Why Microsoft Bought Nokia - and the Implications for the Rest of the Tech Sector

Last month I highlighted a book published in 1996 written by technology writer Bob Cringley (whose real name is Mark Stephens) called Accidental Empires:  How the Boys of Silicon Valley Make Their Millions, Battle Foreign Competition, and Still Can't Get A Date.

Cringley has been following the tech space for a number of years, and has become one of the more astute observers of the group.

He also publishes a blog called I, Cringely which provides regular updates on tech companies.  His work has impact - apparently his recent criticisms of IBM have provoked Big Blue's management to forbid any employees to speak to Cringely upon penalty of dismissal.

Cringely's most recent post on Microsoft and Nokia was very interesting.  He writes that one of the big reasons that Microsoft bought the Finnish company was not because of any intense desire to own a cellphone manufacturer.  Instead, he thinks it was mostly driven by financial engineering decisions:

So why, then, did Microsoft buy Nokia? The stated reason is to better compete with Android and iOS, furthering Ballmer’s new devices and services strategy, but I think that game is already lost and this has more to do with finance than phones.

Microsoft, like Apple and a lot of other companies, has a problem with profits trapped overseas where they avoid for awhile U.S. taxation. The big companies have been pushing for a tax holiday or at least a deal of some sort with the IRS but it isn’t happening. So Apple, sitting on $140+ billion has to borrow $17 billion to buy back shares and pay dividends because so much of its cash is tied-up overseas. But not Microsoft, which just bought Nokia — a foreign company — with some of its overseas cash. Redmond said so today. That makes the real price of Nokia not $7 billion but more like $4.5 billion, because it’s all pre-tax money.

Not only is Nokia cheaper than it looks, those 32,000 Nokia employees coming over to Microsoft transform the company into a true multinational with all the tax flexibility that implies. Microsoft may never pay U.S. taxes again.

http://www.cringely.com/2013/09/03/microsoft-really-bought-nokia/

So if Cringely is right - and I am inclined to think that he is - we may start to see more tech mergers outside the U.S.

Which may also mean that one of the main legs of those bullish observers on the tech sector - that they are sitting on huge stockpiles of cash that will eventually be returned to shareholders - may be much weaker than many realize.

What Will Be the Effect of Higher Interest Rates on Financial Stocks?

Although bond prices are staging a mild rally this morning in the wake of today's weak employment report, the course of interest rates seems to be undeniably higher.

The yield on the 10 year Treasury note poked above 3% earlier this week for the first time since July 2011. 

The yield on the 2 year Treasury note moved higher than 0.50% for the first time in a couple of years despite recent Fed announcements that point to a continuation of low short term rates for at least another year.

As the chart above shows, financial stocks have been strong performers over the past couple of years.  Using the Financial Sector exchange-traded fund (ticker: XLF), financial stocks have risen over +60% over the past two years compared to +42% for the S&P 500.

Bank stocks have benefited from a number of tailwinds.  Investor sentiment on the group was negative in the wake of the 2008 credit crisis, and valuations were at historic lows.  In addition, with the improvement in housing, mortgage volumes increased dramatically, as did other lending business.

Can the good relative performance continue?

Erika Penala of Merrill Lynch was in town earlier this week to discuss her views on bank stocks.  I have written about Erika on several occasions on Random Glenings, as I find her to be one of the most insightful bank analysts on Wall Street.

Erika pointed out that the effect of rising interests on bank stocks is more nuanced than many investors believe.

She noted that while many believe that a rise on longer term rates are always good for banks, if interest rates on short maturities increase by the same amount or more the effect on banks could be negative.

She distributed a handout titled "Debunking 8 Interest Rate Myths".  While all of her points were interesting, I thought I would highlight three:

• Over 50% of a typical bank earnings are NOT priced off long rates.  The simple view that rising rates on longer maturity assets like mortgages is not necessarily a prelude to robust earnings;
• Rising rates are not always good for bank stocks.  Historical evidence has been mixed, and the sector tends to underperform when short rates rise and outperform when the yield curve steepens.
• Rising interest rates do not always generate more bank revenue.  Bank revenue growth historically has been disconnected from rising interest rates on longer maturity bonds.  In addition, higher long rates could mean lower mortgage banking revenues.

Erika also reported that she had visited Wells Fargo in San Francisco a couple of weeks ago.  Wells is the largest mortgage lender in the United States, but they reported that mortgage volumes have dropped dramatically in recent weeks in the face of higher interest rates. While Wells felt comfortable that other parts of their business should help maintain earnings, there is no doubt that higher rates are hurting.

Checking In on J.M. Smucker's

 
As I mentioned in yesterday's post, I have spent the last couple of days at the Barclays Bank "Back to School" conference here in Boston.

My clients own stock in a number of the companies that presented this year:  Colgate; Procter & Gamble; Coca Cola Enterprises; and General Mills, to name a few.

But one of my favorites is J.M Smucker (ticker: SJM).

Smucker's, of course, is somewhat of an iconic American brand, thanks in part to its commercials which evoke nostalgia for a bye-gone era.  With taglines like "With a name like Smucker's, it has to be good", the company created a homespun image for its jams, jellies, peanut butter and a variety of other regularly used food items.

The company in recent years has undergone a major change in the way it runs its business, mostly for the good.  The stock has been a winner for investors, also, as the above chart shows.  The price of SJM has grown on average of +12.5% for the past five years compared to +10.3% for the S&P 500.

Over the last few years, SJM has bought several brands from Procter & Gamble, including Crisco Oil and Jif Peanut Butter, and managed to re-energize sales in a dramatic fashion.  Jif, for example, is now a $1 billion brand thanks to SJM's marketing initiatives.

The biggest acquisition for SJM in recent years, however, was its purchase of Folger's coffee from P&G in 2008.  I remember hearing SJM talk about the purchase at the 2008 "Back to School Conference".

At the time, SJM management said that while a purchase of this size seemed daunting - the $3 billion price tag was more than the total sales of SJM at the time, and they assumed a considerable amount of debt in the process.

But as I recall, management was very confident they could make the deal work, mostly because they had done their homework.  Management had spent 18 months in the field, learning everything they could about the coffee business. In addition, because they had such extensive experience in the "center of the store" grocery business, they knew how to market what seemed to be a tired brand to a whole new group of consumers.

This is fairly typical of the way the company is run, by the way. There are several generations of the Smucker family that is involved in running the company, and most of senior executives who share the last name of Smucker own a considerable amount of shares.  While they do not own the company, they run it as if it was still theirs, which makes them careful stewards of shareholder investments.

The coffee business has turned out to be another success story for the company.  In our meeting yesterday, management pointed out that coffee sales represent roughly $2.3 billion of revenues, or about 39% of the company's total sales. They have not only re-energized Folgers (focusing on the single serving K-cup that has become very popular in home coffee use) but has expanded its partnership with Green Mountain coffee and Dunkin' Donuts.

SJM is trading today at a significant premium to the S&P 500:  21x trailing twelve month earnings vs. 14x for the S&P.  As much as I like SJM management, buying the stock at today's levels is a fairly large leap of faith.

But as Warren Buffett often reminds us, it is better to buy a great business at a fair price rather than a fair business at a great price. And that might be the case with SJM today.