Boring Portfolio

<THE BORING PORTFOLIO>
More Equifax and USB Numbers
And Random Thoughts

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (March 24, 1999) -- Someone asked me this morning why we haven't summed up our philosophy in the Bore port. I thought we had, but I'll repeat it because I know we can get sidetracked at times with details and not state the big picture enough. The one thing you need to know about us is that we like companies that can generate a large amount of earnings from a small amount of capital. The second thing you need to know is that we prefer companies that have the ability to retain those earnings and reinvest them in similarly high-return projects.

That's it. That's all you need to know about us. We can get into a lot of complicated concepts on how to value these things, but if you took some basic math in high school, you should be able to discount cash flows pretty easily. Further, if you know how to discount a bond, that's pretty much the way we think about things. If we had two bonds that are currently yielding 5%, and with one you could reinvest the coupon income at 15-30% and with the other you could reinvest the coupons at 10%, all else being equal, the first bond would be more attractive. That's the way bonds are priced. It's not just the current yield that is important, but the yield on reinvested coupons that determines your yield to maturity. When we look at return on capital, economic value added, and discounted cash flows, we're just trying to figure out what those future coupons might look like.

For instance, with Equifax (NYSE: EFX), if we bought the company today (basing things off Q3-end results, since we don't have a Q4 balance sheet yet), we would be paying 4.04 times invested capital for a company that returns $0.2036 for every dollar invested in the company. If we were to acquire such a company today, our return on capital in that business would be 20.36% / 3.89, or 5.04%. On its own, that's a low return, but you want to look forward at the opportunities to reinvest that cash. For example, Equifax has deployed hundreds of millions of dollars of capital in Brazil over the last year to acquire major interests in a credit card processor and a commercial and consumer credit information company in that country.

The appeal of this kind of company is the international expansion potential. While everyone was excited about the Asian "tigers" back in 1993, I'm personally more excited by it now that the hot air has been taken out of some of these markets. This is a basic financial infrastructure company, like Berkshire Hathaway's (NYSE: BRK.A) General Re unit. The big plus with this kind of company is its ability to extend its strengths in software and intellectual property to other markets. Lenders need to know something about borrowers, both at the initiation of the process and throughout a credit relationship, depending on the financial product. So Equifax is both a transaction-based company and it has annuity elements to the business. Along with the defensibility of the assets, Equifax has offensive elements to its business, such as its ability to apply those assets in new applications like Web-based credit information services. For instance, the company does authentication for eBay (Nasdaq: EBAY), which is an incremental line of business.

We can just eyeball the numbers on Equifax and see that it's a fine business. However, I've included some valuation work I've done on it, along with the business model. I believe the company is pretty fairly valued at right around $36 per share, discounting cash flows at 13% to 15%. I put some stress testing in the EVA model, but to be honest, I'm not totally familiar with what the company's capital needs are and precisely how much it can grow. Sometimes you just to look at a business and say "that's a fair price" or "that's not a fair price." In other words, I could mess around with spreadsheets all day on this. We're open to comment on the spreadsheet, however, on the Boring portfolio message board.

We'll get to a follow-up on US Bancorp (NYSE: USB) in a moment, but first some random notes.

I'm attaching a survey of salaries (Rich-Text Format: 6K) and holdings for insurance executives at major firms, brought to my attention by a fellow Buffalonian who works in the reinsurance business. I think the survey shows a couple great things: 1) Berkshire's Chairman gives us unbelievable bang for the buck, even though our income statement might understate the cost of doing business. Just a little Ben Graham joke there. We're unbelievably fortunate to have such an experienced manager running the company -- he's a bargain even if he were at the top of the list. 2) Both Chairman Buffett and GenRe CEO Ron Ferguson have substantial dollars invested in our company. Of course, you probably know about Mr. Buffett, but Mr. Ferguson is obviously a guy that believes in eating his own cooking, too.

We're glad that the CEO of the largest unit at Berkshire is not on the "moral hazard list," which includes CEOs who get lots of upside from stock options and much less downside. If Berkshire's stock goes down, then Mr. Ferguson hurts as much as we do. And we appreciate that sort of thing in management. The whole thing about "aligning management's and shareholders' interests" is junk unless management has real capital on the line and can suffer diminution in personal wealth if poor decisions are made. I'm not kidding about the moral hazard thing, either. There are lots of former S&L guys running around who destroyed billions of dollars in wealth without any personal consequences. Some of the biggest S&L blowups were in my hometown of Buffalo. Far from being scorned in my community as total jerks who royally screwed up, some of these people are courted as good businessmen and citizens. It's really very screwed up.

Here's an eye-opening article on the quality of some IPOs coming out right now: "It takes an iVillage to raise millions." The author, by the way, frequently indulges in rip jobs, so take it with a grain of salt. I'm a pussycat compared to this guy.

I recently interviewed the CEO of one of the companies on our radar, Network Appliance (Nasdaq: NTAP). Here's the link to that interview. I hope it helps people who are interested in the company. I wanted to be more basic and kind of open-ended and not really talk about the technical details of the storage and caching market. It's more an interview for those who don't know the company than it is anything else.

I ran into news.com's "Computer Darwinism" series yesterday. I thought it was excellent, though I must confess that I might be biased, as many of the viewpoints and facts in the series reflect my viewpoints and the facts that I consider in looking at the PC industry. Notice, also, that Michael Dell thinks the PC industry will continue to grow units at 15% annually over the next ten years. Should I listen to the apocalyptic columnists at thestreet.com, whose views on PC companies might be good for traders but are not useful at all for investors (in my opinion), or should I listen to Michael Dell on PC unit growth? Not a tough choice, and I don't think Michael Dell is trying to pump his stock, either. In all the years I've watched the PC industry, I've never seen a more doleful round of worrying about normal seasonality and normal price deflation than I have this year.

I'm thinking about pairing a Lucent short with our Cisco long. Cisco might be carrying a seemingly high valuation, but it's a better-run company and it's in a much better place strategically than Lucent. And Lucent is FAR from being reasonably priced here.

Finally, here's how US Bancorp's numbers from the 10-K break down. As you can see below, this is a very well-run bank holding company. For its peer group (over $10 billion in assets), it's in the top 5% of bank holding companies in pre-tax net opertating income as a percentage of assets (and that includes heavy amortization of goodwill) and it's in the top 6% of bank holding companies in net income as a percentage of assets.

It's also right below the top 20% in interest income as a percentage of assets and in the bottom 25% of companies in interest expense as a percentage of assets. Its core deposit franchise is excellent, and its noninterest income diversity and growth are very good. These were all from the third quarter of fiscal 1998 -- for the full Federal Reserve performance report on the National Information Center website, click this link. 

USB
(Dollar amounts in millions, except per share numbers)

Price/Valuation

Share Price...$33 1/16
Market Cap...$24,604.39
Price/Book...4.12
Price/ Tangible Book...6.16
BVPS...$8.02
Price/Assets...32.19%
Price/Net Loans...42.33%
Price/Deposits...49.18%
Price/Tangible Assets...33.04%
Price/Revenues...4.63

P/E...16.71
Amortization-Adjusted P/E...15.22
Discount/Premium to Group...22.3%
EPS...$1.98
Cash EPS...$2.17
Diluted Sharecount...744.18
1999 EPS Estimate...$2.21
2000 EPS Estimate...$2.49
Multiple on 1999 Est....14.96
Multiple on 2000 Est....13.28
Amort-Adjusted Multiple on 1999...12.32

Capital Productivity/Efficiency

Asset Turnover2...7.37%
Asset Turnover...7.20%
ROE2...27.26%
ROE...24.83%
Amortization Adjusted ROE...38.47%
ROA...2.19%
ROA2...2.241%
Net margin2...30.40%
Net Margin...27.70%
Efficiency Ratio...46.72%
Interest Income/AEA...8.56%
Interest Expense/AEA...3.71%
Net Interest Margin...4.84%
Net Share Buybacks (Including preferred)...$743.6
Dividends on Common...$516.4
Preferred Dividends...$0
Retention Rate...68.05%
Payout Ratio on Amort. Adjusted Earnings...31.95%
Internal Capital Generation Rate...18.55%
Owners' Yield...5.12%

Balance Sheet

Cash & Nonearning Assets...$8,248.0
Cash & Nonearning Last Year...$8,021.0
Long Term Debt...$14,731.0
Shareholder's Equity...$5,970.0
Last Year Equity...$5,890.0
Tangible Equity...$3,995.0
Last Year Tangible Equity...$4,408.0
Tangible Assets...$74,463.0
Last Year Tangible Assets...$69,813.00
Total Assets...$76,438.0
Earning Assets...$63,138.0
Last Year Earning Assets...$63,274.0
Last Year Assets...$71,295.0
Total Liabilities...$67,623.0
Goodwill...$1,975.0
Last Year's Goodwill...$1,482.0
Gross Loans...$59,122.0
Loan Loss Reserves...$1,001.00
Loan Loss Reserves %...1.69%

Leverage

Equity/Tangible Assets...8.02%
Average Equity/Average Assets...8.03%
Average Equity/Average Assets (Tangible)...5.82%
Assets/Equity...12.46
Avg. Assets/Avg. Equity (Tangible)...17.17
Loans to Deposits...118.16%
LT Debt/Equity...246.75%
Leveraged Capital Ratio...6.80%
Tier 1 Capital Ratio...6.40%
Total Risk Based Capital Ratio...10.90%

Income Statement

Revenues...$5,316.60
Interest Income (TTM)...$5,407.4
Interest Expense (TTM)...$2,346.8
Net Interest Income...$3,060.6
Provision for Loan Losses...$379.00
Noninterest Income (TTM)...$2,256.0
Noninterest Expense (TTM)...$2,627.80
Net Income for Common (TTM)...$1,472.71
Amortization Adjusted Earnings...$1,616.41
Noninterest income/revenues...42.43%
Noninterest income/NII...73.71%
Amort. Adjusted Net/Revs....30.40%
Amortization of Goodwill...$143.70

Credit Quality

Nonperforming Loans...$278.90
Nonperforming Assets...$304.3
Loan Loss Provision/Net Interest Income...12.38%
Loan Loss Provision/Gross Loans...0.64%
Charge Offs...$592.10
Recoveries...$157.90
Net Charge Offs...$453.90
Nonperforming Assets Ratio...0.51%
Reserves/Nonperforming Loans...358.91%
Months Net Charge-Offs in Reserves...26.5
Months Charge-Offs in Reserves...20.3
Loan Loss Provision/Net Charge Offs...83.50%

Deposits

Deposits...$50,034.0
Noninterest bearing deposits...$16,377.0
Noninterest bearing deposits last year...$14,544.0
Noninterest deposits/deposits...32.73%
Deposits/Liabilities...73.99%

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