Boring Portfolio

More on UAM
Still Quantitatively Cheap

By Dale Wettlaufer (TMF Ralegh)

BUFFALO, NY (July 7, 1999) -- Greetings from sunny Buffalo, New York, where I am soaking up the pleasures of Lake Erie, fine Donald Ross golf courses, Allentown, North Buffalo, and the waterfront. Buffalo -- it's a four-season playground! (this message brought to you by the Buffalo Chamber of Commerce). Actually, it's a pleasure visiting my hometown, but the foregoing must be totally uninteresting if you don't come from Buffalo, so let's get back to United Asset Management (NYSE: UAM).

The question of valuing the company comes down to this: On the side of looking at the financials, it's a cash flow sort of valuation exercise, not a GAAP (generally accepted accounting principles) net income accounting exercise. On Friday, I looked at some of the value drivers at work in UAM, including the way I look at return on equity and return on invested capital. Let's say the company never makes another acquisition again. Let's also say that we can grow cash earnings per share (which is the product of reported EPS plus amortization of acquired contracts, adjusted for a 38% statutory tax rate plus goodwill amortization, the last of which I assume is the same pre-tax and post-tax) at 5% per year. The 5% EPS growth can come about through share repurchases or through growing assets under management. A simple annuity formula of EPS / (k - g) where k = the required return of the investor and g = the growth rate of cash flow into perpetuity would put the P/E at x / (0.15 - 0.05) = x / 0.10 = 10x.

With cash earnings as I've defined them above, cash EPS of $2.39 would be valued at $23.90, right around where the market is now. That's using a much higher discount rate than you normally see for stable companies. If we adjusted the equation to reflect something closer to where the market as a whole is valued, using a 10% to 12% discount rate, then the P/E would look like this:

1. P/E at x / (0.10 - 0.05) = x / 0.05 = 20x
2. P/E at x / (0.12 - 0.05) = x / 0.07 = 14.3x

That would put the market value of the equity anywhere from $34.18 to $47.80.

Or you can do the annuity in a longer form in a spreadsheet:

Net present value of cash EPS..... $24.66

The first column is the year the cash flow is achieved, the second is cash flow (or cash earnings, whichever you prefer) growing at 5% per year (starting with the trailing 12 months' figure in Friday's spreadsheet), and the third column is the net present value of that cash flow, discounted at a 15% rate. In the second year 10 row, that's continuing value of the company capitalized at 10 times cash flow per share.

39% of the company's value is found outside the explicit forecast period and 61% is inside the 10-year forecast period. Judging from experience, this is very unusual in that I've found by looking at assumptions on other companies that most of the value lies outside a 10-year forecast period. The value there is consistent with what the annuity model indicates.

Given that I discount at my hurdle rate and don't mess around with betas, something becomes a candidate for acquisition when its discounted value is near the market. Adding to the value of the company is the net present value of the tax shield that is available to equity holders, given that the amortization of contracts is a deductible expense. Looking at the remaining amortization periods for acquired contracts, I get the following series of yearly amortization expenses for 14 years:

Years 1-6: $102 million
Years 7-12: $41.2 million
Years 13-14: $36.2 million

The accumulated value of that amortization should equal the net value of acquired contracts at year-end. The largest parts of the net present value of that tax shield fall within the first six years, as $58 million in yearly amortization expenses resulting in a yearly tax shield of around $0.35 per share will have run their course. In total, the tax shield follows the same declining yearly rate at the amortization expenses, at $38.7 million for the first period, $15.7 million for the second, and $13.8 million for the third (all at a 38% tax rate). The net present value of the tax shield is $211.6 million to $249.8 million, discounting at a 7% to 11% rate, or $3.46 to $4.08 per share. Added to the intrinsic value of the company's equity, that results in intrinsic value of $28.12 to $28.74 per share. Discounting cash flows to equity at 11%, that's $35.06 to $36.68 per share. To all of these, add $1.29 per share in excess cash.

One could go through the same exercise using cash flows to the firm, which is the net present value of net operating profit after tax (NOPAT) less debt plus excess cash plus the present value of the tax shield.

With the highest value of equity using pretty conservative assumptions indicated at 12 times cash EPS, this company is still pretty cheap. UAM has run into some problems with client outflows and a couple of acquisitions that haven't worked out. And in my worldview, the value of the company is predicated upon further investing activities. If, for instance, the company were to engage in further transactions and incremental returns on invested capital were expected to fall below the company's cost of capital for a number of years, that would affect UAM's value. But I believe the company knows how to keep the principals of the firms it acquires happy and interested in growing their businesses. Despite some of the stories that have capitalized on a couple of problems with star fund managers, it appears to me that most of the quality people at UAM's affiliated firms have stuck around and have continuing reasons to do so.

The runoff in assets from defined contribution plans in the midst of a surging bond market and in the face of performance at Pilgrim Baxter is to be expected. It's just not a huge concern for me, not nearly enough for me to stay away from considering an investment. Quantitatively, this company is inexpensive. Qualitatively, I have to mull it over for a while and ask some questions of people who know the industry better than I do. So this company is very much on my priorities list.

Questions, comments, and lower-intensity flames are welcome on the Boring Port message board.

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07/07/99 Close

Stock Change   Bid
APCC  -  5/16  19.56
BRKb  +20      2319.00
CSL   +  1/4   49.25
GTW   +1 3/8   63.63

                  Day     Month   Year  History
        BORING   +0.40%   1.97%   5.95%  42.26%
        S&P:     +0.56%   1.68%  14.13% 132.42%
        NASDAQ:  +0.23%   2.14%  25.10% 163.52%

    Rec'd   #  Security     In At       Now    Change
  8/13/96  200 Carlisle C    26.32     49.25    87.08%
  4/20/99  460 American P    14.48     19.56    35.13%
 12/31/98   12 Berkshire   2276.17   2319.00     1.88%
   2/9/99  100 Gateway 20    72.38     63.63   -12.09%

    Rec'd   #  Security     In At     Value    Change
  8/13/96  200 Carlisle C  5264.99   9850.00  $4585.01
  4/20/99  460 American P  6659.25   8998.75  $2339.50
 12/31/98   12 Berkshire  27314.00  27828.00   $514.00
   2/9/99  100 Gateway 20  7237.50   6362.50  -$875.00

                             CASH  $18091.65
                            TOTAL  $71130.90