Valuation Metrics by Industry From Stu Linde, Head of U.S. Equity Research, Lehman Brothers smartwomansecurities © 2006 Smart Woman Securities. All materials.

Valuation Metrics by Industry

From Stu Linde, Head of U.S. Equity Research, Lehman Brothers

smartwomansecurities

© 2006 Smart Woman Securities. All materials are for SWS

members’ use only

November 8, 2006

By Industry

• Consumer Discretionary & Staples

– Retail; Consumer Goods

• Financials

– Banks; Asset Managers; Asset

Services; Life Insurance; Property

Insurance

• Healthcare

– Pharma; Generics; Biotech;

Medical Devices; Health

Insurance; Managed Care

• Media

– Media & Cable

• Technology

― Telecom, Info

Tech Software; Hardware; IT Services

Consumer

Consumer Discretionary & Staples

• Consumer spending as a share of GDP is on the rise and near 70%

• Trend towards more durable goods purchases; sourcing is more global

• Consumer credit up-cycles last 34 months on average

• Huge diversity in consumer proto-types• Income trends impact decisions

– Inflation

Consumer: Retail• Very low margins and few barriers to entry• Keeping customers from competing stores is a huge

challenge, long-term• Unique products are hard to keep unique; so low price

model often wins out• Category killers (HD, LOW, ODP, SPLS, WMT) achieve

economies of scale in traditionally mom and pop or regional businesses.

• Move off the mall trend has hurt the traditional anchor tenants – duel income families don’t have time to find selection, quality, and reasonable prices at different places. They go where they get it all and get it fast (WMT, TGT, KSS)

Things to Watch and Monitor

• Same store sales comps – investors often over-react to one month’s bad comps

• Sales per square foot and inventory trends Valuation and macro trends since the strongest models are well known

• Most have little debt on the BS but be mindful of off-BS obligations (leases)

• Employee moral and culture (PT vs. FT workers) – they interface with shoppers

• Cash conversion cycle trends: days inventory + days receivable – days payable

• On-line competition

Consumer: Consumer Goods

• Slow growth but very profitable, steady performers

• Scalable models• Old, already largely consolidated industries • Market share wars common (Coke vs. Pepsi) • New products differentiate growth trajectory

(Gillette Sensor and Mach 3 Razor)• Growth by acquisition • Defensive investments


• Slow growth means the focus is on costs and quality of acquisitions

• Slow growth means international sales (and currency trends) are very important

• Valuation and FCF• Use of enormous CF – dividends and share repurchases • Economies of mass scale• Recurring charges after acquisitions• Branding – is it being supported with adequate

advertising?• Increasing power of key retailers (WMT)• Litigation risk – tobacco and high fat products

Financials

Financials

• Growing share of U.S. profits• Share of S&P 500 index (22%) where

past sectors have hit the wall• Benefits from more trade, longer lives,

older populations, and rising affluence• Has exposure to world growth no matter

which sectors generate it• Vital and strategic part of any developed

economy for liquidity and capital

Financials: Banks

• Extremely capital intensive• Regional oligopolies; high switching costs• Not as rate sensitive as they used to be 10-20 years ago• Net interest income (loan rates higher than deposit rates)• Non-interest income (fees) – depositors literally pay banks

for liquidity• Huge, diverse loan portfolios reduce risk and enable lower

capital costs• FDIC guarantees over half the industry’s liabilities • Key strategies include global reach (C), national reach

(BAC), attracting cheap deposits (WFC), right side of balance sheet focus (FITB), and location and customer service (CBH)


• Strong asset base: equity–to-assets ratio of 8-9% (the level varies)

• High levels of loss reserves relative to nonperforming loans

• ROEs of 14-20% (if its much higher, double-check the loss reserves)

• ROAs of 1.2-1.4% or better• Since bank assets are financial and liquid, P/B is the most

common valuation metric and a ratio under 2.5-3.0 often projects good value for a strong large bank

• ROIC analysis is preferred because banks can quickly change their balance sheets, and this analysis is only published by Lehman Brothers, Inc. at present

• DCF analysis is also preferred to P/B and is available at Lehman Brothers, Inc.

Things to Watch and Monitor (Cont’d)

• Lending profitability: net interest margins of 3-4%: high end when rates are low and low end when rates are high

• Fee income share of revenues and fee income growth trends• Efficiency ratios of 55% or less (operating costs as a share of

revenues)• Credit quality: BS, loan categories, nonperforming loan and charge-

off trends • Risk: almost everything known about credit quality is after the fact,

sometimes fast growth signals riskier lending standards• Portfolio diversity• Aggressive collection procedures• Asset (loans) sensitivity in a rising rate environment is preferred;

liability (deposit) sensitivity in a falling rate environment is preferred

Financials: Asset Managers

• Wide margins and excellent economies of scale• Stock prices reflect market optimism or

pessimism (pays to be contrarians)• The most valuable assets are the PMs• Diversity of assets and products helps weather

various market cycles and allows asset rotation to stick within the firm

• Assets held in tax deferred portfolios are sticky assets

• Reputation and regulatory risk


• Assets under management (AUM) = cash flow

• Stocks have higher fees than bonds; bonds have higher fees than cash

• Inflows in a variety of market environments

Financials: Asset Services (Custody)

• High barriers to entry; size begets more clients

• Lower fees and more economies of scale than Asset Managers

• Frequently outsourced by Asset Managers

• Typically offers performance analysis analytics, pension consulting, etc.


• Assets under management (AUM) • Economies of scale have lead to

consolidation• Generous lending to custody clients

(BONY loans to Telecom and Cable in 90s)

Financials: Life Insurance • Mature, slow growth industry with easy to substitute products• Thin margin between ROE and cost of equity• Best to adopt a value approach investing in these stocks• Regulatory and huge capital requirements are only real

barriers to entry• Complex products and financial statements• Takes many years to know if a policy was priced correctly• Claims normally 75% of premiums• Extensive distribution system is a core asset; so biggest firms

have an edge• Net income tends to revert to the mean over time, although

investment returns can vary greatly one year to the next


• Near industry premium growth is preferred, as this is an industry where under-pricing risk to increase sales is bound to fail

• Credit rating (AA or better) – people want to know their insurer will be around

• Diverse investment portfolio and risk management culture (low junk bond to tangible equity or total assets ratios)

• Since there is little detail on actuarial assumptions and returns are hard to predict, tangible book value ex-marked-to-market gains or losses on available for sale securities from shareholder’s equity (in the 10-K) is an important metric

Financials: Property & Casualty Insurance

• Commodity business • Thin net margins; low ROEs• Low levels of pricing power; very hard to predict

costs• Claims normally 70% of premiums• They invest the float (premiums received long

in advance of paying claims)• Good management can often play the insurance

cycle and acquire poor performers when they are very cheap and turn them around


• Make sure management has some skin in the game (owns part of firm)

• Combined ratio is the key profit measure, less than 100 means profitability

• Firms with a combined ratio over 105 for more than a short while typically have trouble recouping their losses via investment earnings

• Unless Warren Buffet is the PM, look for a small equity share of investments

• Investment ratio + combined ratio = operating profit ratio


• Social trends: there has been a tendency for juries to award huge claims that were written years ago under more conservative judicial assumptions (Asbestos)

• Regulation: insurance rates are often approved on a state-by-state basis and are often required to insure less profitable customers without charging them higher premiums as compensation. In many states, insurers are required to fund the losses of competitors who become insolvent

• Voting mood: CA Prop 103, 20% cut in premiums. Customers can lobby states.

• Best to invest with a value approach

Healthcare

Health Care

• Strong growth characteristics: 9% of GDP in 1980 and 15% of GDP now

• $5,444 per capita spending in 2002 in US, 50% higher than next closest country

• 60% of elderly in bottom 2 income quintiles; 75% of uninsured live in households of $50k or more in annual income

• Aging population, longer life spans, desire to be active and healthy later into life

• High barriers to entry: high start-up costs, patent protections, significant product differentiation, economies of scale, long drug development cycle

• Intangibles: provider networks, clinical track records• Pricing issues: costs paid by insurance plans limits consumer

price sensitivity

Health Care: Pharma

• High margin, high FCF, near debt free, $500m and 10-15 yrs to make a new drug

• Procedures are expensive and create demand for cheaper drug solutions. e.g. surgery vs. pill

• Many new drugs are evolutionary rather than revolutionary

Things to Watch and Monitor• ROICs – look for mid 20%+• Gross Margins – look for around 80%• Net margins – look for 25-35%• Focus on high FCF - needed to fund R&D• Political pressures• Pipeline –new drugs to offset looming patent expirations• Preclinical Trails – focus on potential toxicity • Phase I – focus on safety and efficacy• Phase II – how well the drug works vs. what’s out there• Phase III – most costly trial. Focus on efficacy. • Blockbusters need to be bigger to create meaningful percentage

growth• Greater specificity of future drugs means smaller target population

per drug

Health Care: Generics

• Excellent growth outlook: half of all scripts are generics and the share is rising

• Few pure plays • After 180 day exclusivity the edge goes

to the lowest cost producer


• ROICs – look for around 10%• Gross Margins – 40-50%• Net margins – 15-20%• 1st patent challenges• Re-importation and foreign competition

Health Care: Biotech

• Diverse industry with value drivers varying widely by company

• Highly complex and evolving industry• Leading edge of molecular biology, IT, mathematics,

quantum physics, combinatorial chemistry, electronics and material science

• Drugs and bilogics with greater specificity of action vs. Pharma

• Biologic process (cellular and molecular) vs. chemical process of Pharma

• Many one drug or one technology companies; fewer well diversified product suites

Things to Watch and Monitor• High FCF and cash on BS – needed to fund R&D• Research productivity versus financial discipline• EPS and sales growth• Relative Valuation – volatile swings between optimism

and pessimism. Often pays to buy on big dips• Script trends • 10-Ks – often the best description of what’s going on• Independent sales force – reduces dependence on

partners• Many late stage trials are the best assurance of

forward growth

Health Care: Medical Devices

• Excellent growth outlook – aging population that wants to be active

• High switch costs with Doctors; sales force often assists in surgery

• Switch costs lower with cardio devices than orthopedic devices

• Long clinical histories, patent protection, and economies of scale

• Patents protect devices and tools for their installation• Most improvements are evolutionary rather than

revolutionary


• Product innovation and diversification (10-Ks best place to look)

• Strong margins and earnings trends • Relative Valuation• Excellent pricing power –

Medicaid/Medicare reluctant to limit brand choices

• Legal strategies often used as a defensive tactic vs. competitors

Health Care: Health Insurance/Managed Care

• Litigation risks and regulatory pressure reduce attractiveness

• Insurance companies run the risk of under-estimating health care costs

• Rising health care costs makes fee based businesses relatively more attractive, such as claims processing or network access


• Medical loss ratios (medical costs paid/premium revenue) of 85% or less w/trend in right direction

• Minimal dual-options – more choice allows customers to shift costs based on asymmetric knowledge to the provider and creates more industry competition

• Exposure to government accounts – reimbursements generally lag health care inflation rates

Media

Media & Cable

• CDs, movies, and books generate one time transactions and are dependent on stars and authors; costs precede revenue

• Subscription-based models generate recurring revenue; revenues precede service costs

• Advertising models have high operating leverage• Intangible assets: licenses, trademarks, copyrights,

and brands. • Few cities can support more than one newspaper• Cable faces challenged from satellites teaming up

with RBOCs


• FCF margins of 7-10%• Deregulation: has lessened competition in

broadcasting• Recurring capital investment to fend off

competition• Transforming mergers (AOL/Time Warner) • Family run firms • Complicated cross-ownership structures• Ridiculous CEO compensation

Technology

Information Technology• Growing share of equipment and total capital

spending• IT spending is influenced by the incentive to

substitute capital for labor• Only true cyclical growth sector • 64-bit generation of products in very early

stages• Most aggressive users of stock options as

compensation• Trend towards processing and technology-

based outsourcing services

Information Technology: Software

• Intense competition but high customer switching costs• Huge economies of scale• High FCF; high ROICs• Simple financial statements • Excellent growth prospects• High labor costs encourage the use of software for time-

consuming tasks• Software helps companies grow in good times and cut costs in

lean times, but it is highly cyclical and depends on IT spending• Many types: operating systems, database, enterprise resource

management, customer relationship management, security, video games, etc.

• Back-end loaded quarters with majority of revenue booked in final days are the norm and this raises the odds of having big surprises

Things to Watch and Monitor• Network effects – people will create documents

or files and use software if they know the majority of PC users have the same software (Acrobat Reader, Excel)

• Branding –easier for small business or retail software (QuickBooks, TurboTax)

• Sales, EPS, and CF trends

• Expanding margins over time due to scalable models

• Large, stable installed client base


• License revenue best reflects current demand for products and leads service (less profitable) revenue

• Deferred revenue shows cash the company has received before it performs a service and is a good metric for gauging future revenue

• Days sales outstanding (DSO) – trend matters more than level

• Watch out when a firm changes its rules for revenue recognition

• Watch out when a vendor and customer simultaneously buy each others products

• They always look expensive

Information Technology: Hardware

• Cost of computing and storage is going down• Able to manufacture in low cost countries and sell in developed

ones• Highly cyclical industry• Short product cycles, price competition, and technological

advances make it hard to sustain the lead, so distribution channels, scale, and broad product lines are needed to establish a more secure position

• Key asset is the ability to innovate• Switching costs are higher in telecom equipment• Low cost model often wins• Analog chips are highly proprietary and lack direct substitutes and

work on temperature, weight, pressure, and sound rather than 0s and 1s

Things to Watch and Monitor• Network effects – hardware needs to run on an

operating system and be maintained by people who must invest time to operate the product

• Market share • Marketing focus• Flexible models – since demand us so

unpredictable• Gross and net margins • Intellectual property sales • Best to invest with the cycle – very cyclical stocks

often look rich near the trough and cheap near the peak on valuation metrics

IT Services

• B-to-B is growing faster than the overall economy• Outsourcing trend apt to continue• Technology and data processing services can

spread systems development costs over many firms

• Benefits from falling cost of technology• Long-term contracts lead to recurring revenue• Have earned above average returns• Economies of scale prod acquisitions to achieve

higher and higher levels of volume: ADP, FDC • High barriers to entry


• Services vary a lot by company• Service differentiation – needed to

protect sizable investments in software, hardware, and sales networks

• Sales, EPS, valuation

Telecom

• Telecom looks nothing like it did 25 years ago and in another 25 years it will probably have little resemblance to what it looks like today

• Long distance deregulated in 1984: AT&T break-up• Local deregulated in 1996: Telecom Act of 1996 allowed AT&T

and WorldCom/MCI to lease networks at discounted rates• Poor and declining ROICs; low asset turnover ratios • Rural carriers least affected by deregulation• Recurring expenditures and huge fixed costs to build a network• Competition from cable and wireless networks• Most of U.S. population has access to 1-2 local services • 80% of U.S. population has access to 5 or more wireless carriers


• ROICs – borrowing regulatory changes, firms may never earn their cost of capital again on long distance

• Churn – firms need recurring revenue to pay for network costs

• Operating margins of 20-30% - below this level makes it hard to provide customer service, maintain the network, and earn the cost of capital

• EBITDA margin trends – as a guide to cash generation for capital spending needs and the ability to service debt

• Operating CF – EBITDA can obscure accounts receivable• Financial strength and flexibility to technological and

regulatory change

Valuation Metrics by Industry From Stu Linde, Head of U.S. Equity Research, Lehman Brothers smartwomansecurities © 2006 Smart Woman Securities. All materials.

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