>>What intrinsic value should we assign to WIND?.In Post #108 you offered a set of projections for WIND's earnings with growth rates ranging from 50% to 136%..
In past posts I railed against inappropriate techniques for valuing WIND, e.g. trailing PE ratios, and I have tried to downplay concerns about volatility, discussing the nature of risk head on. I have challenged, but not fully explained, asset allocation, essentially arguing that it is best ignored and it is theoretically justifiable to concentrate investment in a small number of high-quality growth stocks. I have projected some possible future outcomes for WIND, including occasional near-term projections (one just the other day). I have done all these things, but what I have never done is put a value on WIND stock. Of course I routinely calculate an intrinsic value for WIND; I have just never posted the figure.
Let's do it now - but only after explaining what it means and how it is done. Whatever I, or anyone else says, is the intrinsic value of WIND, the number is only useful if its derivation is understood clearly. Only then can the serious investor judge the accuracy for personal use. Incidentally, I get questioned frequently about what I think about WIND valuation. Is the PE ratio too high? How much higher can it get? How long should it be held? At a dinner party just prior to the ESC in September, some happy WIND investors were telling me that the stock, at about $36, just couldn't go any higher for a while. I just smiled, not offering an opinion, but knowing the ESC was coming the next week, no doubt accompanied by the sort of news that would push the stock, and it did. I went to a technical show last Spring, and visited the Wind River booth, catching it in between other visitors. As I was talking to the Wind salesperson at the booth, three other WIND representatives returned from lunch and joined the conversation. What were we talking about? WIND stock value, and why they should try to horde whatever shares they can get their hands on, despite the apparent high price. That's right, even WIND employees struggle with stock valuation.
The valuation of a company like WIND is not a light matter, so it has to be done constructively, and carefully to be trustworthy. Lets start by redefining Intrinsic Value, and discussing what it means to us, and how we intend to use it. It is commonly understood that stock is valued on the basis of the free cash flow it generates now and in the future, and Intrinsic Value is the present value of that cash flow. In more practical terms, Intrinsic Value can be viewed as the value the market would place on the stock if its future earnings and consequent cash flow were completely known in advance. It can also be viewed as the price you might pay today for the stock so that in many years from now you would feel that you got a decent return comparable to high-quality bonds. If interest rate remain unchanged, these definitions should result in approximately the same Intrinsic Values.
Based on the definition above, you do not want to pay the Intrinsic Value when buying stock. Like Warren Buffett, your job is first to determine the Intrinsic Value, then pay much less to buy the stock. You make your profit, at least on paper, when the true value begins to show though, as indeed ultimately it must. In the long term, the market must value stock at the Intrinsic Value. If the true Intrinsic Value of a stock today is $X, then next year, if events unfold exactly as expected, the Intrinsic Value of the stock will be $X * (1 + r), where r is the yield on high-grade bonds. In other words, the true Intrinsic Value of a high-flying stock is not high-flying. This is why you do not want to pay the Intrinsic Value to buy a stock, unless you are content with modest returns.
It has to be realized that there are many problems inherent in calculating Intrinsic Value, which is why generally I only have an interest in my own calculations. As I explained in a previous post, present value calculations of future cash flows are unreliable, as they tend to be extremely sensitive to out-year performance assumptions. As another inherent limitation, the calculation of Intrinsic Value generally takes into account what the analyst can identify that will contribute to future revenues, not the sometimes weighty unseen events. When I project WIND revenues, I base future revenues on forecasted growth of 32-bit Microcontrollers/Microprocessors and specific, known design wins, such as I2O. If Ford were to announce a very big design win for WIND, it will be under-represented in the model because it would only be captured indirectly, as Ford's use of 32-bit Microprocessors increases because of the initiative. This is an error by omission, and cannot be avoided. This makes any Intrinsic Value estimate of WIND conservative, and limits its usefulness to establishing buy points, not target sell points. The high end of Intrinsic Value for WIND cannot be calculated.
Of course there is also the possibility that WIND under-performs assumptions, causing the calculated Intrinsic Value to overstate true value. Actually, this is the biggest problem with valuing most technology stocks, as opposed to great growth companies like Coke Cola. Just as you begin to assume that earnings are sustainable, the company disappoints, restructures, and you are stuck with a classic turn-around. In fact, this problem is so common that we need to take some time, right now, to examine it in depth, and figure out how to deal with it.
With rare exception, all high-growth stocks, especially high technology stocks, are grossly undervalued, IF AND ONLY IF expected high growth rates materialize. Understand this completely. If high growth rates of, say, high-technology stocks occur as often expected, then virtually without exception, the stock, as currently priced, is grossly undervalued. The few exceptions are the incredible values given to hyped, so-called story stocks, that have to produce exceptional results to warrant their valuations. The notion that the trailing PE ratio should be about the same as the growth rate, is total nonsense when the stock will be growing at rates above 25%. However, it is not so nonsensical if earnings are growing above 25% now, and possibly next year, and after that the company may face competitive pressures which might reduce earnings growth significantly. In other words, the key factor that governs Intrinsic Value is the sustainability of earnings growth. In real estate there are three critical factors: location, location and location. In stocks there are also three critical factors: sustainability, sustainability and sustainability.
Consider WIND's competition, INTS and MWAR. How sustainable are their earnings growth rates? Personally, I have no idea. I think INTS has problems sorting out it many acquisitions, and I suspect it has a major problem trying to compete against WIND while maintaining margins. (From recent posts, I presume others might feel comfortable projecting revenues for INTS.) MWAR may yet be a tremendous success story, but near-term there is no guarantee whatsoever that product licenses will expand, suggesting that it too may end up suffering excessively from competing against WIND. The fact is that if you decide to erect a tent and enter the RTOS business, your biggest nightmare would be that a Tornado will blow it down. (It wouldn't help you sleep at night knowing that WIND just announced a Transition Kit, enabling your customers to convert to VxWorks effortlessly.) Consequently, I can't project earnings for either of these companies, even though each of them may well enjoy a fine future. Since I can't project earnings, I can't calculate an Intrinsic Value for either of them, either.
Now, what about WIND? Frankly, I think I am able to project revenues, expenses and therefore earnings for WIND that seem reasonable to me. Basically, I assumed run-time license revenue track estimated increases in 32-bit Microcontollers/Microprocessors (MCU), with additional assumptions about market share and decreasing unit run-time license fees. Mitchell, when you said I projected growth rates for WIND between 50% and 136%, actually those were various estimated annual growth rates for 32-bit MCUs. The 32-bit MCU growth rates that I now use, and am most comfortable with, is 60%, near the low-end of rates estimated by others. In addition, I include revenue assumptions about I2O, since it is a very, very big deal. I expect that next year I will also augment revenue to reflect the Network Computer. Expenses are projected extremely conservative, generally forfitting opportunities to benefit from high growth from the sale of products that do not have significant cost of goods sold. In addition, my model attempts to constrain operating margin to be no greater than 30%, a stated goal of management.
Putting it altogether, what are the numbers? WIND should make about 60 cents this fiscal year, $1.08 next year, and $1.80 the year after that. Again without considering the NC, or any other new big deal that comes along, WIND should enjoy sales of over $430,000,000 by FY 2001 with earnings of about $6.00 a share. If we assume the market will assign a 60 PE ratio at that time, which would be low given the prior five years of consistent, increasing performance, the stock would be worth then about $360 a share. Discounting that back to present value puts the current Intrinsic Value at about $265 a share.
You might have noticed that projected out-year earnings growth remains spectacular, due primarily to the added value projected to be derived from I2O run-time license fees from Intel. If we eliminate I2O completely from my projections, and continue to ignore the upside potential of the NC and other probable big deals, this year's projected earnings will not be affected, but next year's will be reduced to 98 cents, the year after that would become $1.37, and finally by FY 2001 earnings would be $2.98, substantially below the $6.00 indicated above. Assuming a PE ratio of 50, the Intrinsic Value then would be $134, which discounts to $97 today.
I conclude that today the Intrinsic Value of WIND stock is probably well above $200, not including the NC deal with Oracle, but conceivably as little as $100 if I2O failed totally to gain market acceptance. However, I do not expect the Intrinsic Value to remain even at this level for long, or only to grow at market interest rates. Each very big deal has the potential to increase the Intrinsic Value by as much as $150 (look at the effect of eliminating I2O). WIND has announced two such deals so far in 1996. I would expect additional big design wins to be announced in future years.
The last step in the analysis is to compare our Intrinsic Value with the market price, around $40. As I indicated earlier, the market grossly undervalues high-growth stocks - assuming the stock really will grow as, or nearly as, expected. What this means in simple terms is this: If you can find a stock that really is going to grow, and grow, as expected, then buy the stock at the market, relax and watch the stock achieve its true value. This is why WIND remains a buy even though its trailing PE, Price to Sales Ratio and other rear-view-mirror measures are high.
By the way, if you are wondering about the meaning of WIND's news release the other day in which the CEO and CFO affirmed that gross profits would come in at around 81% to 82%, and operating profits would be about 22% for the year, they are telling analysts that they are not under any pricing pressure, and are able to continue increasing margins. Stated differently, I think this means that WIND management expects no problems in making their numbers, not only for the upcoming quarter, but for the year.
Allen
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