What A Difference A Decade Makes!

There was a lot of talk on CNBC this week about the trailing 10-year returns of the S&P 500 index and what, if anything, they tell us about the duration of the current equity bull market. Interestingly, the U.S. stock market bottomed at 666 on March 6, 2009, and has since returned nearly 18% annually for a decade.

The consensus view is that periods of strong market returns are often bookended by low valuations on one side and high valuations on the other side. That is certainly the case in this instance, and I am not sure it tells us very much about the current bull market (in terms of when it loses steam). Using the intra-day bottom during the worst market environment in nearly 100 years, as a starting point, is almost assured to subsequently produce a decade of strong returns.

While we cannot use this data to predict the next bear market, it is noteworthy that the market does tend to go in cycles that last one or two decades. The last 10 years have been characterized by strong index returns, and the rise of the index fund as the go-to investment option for individual investors. But I would argue that recency bias is playing a large role in this trend.

Consider that from January 1, 2000 through December 31, 2009, the S&P 500 went from 1,469 to 1,115, a loss of 24%. Dividends made up for a lot of the decline, such that $1 invested in the index including dividends was worth 91 cents in the end, but still, that decade produced a cumulative loss of about 1% annually.

Perhaps that is why there were not nearly as many people piling into index funds 10 years ago. They work... until and unless they don't. Just as the economy and the equity market are cyclical, so to will be the popularity of index funds.

Interestingly, even Warren Buffett (arguably the greatest active portfolio manager in history) has been bitten by the index fund bug, having recommended them many times in recent years.

Side note: I think the saying "do as I do, not as I say" is fitting here. While Buffett now praises the index fund category, it is important to note how the 88 year old plans to transition his stock picking duties at Berkshire Hathaway when he is no longer around. Move all of his investments into index funds? Hardly. Instead, he has hired two hedge fund managers, Todd Combs and Ted Weschler, to take over management of Berkshire's stock portfolio. Fascinating.

So what can we expect over the coming decade for the stock market? Well, it is not exactly going out on a limb to say that returns will likely average less than +18% and more than -1%, but that is a start. After all, the coming decade is unlikely to be as good as the go-go 1990's, or as bad as the ten years immediately following them.

History would tell us that average returns will be somewhere in the single digits. I won't hazard a guess as to whether we get 3%, 5%, or 7% a year, but I think mid single digits is as good of a guess as any based on historical data. It will be interesting to see if, in such an environment, index funds remain the asset of choice, or if tastes shift to something else (and if that something else is already in the marketplace or if it has yet to be created).

Chipotle Valuation Surging to Dizzying Heights, Surpassing Amazon!

It should not be surprising that hiring a veteran restaurant executive to replace an inexperienced founder will have a material impact on the business and its stock. Chipotle Mexican Grill (CMG) is a classic example, as Steve Ells stepping aside for Brian Niccol (formerly of Taco Bell) has launched CMG's shares into the stratosphere:

CMG's customer traffic has rebounded (+2% in Q4 2018) after flat lining earlier in the year and material price increases (+4% in Q4 2018), which were sidestepped after the e coli incidents, have same store sales rising 6% and profits surging even faster. The current analyst consensus estimate has CMG earning $12 per share in 2019 on a mid single digit same store sales increase and 5% unit growth. Those figures would place CMG near the top of the sector.

As is often the case, the biggest issue is the magnitude of CMG's recent stock gains. At more than $600 per share, CMG's forward price-earnings ratio is a stunning 50x. Why a casual dining chain with 2,500 locations already should trade at such a valuation is hard to understand, unless one believes they are going to steal a lot of market share going forward from here. Many folks believe that will happen, but I am less excited.

To give readers a sense as to how nutty this CMG valuation appears to be, let's compare it to Amazon (AMZN). I know AMZN is not a dining stock, but I find it to be an interesting comparison because they are both loved consumer brand stocks right now. Not only that, I would venture to guess that an investor poll would conclude that Amazon's business is better than Chipotle's and is likely to grow revenue and profits faster over the coming decade. And yet, today we can invest in Amazon at a cheaper valuation:

Looking at 2018 reported financial results, CMG trades at 31x EV/EBITDA, versus 28x for Amazon. I used EV/EBITDA to account for balance sheet items as well, but on a P/E basis the numbers are also similar: 50x for CMG and 59x for AMZN.

For those who are intrigued by Chipotle stock, I would simply point out that Amazon has long been a loved growth stock for which investors are often willing to pay sky-high valuations for. Today an argument can be made that CMG is more expensive and you would have a hard time finding people who expect CMG's business to outperform AMZN in coming years.

If that's true, either CMG is overvalued quite a bit, or AMZN is relatively cheap, or both. I would bet that AMZN outperforms from here. For those who like paired trades, being short CMG against an AMZN long looks interesting.

Signs of Topping in the Consumer Credit Cycle

Don't bother counting me in the camp that thinks they can predict when the next recession will hit. The current consensus from those who try to do such things seems to be sometime in 2020, but I don't think anybody really knows.

But that does not mean that keeping an eye out for economic signals is not worth doing. If the consumer credit cycle, for instance, is nearing a top, it very well may impact what multiple of current earnings you are willing to pay for shares of financial services companies. When you see strong return on equity metrics for full year 2018 this earnings reporting season, you might consider the notion that further expansion could be minimal.

In recent months I have come across a couple of interesting press reports that help shed some light on where we are in the current consumer credit cycle, both from the Wall Street Journal.

First, we had a piece in mid December about how credit reporting giant Experian was going to start including cell phone bills in credit reports. The goal is to boost credit scores so that lenders can widen their pool of eligible borrowers:

"Most lenders tightened standards dramatically after the 2008 financial crisis, and have been in intense competition for the most creditworthy borrowers ever since. And while most large banks have limited appetite for the subprime borrowers they lent to in the runup to the financial crisis, some have been eyeing customers with thin borrowing histories as a new revenue stream, a sign the lenders believe the good economy still has room to run."

So rather than scare their investors and regulators by accepting lower credit scores when considering new borrowers, why don't we ask the credit scoring bureaus to find ways to raise credit scores so that more people qualify. Yikes.

And cell phone bills are not the full extent of the changes. The article goes on:

"Fair Isaac Corp. , creator of the widely used FICO credit score, is close to launching a new credit score in partnership with Experian that will factor in consumers’ history managing their checking and savings accounts, which will give a boost to most consumers who keep at least several hundred dollars in their accounts and don’t overdraw."

Given that the credit reporting companies get paid by the lenders, not consumers, it stands to reason that when approached by their customers to refine their scoring methodologies, they were amenable to the idea. Kind of reminds me of the scene in the movie The Big Short when the Standard and Poor's employee explains why they rated all of those sub-prime mortgage bonds triple A; "because if we didn't give them the ratings they wanted, they would go down the street to our competitor."

The signs of a topping credit cycle don't end there, unfortunately. It appears unconventional mortgage underwriting is making a comeback as well:

"Aryanna Hering didn’t have pay stubs or tax forms to document her income when she shopped around for a mortgage last year—a problem that made it tough for her to get a loan. But the nursing student who works part time providing home care for children and the elderly eventually hit pay dirt: For a roughly $610,000 home loan, a mortgage company let her verify her earnings with 12 months of bank statements and letters from clients. Ms. Hering said money she collects from roommates and from renting to Airbnb guests covers more than two-thirds of her roughly $4,300 in monthly payments, and her earnings cover the rest."

While not a large proportion of the overall home lending pool, these types of loans are growing quickly:

"Lenders issued $34 billion of these unconventional mortgages in the first three quarters of 2018, a 24% increase from the same period a year earlier, according to Inside Mortgage Finance, an industry research group. While that makes up less than 3% of the $1.3 trillion of mortgage originations over that period, the growth is notable because it came as traditional home loans declined. Those originations fell 1.2% over the same period and were on track for a second down year in 2018."

So what exactly were the terms of the loan Ms. Hering received? Tell me if this sounds familiar:

"Ms. Hering, who is 30 years old, received a loan at a rate of just over 6% for the first five years; it adjusts after that."

Do these stories mean that the economy is about to collapse a la 2008? Of course not. All it means is that the business cycle is alive and well and that consumer lending has reached the point where prime borrowers have reached a level of debt they are happy with and lenders are now stretching a bit to grow. This happens every cycle, frankly. What it tells me is that delinquency rates are probably troughing out and overall credit quality and lender returns are probably peaking.

While these are important tidbits to consider when valuing financial services companies on multiples of book value or normalized return on equity, it is probably not going to help pinpoint the next recession. Leave that job to the economist community that has correctly called ten of the last five recessions, or the Federal Reserve, which has never (and will never) predicted one at all.

My Recent Target Experience and How The Chase for E-Commerce Market Share is Killing Retailer Margins

There is a Target (TGT) store very close to my house that my family visits frequently. We even keep a shopping list on the fridge labeled "TGT" to simplify our trips.

Given the vast selection of products Target carries, sometimes it is harder to find something in the store than you would think, even if you are very familiar with the layout. To minimize the time we meander up and down various aisles, I have the Target app installed on my phone, which will tell me which aisle each product is located at my local store.

In recent months I have noticed that the prices on the app for many categories are materially cheaper than they are in store. This becomes obvious when you lookup the location of something on the app, see the price, and then 30 seconds later you pick it off the shelf and see a clearly higher price. I would say the discounts average about 10% (just a guesstimate) and are focused on certain categories such as toiletries and cleaning products.

After several trips of noticing the pattern, I became pretty annoyed. If my bill totaled $100 I invariably felt like I was getting ripped off by shopping in-store, even if only to the tune of $10 or so. I looked up Target's online price matching policy and sure enough, they will match their online pricing for in-store purchases.

The process for collecting the difference is far from helpful, though. Rather than visiting the customer service area and having them scan your receipt or something easy like that, you need to show evidence of the lower price online while the cashier rings up your purchases. So if you have a dozen items that are cheaper online, you need to show the cashier each item on your phone app individually and they will then manually enter the cheaper price for each item. Not only is this time consuming, but it will make the check-out experience awful for the people in line behind me, as they wait for me to bring up each and every item on my phone. As a result, I refuse to do this and am ticked off that I need to in the first place.

The other day I decided that I could have the best of both worlds. Even though the store is right down the street from my house, I can order the items online, have them delivered in 2 days, and save money on top of that by getting the lower online prices. So I fired up the app and began adding items to my cart.

Without a Target Red Card, there is a $35 minimum order to get free 2-day shipping. I was short of that level initially, so I decided to see if they would actually deliver cat litter for free (many retailers have weight limitations for free shipping). I thought it was a long shot since each box of litter weighs over 25 pounds, but sure enough, cat litter is eligible for free shipping. By adding 2 boxes I reached $36 and submitted my order.

Two days later a large flat shipping box was left on my porch by UPS. The box was nearly coming apart, as both boxes of litter had been placed flat/sideways in the shipping box, with some soap and toothpaste tossed in as well without much in the way of padding. I have no idea how much UPS charged Target to deliver this 50 pound box to me in 48 hours, but I would have to say somewhere between $5-10, right? There is no way Target made a profit on this online order and I am not paying them an annual membership fee (like Amazon Prime) to help cover the cost.

Why am I telling this boring retail story? Because when we consider the economics of the decisions Target is making here, it makes no sense. My local Target store has high fixed costs. They should want me to drive to the store, pick my own items off the shelves, go through the self-checkout lane, and drive home. That route will maximize their profit by leveraging their fixed costs and minimizing labor expense, which is only rising (and is now $15 per hour here in Seattle).

Instead, they are offering me higher prices if I visit the store, and that is made obvious to me when the lower online prices are shoved in my face whenever I use the smartphone app (which they encourage me to use in-store to boost the shopping experience). From an economic perspective, they should be trying to coax me into the store by offering perks for doing so. Instead, they are almost begging me to order online, where they will likely barely earn a profit on each order, if at all.

And on the flip side, they are offering cheaper prices online, with free 2-day shipping, and including products such as 25 pounds of cat litter in the free shipping offer. At least make me drive to the store to pick up the cat litter!!!

So, here I am planning to order more of my Target purchases online, which will crush their margins both on the retail side (as store traffic declines) and on the online side (where 2-day shipping via UPS will eat their already reduced margin).

The result is that Target succeeds in their goal of keeping my business and not donating it to Amazon (AMZN) or Wal-Mart/jet.com(WMT). Okay, great, your same store sales will hold up nicely in a very competitive retail world. And your margins will erode quickly, resulting in the same absolute profit dollars earned on higher volumes. Seems like the opposite of what should be happening (keep prices low and make it up on volume).

In fact, there are some items at Costco (COST) that are cheaper in store than they are online, even though this flies in the face of what chains like Target are doing. And that pricing strategy is from a company that chooses volume over per-item margin all the time. In fact, Costco marks up their items (from their cost) the least of any retailer I am aware of. Smartly, they are not getting sucked into this notion that to compete online and keep their stock price up, they need to give away products through the e-commerce channel.

Call me crazy, but some of these hybrid online/in-store business models don't seem very well thought out, and surely won't benefit shareholders much in the long run. I love shopping at Target, but it is hard to see how they are going to materially increase per-share profit.

Full Disclosure: No position in Target, long or short, just baffled by the pricing dynamics they currently have in place and believe it reinforces that we are now seeing retailers focus on same store sales and not profits, even at mature, established companies which clearly are not second-comings of Amazon.

U.S. Stock Market Seems Like An Obvious Buy For First Time In A Long Time

With the S&P 500 index now down roughly 18% from its peak reached about three month ago, for the first time in years it appears the U.S. stock market is severely oversold and pricing in worse than likely economic conditions. In the two weeks since my last post discussing valuation, the S&P trailing price-to-earnings ratio has dropped by more than a full point and now stands at just above 15x.

I have previously posted that we should expect P/E ratios of between 16x and 17x with the 10-year bond yielding in the 3-5% range (current yield: 2.75%). Given that 2018 corporate profits are pretty much in the books already, the current valuation of the S&P 500 assuming ~$157 of earnings is 15.3x (at 2,400 on the S&P 500).

Let's consider what this valuation implies. First, it presumes no further earnings gains, or put another way, 2018 is the peak of the cycle for profits. Could that be possible? Sure it could, but right now that is the base case. And even with that base case, stocks are 5-10% below the 16-17x P/E we would expect to see.

One could also make the argument that U.S. stocks are pricing in a mild, normal recession. Let's assume a typical 6-9 month recession occurs over the next 12-24 months, and as a result, S&P 500 profits drop 11% to $140. If a normalized P/E ratio would be 16-17x, I would guess stocks would fetch about 18x trough earnings during a recession (investors often pay higher multiples on depressed earnings). If we assign an 18x multiple on $140 of earnings, we get an S&P 500 target of 2,520, or 5% above current levels.

If we take a more bearish stance and assume a normalized P/E (16.5x at the midpoint, given low interest rates) on that $140 profit number, we would peg the S&P 500 at 2,310, or less than 4% below current levels.

I am not in the game of predicting short-term economic paths or stock market movements. All I can say now is that stock prices for the first time in many years are pricing in several of the most likely economic outcomes (normal recession or materially slowing GDP growth). Furthermore, it appears that the S&P 500 will close out 2018 at the lowest valuation since 2012.

Given those conditions, I am aggressively buying stocks with the majority of current cash balances in the accounts of those clients who are aiming for more aggressive, long-term, growth-oriented investment strategies. Put simply, I am seeing a ton of bargains right now and am not content waiting for further downside to pounce. For those who have excess cash on the sidelines, now could turn out to be a great time to add to your equity exposure, assuming that fits with your risk tolerance and investment goals.

Johnson & Johnson Stock Not Discounted Much After Renewed Talc Media Blitz

Shares of healthcare giant Johnson and Johnson (JNJ) have come under pressure in recent days as media reports have once again resurface, suggesting that the company has potentially hid evidence that trace amounts of asbestos have been found in the talc powder products over multiple decades.

Whenever news like this hits, especially with large dominant franchises with plenty of free cash flow to cover possible legal verdicts (think BP earlier this decade), it pays to see if investors are getting a short-term bargain, enough to compensate them for what is likely to be plenty of headline risk over the coming weeks and months.

With JNJ shares only down about 15% from their highs (not much more than the S&P 500 index), no such bargain seems to have presented itself yet. I estimate JNJ is likely to report free cash flow of around $6.75 for 2018, which gives the stock a current multiple of 19.3x on a trailing basis.

While such a price is not sky high by any means, it is probably about right for a company of JNJ's size. Looking back over the last five years, we can see that JNJ has closed out each of those year's with a trailing free cash flow multiple of between 18.3x and 21.6x. Therefore, the market seems to agree with my conclusion about a fair valuation.

For me to get interested in playing JNJ as a short-term contrarian, long-term investment play, I would probably have to pay around 15x free cash flow, or near $100 per share. We are far from there at this point, and unless some impressive jury awards play out in plaintiffs' favor, or the media finds evidence that is a bit more damning, we probably won't see the stock get that low.

With The Elevated Valuation Issue Solved, 2019 Earnings Growth Takes Center Stage

With S&P 500 profits set to come in around $157 for 2018, the trailing P/E ratio for the broad market index has fallen from 21.5x on January 1st of this year to 16.5x today. Surging earnings due to lower corporate tax rates have allowed for such a significant drop in valuations despite share prices only falling by single digits this year, which is a great result for investors. Normally, a 5 point drop in multiple requires a far greater price decline.

With sky high valuations now corrected, the intermediate term outlook for stocks generally should fall squarely into the lap of future earnings growth in 2019. On that front, there are plenty of headwinds. With no tariff relief in sight, the steady inching up of interest rates, a surging federal budget deficit, and no incremental tax related tailwinds next year, it is hard to see a predictable path to strong profit growth from here.

Even if 10-year bond rates go back into the 3's, market valuations should stabilize in the 15-18x range, so stocks today appear to be fully priced for a relatively stable economic environment. Although current profit estimates for 2019 are quite high (double digit growth into the $170+ area), I suspect those figures will come down meaningfully once companies issue 2019 guidance in late January and into February (analysts don't often go out on a limb so they will wait for companies to tell them what to expect).

Putting all of this together and we are unlikely to make new highs in the market anytime soon, in my view. We probably have 10% downside and 10% upside depending on various economic outcomes over the next few quarters. In the meantime, there are plenty of cheap stocks to accumulate and hold for the long term, until attractive exit points present themselves. Goldman Sachs (GS) is a perfect example, at it inexplicably trades for $176 today, below tangible book value of $186 per share.

Full Disclosure: Long GS at the time of writing, but positions may change at any time.

Facebook Sell-Off Hard To Ignore From A Contrarian Perspective

Shares of Facebook (FB) are dropping below $130 today as the high-flying tech sector continues a sharp correction in the market.

After such a punishing drop, it is hard for me to look away because there is a bullish fundamental story buried here, and the valuation is becoming quite undemanding.

From the business side, FB continues to offer a return on investment for small businesses that is unrivaled in the media industry. Couple that with a huge user base, that can make any successful new product launch (dating service, streaming TV, anything else they come up with later on, etc) inherently materially incremental to profits over the long term, and there are reasons to believe that the company's business model is far from broken.

From a valuation perspective, investors are getting FB's operations for about $113 per share (net of $14 per share of cash in the bank). With GAAP earnings of roughly  $7 likely for 2018, and a path to EBITDA of $30 billion in 2019, the metrics look meager on both a trailing and forward basis, despite slowing growth and falling profit margins. I understand that FB is dealing with many operational challenges, but 16x trailing twelve-month earnings? 11x next year's EBITDA, net of cash? At a certain point, the price more than reflects those challenges. It appears we have reached that point, so I cannot help but take notice.

There is still a bear case that deserves to be considered; namely that the business is permanently impaired and that revenue cannot continue to grow double digits. Essentially, the existing business is peaking and new offerings will fall flat (the new Portal hardware device?). Without growth, a near-market multiple would roughly be appropriate.

However, if the core story remains the same; rising revenue will be met with even-faster rising expenses, resulting in lower operating margins and slower profit growth, it appears the stock already more than reflects that outcome. Put another way, if GAAP earnings don't stop at $7 and instead go to $8 in 2019 and $9 in 2020, etc, the stock is not going to stay in the 120's for long.

Full Disclosure: I have begun to build FB long positions in client accounts that have seen fresh cash deposits in response to the most recent market decline and those positions could very well grow over the near to intermediate term based on market conditions

The Dizzying Ride That Is Wynn Resorts Stock Is Not Slowing Down

Since I first wrote about gaming and hospitality company Wynn Resorts (WYNN) three and a half years ago the stock performance has been nothing short of an intense roller coaster. For a large cap company with a relatively simple business, you are unlikely to see more volatility in the equity markets. Such wide gyrations are great for investors, especially those willing to be contrarian and buy when things look the bleakest, but the exercise can admittedly become tiring while also predictable.

Fast forward from May 2015 to today and I am still a rider on this roller coaster. Although I bought stock at low prices and sold much of it at high prices, I failed to sell everything near the top and we are now stuck in a down cycle for the shares, despite the fact that the company is doing just fine.

Below is a five-year chart of Wynn Resorts shares that shows just how dizzying the ride has been:

I was buying the stock in 2015 after the prodigious collapse from the 2014 highs and began trimming positions in late 2017 and well into 2018, but the long-term outlook (still very bright in my view) caused me to hold onto to a smaller position even as the stock reached the $200 level. And now we are left with an interesting question; what to do now?

Given the stock chart above, you would probably guess that Wynn's business is in trouble, but you would be wrong. In fact, company EBITDA this year is likely to come in right around their previous best two years ($1.68 billion in 2013 and $1.61 billion in 2017) and could even reach $1.7 billion, a new company record. As is usually the case, the financial markets extrapolate current results and value the business based on those  near-term figures, ignoring both longer term historical track records and the future outlook a year or two down the road.

That trend is playing out now, as Wynn's business has gotten soft in recent months and is unlikely to bounce back quickly in the near term. Never mind that their Boston property will open in June 2019 and offset weakness seen elsewhere in their property portfolio. Never mind that the company is in the process of designing new additions to their properties in both Las Vegas and Macau that will grow profits over time.

What happens when near-term stock valuations are based mostly on near-term financial results is that prices and investor reactions overshoot in both directions. When things are great, the stock reflects that and analysts have high estimates for future profits and use high valuation metrics due to those rosy outlooks. The opposite is seen as well. This week, as near-term profit expectations come down for WYNN, the multiples used to determine Wall Street price targets will also come down, undoubtedly justified in their minds "to reflect the near-term weakness of the business."

From a valuation perspective, the value of a dollar of profit should not change based on near-term trends. The notion that WYNN should be valued at 15x EBITDA one quarter and 12x the next makes little sense, if indeed we believe that the stock should reflect the discounted present value of all future profits in perpetuity.

To illustrate this phenomenon, let's look at Wynn's stock price and financial results since 2013. The 2018 revenue and EBITDA figures shown are my firm's internal estimates.

As you can see, the stock price reacts far more violently, in both directions, than the actual financial results of the business. In each and every year, the stock move is more aggressive than the year-over-year (yoy) change  in sales and profit. Interestingly, the stock today is 50% below the level of year-end 2013, even though EBITDA is roughly the same.

Generally speaking, this is why it makes sense to many of us in the industry to have a portion of one's investment portfolio allocated to active managers; to try and take advantage of such mispricings in an inefficient marketplace.

In hindsight, it would have been nice to sell every share earlier this year and buy back each of those shares today. In actually, I am quite pleased that I bought it low and sold a portion when I did. While the roller coaster ride that is Wynn Resorts stock can be frustrating at times, there is no reason to jump off now. If my investment thesis is right (the Boston property does well and the legacy resorts in Las Vegas and Macau grow revenue and profits over the long term, despite short-term bumps along the way) then investors will surely get another chance to sell at a fair price in the future, just as they get chances to buy at attractive prices periodically.

Full Disclosure: Long shares of WYNN at the time of writing, but positions may change at any time

IBM: Damned If You Don't, Damned If You Do

For years investors have been clamoring for IBM (IBM) to transform their business via acquisition, as tech infrastructure moves to the cloud and away from IBM's legacy businesses. Despite some very small deals, the company instead opted to buyback stock and pay dividends with its prodigious free cash flow.

To put this capital allocation decision in perspective, consider that between 2010 and 2017 IBM spent $34.4 billion of dividends and repurchased $82.4 billion of stock, for a total of $116.8 billion of profits that were not reinvested in the business over and eight year period. Compare that with IBM's current equity market value of $110 billion. Wow.

The result has been a stagnant business from a numbers standpoint ($15 billion of free cash flow in 2010 versus $13 billion in 2017), and a larger lead for the new age/cloud-based competition.

When we learned yesterday that IBM had agreed to buy Red Hat (RHT) for $34 billion, or $190 per share, a stunning premium of 63% compared with the prior closing price, you could have a few different reactions (or combination thereof). One, "it is about time they make a big move." Two, "well, oh well, it's five years too late." Three, "great move, but why on earth pay such a steep price?"

IBM stock went down yesterday, which makes sense when taking a short term view (the deal is dilutive in the early years), but seems strange with a long term view (could IBM possibly be worth less on a per-share basis with RHT onboard?).

The way I see it is that if IBM was valued at 9x free cash flow without Red hat, it should not be worth less than that with it. But that begs the question, can RHT really make a dent in IBM's massive business? If IBM's valuation multiple is going to expand on the heels of this deal, RHT needs to show up in the numbers.

So let's go through the numbers. RHT adds $3.3 billion of revenue, $650 million of EBITDA, and $775 million of free cash flow to IBM. If we assume IBM uses $10 billion of cash and borrows $24 billion at 5% to fund the $34 billion acquisition, debt costs will rise by roughly $1.2 billion pre-tax. Call it $1 billion annually after-tax. There goes the added free cash flow generation from RHT... completely negated (and more) from the added debt load.

IBM said that they would suspend share buybacks until 2022, so let's assume they use 100% of free cash flow after dividends (roughly $6 billion per year) to repay 50% of the RHT-related debt in 2020 and 2021. At that point, perhaps the RHT business is generating $1 billion of free cash flow and debt service on the remaining $12 billion of incremental RHT debt is $500 million after-tax. The result in 2022 is a deal that is accretive to free cash flow by $500 million, or roughly 4% vs 2018 financial results ($12 billion free cash flow guidance for 2018).

Does this Red Hat deal add risk to IBM? Unlikely. Does it materially change the growth rate and underlying profits of the business? Unlikely. Does it mean IBM stock should go down? Unlikely. Could it result in a 10x or 12x free cash flow multiple longer term, vs 9x today? Perhaps.

Add in a dividend yield north of 5% and IBM stock around $120 per share seems likely to be able to put in a floor, assuming the RHT deal does not spur competing bids. Given the price being paid, it will likely not result in a surging IBM stock price, but from a risk/reward perspective, I would conclude that IBM is a meaningfully more attractive deep value/income-producing stock with RHT than it was without it.

Full Disclosure: No position in IBM at the time of writing, but holdings may change at any time