Monday, June 26, 2006

Big Oil

We have resisted taking a position in big oil for many years for two reasons: (1) None of the integrated oil producers/refiners were producing enough return on investment (ROI) to consistently create value for their shareholders; and (2) The business seemed too volatile, what with oil and natural gas prices bouncing all over the map, and political risks challenging foreign operations, thereby creating questionable risk/reward relationships.

However, things have changed with dwindling domestic oil and gas supplies, $70/bbl (plus) international oil prices, and the prospects of $3 per gallon (plus) gasoline as part of the permanent American life style. Quite simply, this means that the vast in-ground resources and producing assets of the big oil companies are now able to generate the kind of internal return on investment (ROI) that we have to see to interest us as long-term investors. Despite the political risks, which are not likely to ever go away, the value of higher-priced oil and natural gas, and permanently higher gasoline pump prices, have made the integrated oil companies much better long-term investments, in our view.

To add some perspective to our thinking, some analysts are saying that oil will drop to $50/bbl this summer. The oil analyst at Bear Stearns is using a $60/bbl assumption for 2006. However, oil futures are saying something else altogether, with a basing pattern in crude futures predicting a rally above the April high of $75.40. This gives rise to estimates among traders that crude oil will be headed above $100/bbl in the next 12 to 18 months. In any event, the probability that we will be seeing gasoline prices of $3 plus in the next several years, as a norm, seems like about 100% to us, especially when we consider that the Europeans, even countries with their own oil resources like Norway, are paying $5 plus at the pump.

The bottom line? Get used to it, and do something as investors that will allow us to cash in on the situation in the long term. We did our research, ran our valuation model on several integrated oil companies, and decided that ConocoPhillips (COP) is the big oil company we want to own. COP produced 17% ROI against a Weighted Average Cost of Capital of 10.7% in 2005, which nicely meets our EVA requirements, and our model conservatively indicates a valuation in excess of $80. The stock is currently trading in the low $60s, with a one-year forward P/E ratio of 6.5, pays a 2.4% dividend, and has a 12 month trading range between $57.05 and $72.50. Conoco is also using its very substantial free cash flow to aggressively buy back its own stock at these levels; something we really like to see.

ConocoPhillips is one of the largest integrated oil producers and its recent acquisition of Burlington Resources makes it the largest supplier of natural gas in North America. We were also pleased to learn that Warren Buffett has recently acquired a 17.9 million share position in the company (more than 1% of outstanding shares). We don’t always agree with Warren, but we think he is right on his oil and natural gas strategy, especially his choice of COP.

Jack and Peter Falker

Note: At the time of publication, the clients of FalkerInvestments Inc. and Jack and Peter Falker were long COP.

Tuesday, June 20, 2006

Misery Loves Company

More on Option Backdating

The announcement over the weekend that Home Depot (HD) backdated stock options in what appears to be an almost identical fashion as United Health Care (UNH) seems like pretty good news to us.

About 40 companies are currently under investigation by federal authorities looking into whether firms backdated options or otherwise gamed their timing to benefit insiders. In addition to Home Depot, that number also includes Microsoft.

The “Wall Street Journal” reported last week that Microsoft had previously disclosed to the SEC that they had engaged in a form of backdating before 1999 and had voluntarily stopped the practice at that time. Microsoft awarded options at monthly lows each July from 1992 to 1999, with varying dates, and also routinely issued options to new employees at the stock's lowest closing price in the 30 days after they joined. Those practices, which Microsoft ended in 1999 after seven years, amounted to a variation of backdating, since they couldn't be priced at the low for a month until the month was over. The big difference, of course, is that Microsoft voluntarily stopped the practice and disclosed it. In a news release issued on July 19, 1999, the company said it was ending the monthly-low policy and taking a $217 million charge.

It seems to us that these recent revelations are good news for UNH because, in this case, misery should indeed love company. Apparently all of the boards of these 40 companies approved these practices and all of the public accountants and lawyers signed off on them for many years until the Sarbanes-Oxley Act of 2002 apparently put a stop to it.

Does that make it right? Certainly not, but it seems like the whole options backdating issue could end up being pretty inconsequential, given its prevalence. In that case, the market will go back to looking at the fundamentals of each company’s franchise, and that will definitely benefit UNH. However, we still want to hear about the result of their internal investigation, before we take further action. We would expect an announcement sometime in the next month, when their second quarter results are made public.

Stay tuned.

Jack Falker

Note: At the time of publication, the clients of FalkerInvestments Inc. and Jack and Peter Falker were long UNH.

Thursday, June 08, 2006

Backdating Backlash

We have a substantial position in United Health Care (UNH), which, even at current levels, has doubled in value over the last few years. When the Wall Street Journal revealed in April that a probe had been initiated into the company’s practices of issuing executive stock options at prices that were essentially “too good to be true”, we decided, as long-term investors, to wait and see what would happen. Subsequently, this practice has been identified as being more widespread, so UNH is not alone in the SEC probe. We believe that UNH is the best company in the HMO segment of the health care industry and, right or wrong, we have not been anxious to hit the sell button, as so many investors (including, we are told, Fidelity Investments) have already done. This scandal has significantly lowered the price the market assigns to the company; however, we do not believe that it has substantially changed the value of the company’s extraordinary healthcare franchise.

Here’s what we know at this point: Based on a chart we got from Bear Stearns, UNH has had 16 option grants since 1994, four of which were issued on the exact date of the low close in the quarter; three of which were also lows for the year. The dates were 4/20/94, 10/27/97, 10/13/99 and 3/8/00. Using Big Charts, we went back and created the charts for the several months surrounding each of those grants. Interestingly, the first two just look like good calls on the part of management. The stock had been tanking for several days so they picked a day they thought would be close to the low and authorized the options. It also appears they might have known that some good news was about to be announced, because in both cases the stock went up significantly in the next week. Unfortunately, that pattern does not follow through on the last two grants in 1999 and 2000. In both cases, the stock had been trending lower, they picked the exact date of the low, and the stock slowly began to improve from that point. It would have been virtually impossible to choose those exact dates, so backdating seems quite likely. In their 10-Q SEC report filed in May (which under the circumstances would have been blessed by their auditors), they say that “the Company has identified a significant deficiency in its controls relating to stock option plan administration and accounting.” The context that follows implies that the board had given some sort of blanket authority to management and that the authority had been misused by someone in “the Company’s human capital, finance and legal departments”, which, of course all report to Bill McGuire, the CEO and largest stock option beneficiary. The 10-Q goes on to say that the board has changed all of that and it won’t happen again, because future option grants “are to be made by the Compensation and Human Resources committee, and no authority to grant options is delegated to management.” In other words, the fox is no longer guarding the chicken coop.

As a former corporate treasurer, I’m in shock about what UNH apparently did, and why. My first reaction, when the probe was announced in late April, was that it would not be at all difficult for the management of UNH to grant options at or near the low trading points in their stock. Assuming that they did it the way we always did, options are very easy to grant with a telephonic meeting of the board compensation committee, to be ratified by mail etc. I saw it done frequently and it was entirely proper, albeit opportunistic. In UNH’s case, with board authority apparently already making it so easy to grant options, at or near a low point, why would someone in management engage in backdating to the exact date of a low? At the least, this is very greedy, and at the worst it’s outright fraudulent, not to mention stupid. In any event, if backdating is proven, Bill McGuire would likely have to take responsibility and he likely will not go unpunished. That could be messy, a la Ace Greenberg at AIG. Greedy CEOs have been kicked around a lot lately and it probably isn’t over yet.

Reading between the lines of UNH’s recent SEC filing, it seems that they have pretty much acknowledged irregularities, so it’s just a matter of time before the full story will be released in another SEC filing. The company’s board has hired the former enforcement chief of the SEC, who has a reputation as a very tough lawyer, to conduct an investigation into exactly what happened. This very constructive move was announced more than a month ago, so it’s likely that a report will be forthcoming shortly, and that’s when all the information should be available for decision making. If it’s not any worse than what the company has already reported to the SEC, we will keep the stock and consider adding to it at current levels, which represent a substantial discount from what our model tells us the ongoing franchise is worth in the longer term, with or without Bill McGuire. However, if the news is worse than what we currently know, we may have to quickly protect our capital.

Trading action in the stock during the last week or so seems to indicate that the street believes the worst news is already out. We will wait and see. Stay tuned.

Jack Falker

Note: At the time of publication, the clients of FalkerInvestments Inc. and Jack and Peter Falker were long UNH.