Intel (INTC) and Research in Motion (RIMM)
Intel (INTC) and Research in Motion (RIMM) came onto CT Capital’s buy list over the past month after having been brow-beaten by many security analysts. Analysts believed these firms are, or soon will be, succumbing to the modern tablet era which will either make their current product line-ups obsolete or less relevant, as a new stream of products gains a foothold on their market share.
How should this be construed and evaluated by the securities analyst, and more importantly, do the stocks of these firms offer value for investors?
The means to adjust for such events is through the discount rate (cost of equity), which measures the uncertainty of the free cash flows. Thankfully, in both cases we have a long enough history covering several business and product cycles from which a free cash flow projection can be conservatively estimated.
We find both firms are somewhat undervalued and have been value-creating enterprises.
If, however, the cash flow characteristics changed, even quarterly, given they are consumer led—could result in a ramp up to cost of equity and cause a lowering of fair value. But keep in mind, their high cost of equity capital already takes into account some of this uncertainty, such that we would not overreact to disappointment. On the other hand, if the cash flows of these firms grow by a modest amount, their stocks would see large appreciation from current levels.
In RIMM’s case, the riskier of the two, which we assign a 11.47% cost of equity, about 25% higher than the median S&P 500 company—we expect to see uncertainty of cash flows , and if we get it, it would not force a sale as fair value would not change. In 2006, RIMM had negative free cash flow, and for 2009, its free cash flow was about half of its prior year—thus we expect to see volatility of metrics and are prepared for it given the free cash flow yield the firm now offers. I point out investors who held RIMM shares throughout 2006 and beyond were richly rewarded for making an accurate assessment of risk and free cash flow, presuming they had the sense to sell when valuations reached ridiculous levels (to that below treasury yields).
RIMM’s cost of equity is also raised from its operating cash flows, which are normalized as lower than reported, the announced large share repurchase program (which will not add value) , and deterioration in net working capital to total debt. On the other hand, its credit remains strong and the company possesses a good deal of financial flexibility, if needed for protection or value-adding opportunities. Its large research budget has yielded increasingly higher normalized revenues and cash flows.
When we discount RIMM’s free cash flows using its high cost of equity, it results in a fair value of $57.38, about 20% higher than its stock is currently selling. A 1% reduction in the cost of capital increases fair value to $63.13, or 10%. With its stability metrics, RIMM will almost carry a higher cost of equity, which must be evaluated as closely as its revenue and free cash flows-see table for sensitivity to changes.
Only after such analysis can the investor be comfortable and fair value be established.
The sensitivity analysis is based on RIMM’s current level of free cash flow to which 3% annual growth is assumed and a $48 terminal value in 20 years (zero appreciation).
Figure 1: RIMM Sensitivity Analysis-Current Free Cash Flow and Cost of Equity
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Disclosure: No positions
Kenneth S. Hackel, CFA
President
CT Capital LLC
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