flow generation to pay dividends should be at a premium. Many of the companies mentioned above, even some of the tech companies, have tax-adjusted dividend yields that rival the online savings bank rates.

3. Niche domination

So the companies listed above are generally safer, but they probably won't enjoy really spectacular returns either. To double your money with Microsoft, you'd have to wait for it to become a half trillion dollar company. That might be a long wait. The same holds true for the other companies on the list as well. This is where having smaller companies with similar characteristics of a strong balance sheet, safe dividends and free cash flow generation might be more enticing.

Here are a number of smaller companies that hold large shares in their markets. Most of these markets still have quite a lot of room to grow.

• Autodesk (ADSK): $960M / $120M / $7.7B
  
• Akamai Technologies (AKAM): $290M / - / $2.9B
  
• Chipotle Mexican Grill (CMG): $200M / - / $1.9B
  
• Columbia Sportswear (COLM): $350M / - / $1.5B
  
• Dolby Labs (DLB): $400M / $2M / $4.1B
  
• NVIDIA (NVDA): $1.6B / - / $6.4B

4. Sector ETFs

I generally prefer looking at individual stocks over ETFs, but I would consider them in growth sectors as a sector index fund, or if the holdings include companies that are difficult to purchase from the U.S.

Here are two that interest me:

• Alternative energy - Market Vectors Global Alternative Energy ETF (GEX)
  
• China - PowerShares Golden Dragon Halter USX China Portfolio (PGJ)

Alt Energy Stocks includes a fine writeup on alternative energy ETFs and mutual funds, and why GEX is preferred. GEX has a solid mix of international and U.S. companies, holding 30 stocks with an expense ratio of 0.65%. While alternative energy has sort of been a fad in the past, I get the feeling that this time it will have some more staying power. It seems likely that the next administration, regardless of who wins, will have to implement policy changes that will benefit green energy, either as the primary goal or as a compromise for increased drilling. I still need to pick up Tom Friedman's new book addressing the matter. The bottom line is that I believe alternative energy will become a much larger industry over the next decade, both in the U.S. and internationally.

Among China's ETFs, FXI is the largest with over $6B in assets, but I prefer the PowerShares offering PGJ as it provides a more balanced industry distribution in its holdings. FXI is weighted almost 2/3 energy and financials. While not as large as FXI, PGJ still has over $400M in assets and a 0.69% expense ratio. China has taken quite a hit this year, but the fundamental growth story and demographics shift to urban middle class remains the same. The RMB should also aid in investment returns relative to the U.S. When it comes to investing in these, I expect to build positions on the dips.

TogaPF Design Change - No More Frames

I decided to change the design of this site after all the frustration of not being able to link to individual posts. Consequently, I've gotten rid of all of the frames on this site. There really shouldn't be any impact to the actual "look" of the site.

There are still a number of bugs to be worked out, although they only seem to appear in Firefox. Internet Explorer seems to be working just fine. For about 1/3 of the posts, clicking on the link or typing in the URL directly redirects me back to the home page. I have no idea why that would be the case, but I'm working to resolve it. Please let me know if there are any other bugs out there. Thanks.

Buffett and Goldman Sachs

There's been a lot written up about Buffett's $5 billion investment in Goldman Sachs. Most of the press has been calling it a vote of confidence in Goldman by Buffett. I think the more accurate description for it may be a celebrity endorsement, or even extracting a pound of flesh from Goldman. Both of those posts have excellent writeups detailing why Buffett's move is both juicy and virtually riskless. It is certainly a better deal than his adventure with Salomon back in the 80s and 90s which turned into a major headache. It seemed like there was little chance that he would venture back into the business after that experience, but it looks like the Goldman deal was too good to pass up.

Fortunately, Berkshire Hathaway shareholders are going to see the full benefits. I'm not sure if this deal would have happened at such favorable terms without Buffett. There must be a fair number of companies and investment funds that could have just as easily put up the $5 billion, but I doubt that any of these investors could have negotiated the deal at the same terms. Goldman certainly paid up for the value of the Buffett name, and I don't think they would have agreed to do the deal at those terms with any other investor. A sovereign wealth fund or a foreign bank just doesn't send the same positive signals through the market as Buffett does.

So with the Goldman investment and the Constellation Energy purchase, Buffett has spent close to $10 billion in the past week, or nearly one-third of Berkshire's cash balance. I think that's a good endorsement on Buffett's part that there are definitely good values to be had. Even after the moves, Berkshire should still have over $20 billion in cash, so there should still be future moves in store.

Interesting bit of trivia: now that Goldman Sachs and Morgan Stanley have decided to become commercial banks, that now leaves Raymond James Financial as the largest investment bank out there. Here's a pretty devastating graphic depicting the current state of the investment banking industry.

Getting out of BAC

I plan on taking the opportunity that the government has provided to sell my BAC stake. The whole financial sector, and to some extent the U.S. and global stock market, has become tied to the decisions of the Fed and Treasury department. Speculation over what the government will do is driving price movement. I believe the gesture is the correct one, as it provides some much needed stability. I'm sure Lehman Brothers, AIG and Bear Stearns are all applauding the timeliness of the decision. However, now that the government has become a deus ex machina in the investment thesis for BAC, I don't see the point in owning it anymore. I don't like it when it is used in fiction, and I certainly don't want it determining whether I can profit or not.

The government backstop basically ensures that BAC will survive this crisis, answering one of my two key questions for owning BAC. The question as to whether the dividend is safe, however, no longer has a clear answer after the announcement of the Merrill Lynch acquisition. Ken Lewis has indicated that cutting the dividend is now an option, a far cry from his assurances back in July when he made the following statement:

"Given these parameters our outlook for the economy and our earnings potential we have not changed our philosophy about the dividend. I will recommend to The Board that we maintain the current dividend of $0.64. Given our current economic outlook we believe the drivers of earnings for the remainder of the year will be most of our core businesses along with the continued tight grip on expense levels across the company."

Now none of this means that the dividend will be cut for certain, but it doesn't bode well given what other financial companies have done with their dividends. Coupled with the huge task of integrating a 65,000 person company in Merrill and a 50,000 person company in Countrywide, there are certainly execution risks as well. The temporary ban on short-selling has forced them to liquidate their positions, driving up the stock price today. It's not clear what will happen in 2 weeks when the ban expires. This isn't the first time the government has stepped in, and this crisis may well demand further action.

With uncertainty in the dividend and current prices in the mid to high $30s, I'd rather have the money than be subject to more 20% swings, even if it is to the upside. There will be better uses for that cash.

Some Tech Stock Ideas

As Warren Buffet put it, "Be fearful when others are greedy and greedy when others are fearful." Looks like it's time to get greedy, and even Buffett made a purchase today.

There have been some wild swings this week. Currently, there is a rather large upward spike due to reports that the government will step in to bail out institutions by buying their risky mortgage assets at a discount . Before that announcement, it looked like the market was heading for certain panic. That may still happen. I think it will be relatively easy for the market to get fooled into thinking that a meltdown is imminent, that more companies will collapse, and that converting investments to cash is the prudent strategy. That strikes me as the same misguided thinking that led to the widespread belief that real estate is a safe investment and always appreciates.

I don't expect the announcement to mark the bottom. There will likely be more fluctuations in the coming days, weeks and months. The upside to these massive fluctuations is that a good many stocks will be selling at mouth-watering prices.

I want to highlight a few names in technology that look interesting to me, particularly if they drop in price significantly. Technology is looking pretty good in this environment, as they typically have a lot of cash on their balance sheets, don't require large capital expenditures to operate, yet generate a lot of free cash flow. Many have strong positions in industries and markets that should continue to grow despite tough economic conditions.

Autodesk (ADSK)
Most people know this company for AutoCAD, but check out their product list. They actually have quite a few leading software offerings. Overall, this looks to be a solid business with solid financials. They have close to $1B in cash, a small amount of debt, and free cash flow generation of almost $500M per year. The current market cap is about $7.5 billion with a $33 share price. I don't consider this company to be too undervalued, but I think the risk reward is reasonable given the strength of its business. Adobe is another company that is very similar in that it dominates its niche software market, except that it's about 3x bigger than Autodesk.

Demandtec (DMAN)
This is a small company that went public last year. They provide software that lets retailers optimize their merchandise mix and helps them set pricing and promotion strategies to maximize their profit. They have such big customers such as Wal-Mart, Target and Best Buy, which they sign to multi-year contracts. Of their $275M market cap, about $70M is cash. They are free cash flow breakeven/positive, although their net income is still negative. The weak economy will likely push out their ability to sign new customers, but since the software ultimately helps retailers maximize profit, this should be something that has an easily demonstrable return on investment.

eBay (EBAY)
The stock has come down with the rest of the market and now has a market cap of $30B. The company has guided $2.4B in free cash flow for 2008, which is an 8% yield. This is already one of my larger positions, but I won't mind adding to this position.

Google (GOOG)
I never thought that this company would ever drop to a price that I would consider investing. They have a pretty awesome cash generating machine, which throws off over $1 billion in free cash flow every quarter. Of course, that machine in search is basically all they have right now, which is a risk. However, that machine looks fairly safe right now, given its market dominance as well as the turmoil affecting its competitors. I think they may even benefit in a downturn, as that would simply accelerate the shift from other forms of advertising to more measurable online advertising. I would like to see their spending practices reined in soon, but those may simply be potential cost savings that may simply act as a catalyst later on. In the meantime, they have $12B in cash, despite almost $3B in annual capital expenditures. The stock has flirted with the $400 threshold, which would imply a market cap of $125B. If we can assume that they will grow free cash flow from the current $4B level to about $10B in the next 3-5 years, then that price would seem quite reasonable.

Microsoft (MSFT)
For all of the reasons to not like Microsoft, consider the following:

• $30B in cash and investments
  
• A steady record of growth in free cash flow, with $18.5B in FY 2008
  
• Returned over $55B to shareholders in the past 3 years ($11B in dividends, $46B in stock repurchases)
  
• Dividend yield is about 1.8% now, and only costs about 20-25% of free cash flow
  
• Market cap of $230B, which implies about 8% in free cash flow yield
  
• 9.1B shares outstanding currently. In 2003, there were 10.8B shares outstanding, which means that on average about 300M shares are retired annually

Of course, this case could have been made for each of the past 8 years. But then, the case just gets better and better each year.

Nokia (NOK)
Similar argument to Microsoft. It's now a $75B market cap company, with $17B in cash and $10B in free cash flow generation last year. Additionally, they have a 4% dividend yield, but the dividend only costs them about 25% of free cash flow. They also repurchase $4B to $5B in stock annually. The last time they were this low was when the market thought Motorola's dominant clamshell phones meant the beginning of the end for Nokia. That didn't really play out, and Nokia has since expanded its market share to 40%. The question now is how much of an impact will the iPhone have on Nokia. This may be significant, but at Nokia's current valuation and financial results, the margin of safety may be sufficient.

Market Declines Can Be Good

It was too bad I couldn't wait until Monday to execute my Friday trades. Oh well.

In eventful trading days like today, I think it's helpful to remember that market declines can be a good thing. If you plan on being a buyer of stocks over the next few decades, then the ideal scenario for you would be for stock prices to decline. As your earning power increases, you're able to invest your money in securities that are cheaper to buy. In fact, you would only want stocks to increase in price when you are looking to sell.

So while today's news on Lehman Brothers, Merrill Lynch and AIG are symptomatic of the rotten state of our markets, a fair number of decent companies have likely been dragged down with them. It's been some time since our last full blown downturn back in 2002, when market sentiment overshot in the negative. In this investor psychology scale, , I'd have to put the current market squarely in the fear, panic and contempt category. The sense I get from reading the financial press now is to expect things to get a lot worse before they get better. This is much different from earlier in the year, when the press was more prone to wondering whether a bottom was imminent - I think the consensus now is that it is not. Capital preservation and caution are now the recommended strategies.

So now to assess the damage to my portfolio today. Except for Bank of America dropping 21% due to the Merrill Lynch purchase, my portfolio wasn't really impacted. I find it interesting and encouraging that BAC has been so active on the acquisitions front. Given the current state of the markets, I doubt that they would or could pursue anything too reckless. I would have to think that BAC is dealing from a position of power when it picks up companies like Countrywide and Merrill Lynch, the latter at a sizable premium. It's certainly better that they're shopping for companies rather than shopping their business units for quick cash. The questions that concerned me when I took a look at this stock in my initial portfolio evaluation still hold: what are their chances of survival, and can they afford to keep their dividend payments. But their actions would suggest either that they are confident they will survive and continue their dividend payments, or they really like to gamble. Somehow, I don't think they would be interested in any sort of gamble at the moment. If BAC continues to drop, I will be interested, but I think there are going to be even better opportunities elsewhere.

Bought NVDA and GA

I made the following purchases yesterday morning:

• NVIDIA (NVDA) - 250 shares at $9.75 per share, for total cost of $2,445
  
• Giant Interactive (GA) - 300 shares at $7.95 per share, for total cost of $2,394

I had written up my thoughts on both NVIDIA and Giant Interactive earlier this week.

With NVIDIA dropping over 10% this week, the risk reward proposition became even more compelling for me. As noted previously, $3 of the share price is cash, and the stock is supported by a large share repurchase authorization that could potentially cover approximately another $3 in share price. Given that NVDA is still generating substantial free cash flows, I assume a conservative floor at $6 per share. From current levels, that's a potential $4 per share loss. The potential gain could be significant as the stock was trading above $30 just 12 months ago and above $20 just 3 months ago. If market sentiment returns to NVDA's favor, and I think it will given their market position, cash flow generation, solid balance sheet, and management team's track record, I think the potential gain could easily be 3x or more the potential loss.

Giant Interactive (GA) - Giant Opportunity

Fan has been clueing me in on chinese gaming stocks, namely MMORPGs, so I decided to take a look at them. I think it's basically a given that the industry in China will do well - the real question is which company will triumph. However, despite the market being as competitive and overcrowded as they come, many of these stocks have fallen so far that it almost doesn't even matter which one will win. In any event, I think we've come to the agreement that Giant Interactive looks to be the most attractive of these.

Here's a list of the major publicly-traded players:

• Perfect World (PWRD)
  
• Shanda (SNDA)
  
• NetEase (NTES)
  
• The9 (NCTY)
  
• Giant Interactive (GA)

There are many more, but these are essentially the main players. This is a fascinating industry, characterized by high growth and insane margins. The9 is an interesting little company as it has the license to operate the highly popular World of Warcraft game in China. Unfortunately, that's also just about all it does, so I'm avoiding that one for now. I've ruled out the first 3, because they simply don't look as attractive when compared to Giant Interactive.

This is an interesting article giving a nice background of the company and some of the things that set GA apart. GA's strategy is to target the middle market. GA's key title ZhengTu Online is geared toward mass adoption as it is free to play and requires only a 10Kb connection to play. Similar to how Wal-Mart grew its business by staying away from major metropolitan areas, the company has concentrated its 2,500 person marketing force on medium and smaller sized cities in China. The goal is for players to become addicted to the game and fork over real money to purchase upgrades like weapons, gear, or clothes for their in-game characters. The company evidently has become really good at executing on this plan as it now has 2.1 million peak concurrent users (2nd most in China) and the highest ARPU (~300RMB per quarter) in the industry.

The MMORPG model is attractive because once a game reaches a certain critical mass, it essentially becomes a self-contained money machine. It basically takes virtual goods and converts it to real hard cash. The only expenses are the R&D to create it and the marketing expenses to spread the word.

Here are some other interesting findings gleaned from the 2007 annual report, IPO prospectus, the Q2 08 earnings call transcript, and the company's investor relations site:

• The company went public in November 2007 at a price of $15.50, raising net proceeds of $780M. The stock is now roughly half that level despite delivering stellar returns.
  
• The CEO/founder Shi Yuzhu owns 49% of the company, and principal shareholders and entities own 70% of the company.
  
• $835M in cash and equivalents as of June 2008
  
• Announced $150M share buyback in August
  
• The company is planning to launch ZTOnline in Vietnam - perhaps the first of many such launches. The game's minimal tech requirements are conducive for this type of expansion.
  
• Active Paying Accounts: 1.76 million, 41% growth YoY. However, slightly decreasing ARPUs. The company recently changed its revenue model to grow paying accounts at the expense of ARPU, part of the reason the stock's been hammered.
  
• Net margins of 70% - but this will likely come down
  
• Operating Cash Flow of $203M, free cash flow of $188M in 2007
  
• No taxes paid in 2007. Their 2007 annual report says that they have a 50% tax holiday from 2008-2010, or 7.5% effective tax rate in those years.
  
• The last quarter's results were also tempered by the Sichuan earthquake as well as the Olympics distracting people from playing games.
  
• GA is the only Chinese gaming stock (and one of the few Chinese stocks) to trade on the New York Stock Exchange rather than NASDAQ. I thought that was interesting as NYSE tends to be less volatile and more expensive than NASDAQ, while NASDAQ is more often associated with technology stocks. Here's a breakdown of the differences between NYSE and NASDAQ.

Decision:
I'd have to think that the downside to this stock is limited. At under $8, this is a $1.9 billion market cap stock with an enterprise value at about $1.1B. With the share repurchase plan, the company can afford to buy back almost 20M shares. This is over 15% of the 114M share float according to Yahoo Finance. The company certainly has the cash balance and cash flow generating ability to to buy back more shares.

The operating margins are sure to come down though. Operating expenses was close to 33% of revenue in Q2, with the bulk of that coming from marketing. Taxes will also play a larger role going forward. However, even factoring those in, this is still likely a conservative 40% to 50% net margin business with very limited capital requirements. The company only has one hit game for now, but they do have a few in the works with new game Giant Online reaching 344k peak concurrent users. Even if you disregard the other games, ZT Online can be a cash cow for GA for quite a number of years given its track record and critical mass, and it is still growing. It seems highly probable that GA can generate at least $150M in free cash flow annually over the next few years just off of ZT Online. Any additional value from new games or from newly acquired businesses would just be gravy.

I don't see this stock dropping below $1.2 billion in market cap, which is basically its cash balance plus two years of free cash flow. That translates to a bottom of about $5 per share, or a loss of less than $3 per share from these levels. However, the upside here can be quite substantial. If we assume the company reaches $300M in free cash flow in 3 years (CY 2011) and the market values the FCF conservatively between 9-12x EV/FCF, that translates to a market cap range of $3.5B to $4.5B, or $14 to $18. Even a return to its IPO price of $15.50 would yield a 100% return. When this sector and company return to the market's favor, the limited float and high margin/high growth characteristics of the business could potentially justify a multiples expansion and yield a return several times higher than that. The risk/return proposition appears very favorable, and I'll be looking to build a fairly substantial position here.

Looking at NVIDIA

Work has been pretty busy lately, and I haven't had much time to think about stocks over the past few weeks. However, a lot has happened in the markets in that time, with the end result being that prices have come down quite a bit. NVIDIA (NVDA) is one that has caught my eye.

This one has come down nearly 70% since the start of the year, when it was trading in the low $30s. Even though I would normally stay away from this industry, with the major players swapping positions on an almost annual basis, the stock looks very attractive with limited downside at $11. Coupled with today's slide fueled by a downgrade by UBS based on competitive issues from Intel's Larrabee that are already known, it looks like the market is being overly pessimistic about NVDA's opportunities.

The key question is how much further can the stock fall? With $1.6 billion in cash and securities, nearly $3 of the company's share price and over 25% of the company's market cap is basically cash. The company also has a $2.7 billion stock repurchase plan in place, having added $1 billion to the authorization in August 2008. They have used up $1.16 billion since the plan's start in 2005, leaving over $1.5 billion in repurchase capacity remaining. Now this capacity does not guarantee that they'll use it to repurchase shares, as they only bought back $327M in 2007 and only about $60M each in 2006 and 2005. Any repurchases will also be offset by share dilution, which has averaged about 3% to 4% in the last 4 years. However, potential repurchases should provide a guard against excess selling pressure. Taking into account rule 10b-18 trading limitations for repurchases, the company could theoretically buy back its own shares every trading day for the next 2 months. This is unlikely, but there is a vast source of latent buying power in the stock that should support it against future price drops.

Moreover, despite all of its problems, the company is still generating free cash flow. They can do this because as a fabless company, their capital expenditure requirements aren't too high and average about $60M per quarter. Even in its disastrous Q2, which included a $196M charge to cover customer warranty issues, cash flow from operations was still $81M and free cash flow was $27M for the quarter. Certainly, this isn't as good as the $250M in free cash flow that the company averaged per quarter in 2007. But once you back out the $196M one-time charge, adding back about $120M to $150M tax-adjusted to the bottom line, it's not as severe as the Patriots losing Tom Brady for the season. Yet, those results basically cost the company about $3 billion in market value when they were revealed in early July.

So of NVDA's $6 billion+ in market cap, a quarter is cash, and another quarter the company has indicated it may repurchase (and could very well fund from free cash flow). That more or less implies the actual NVDA business is worth about $3 to $4 billion. That's down from close to $20 billion just 12 months ago.

Has anything happened in that time span to warrant such a decline? Probably the most significant would be Larrabee, Intel's foray into NVDA's bread and butter business announced last month. This probably isn't the best news for NVDA. With the amount that Intel spends on annual capital expenditures, they could basically buy an NVDA at today's price every year. On the other hand, Larrabee probably shouldn't fall into the Sarah Palin category of unexpected news developments either. It would appear that the market may have overreacted to the news. Larrabee won't be introduced until 2010, but based on market sentiment, I would have surmised that NVDA's chances of survival were about as good as the hapless barbarian tribe against Maximus' Roman legions. Even after the introduction, I don't think anything is necessarily guaranteed for Intel. It would take at least a few years for it to unseat NVDA, and that's assuming Larrabee meets expectations. There will be formidable competitive pressures, but it's not like NVDA hasn't faced that before. But who knows?

Actually, Larrabee doesn't worry me as much as whether or not this falls within my circle of competence. Can I say I really understand the business? Well, yes and no. I can't really claim to know the technical differences between the various offerings from NVDA, AMD and Intel, just as I can't really claim to know what technically makes Coke different from Pepsi. I can only look at market share and profitability. The company is in a perpetual race to make high-end and highly demanded widgets faster than anyone else. For some generations, NVDA will come out on top and dominate. For other generations, one of its competitors will be in the driver's seat. There isn't much pricing power; if a competitor slashes prices, everyone needs to follow suit. As the company's 10-K puts it, their markets are characterized by "rapid technological change, evolving industry standards and declining average selling prices." It's not the most compelling business model, and I don't expect Buffett will be backing up the truck on this one.

But at some price, the risk/reward becomes too interesting to disregard. I think it's approaching that price. The company generates solid free cash flows, has a strong market position in a large growing industry, and has a solid management with significant ownership stakes (albeit with a board that has some shareholder unfriendly practices). It has the cash to weather a downturn for several years, and is in a great position to reap profits once the economy improves. If I do invest, this will be something that will fluctuate a lot, and will demand a lot of attention to monitor new developments. It will be a high maintenance investment. The fluctuations, however, will likely be confined to the upside, as I do think the downside is limited. Not sure if I'll make a move, but it's something to keep an eye on.