When an investor buys shares in a company, he or she is buying a portion of that company. It is a material commitment of resources. The assumption is that the management team of the selected company can better use the investor’s resources than the investor can and, thus, earn a return for the investor in the form of distributions (normally dividends) or a higher stock price. A bond investor makes a similar choice, though the expected return is in the form of regular interest payments and a return of the original sum lent to the company. It can be difficult, however, to get a clear picture of how well a company makes use of the resources it has at its disposal.
One quick way to cut through the large number of investments available is to review return on total capital. This statistic measures the percentage a company earns on its shareholders’ equity and long-term debt obligations. Value Line calculates this number, which appears in the Statistical Array on every full-page report, by dividing net profits plus half of the current year’s long-term interest due by the sum of shareholder equity and long-term debt. The general idea of the measure is to see how much a company earns on the money it has been given by outside investors. Companies with high scores are, presumably, better wards of capital.
That said, this measure is best used as a starting point and a comparison tool. Some industries will never show up on a screen of this nature, others will have many representatives. Thus, comparisons between companies in the same industry will provide more insight than comparisons between companies in different industries. In addition, comparing this measure to return on shareholders’ equity can provide insights into how well companies are making use of debt—if return on total capital rises, but return on shareholders’ equity doesn’t, additional debt financing may not be benefiting shareholders.
Since a quick review of this one measure can highlight companies that are making the best use of investor capital (on a combined basis from stock investors and bond investors), each weekly Index of The Value Line Investment Survey includes a screen listing the 50 companies that score highest on this measure (subscribers can view recent and historical Index information here). To help refine the screen, and remove companies with a temporarily inflated score, we use a five-year time period when selecting the top companies. In addition, the list is sorted by earnings retained to common equity to highlight those companies that are doing the most to benefit their equity investors. A recent review of the screen turned up several companies worth a closer look, including MasterCard Inc. (MA) and InterDigital Inc. (IDCC).
MasterCard Inc.
MasterCard is a leading global payments company linking financial institutions, businesses, merchants, cardholders and governments worldwide by enabling them to use electronic forms of payment instead of cash and checks. The company processes credit, debit, prepaid and related payment transactions over the MasterCard Worldwide Network. It manages a number of widely accepted payment card brands, including MasterCard, Maestro, and Cirrus. MasterCard generates revenues by charging fees to its customers for providing transaction processing and other payment-related services and by assessing clients based on the dollar volume of activity (gross dollar volume, GDV) on the cards that carry its brands.
MasterCard is coming off a strong third-quarter performance where higher volume and transaction trends led the top line up 27% (24% excluding acquisitions). The company appears to be gaining market share in established regions as well as creating new business from emerging ones. Latin America has been a particular bright spot, thanks partly to MasterCard’s new relationship with Itau Bank in the booming Brazilian market. That customer is now using MA for all of its transaction activity. In general, emerging markets pose a significant earnings growth opportunity as use of credit and debit cards for payment (instead of cash or checks) expands, the company takes advantage of their low tax rates, and personal consumption expenditure rises due to a greater number of middle income consumers. According to MasterCard, over 85% of global transactions are still conducted through hard currency. The company has also made a firm commitment to new technologies that facilitate payment on smartphones, most notably Near Field Communications. Value Line analyst Bryan Fong believes nascent mobile payment technology will rise in popularity and eventually benefit overall volumes.
MasterCard is set to release its December-quarter earnings report on February 2nd. Currently, there is significant inconsistency in earnings estimates among the equity community, largely due to uncertainty regarding rebate and incentives activity. The company has handled reduced demand situations well in the past, effectively lowering incentives and marketing spend when transaction volume slows. We believe retailers' efforts to drive traffic through discounting helped keep transaction activity healthy this past holiday season, but may have also hindered GDV. There is also concern that troubles in the European economy and a potentially stronger U.S. dollar will impact transaction volume and GDV. Although we do not expect an ongoing merchant lawsuit to hurt the company at this time, this situation ought to continue being a mild overhang on the stock as an unfavorable outcome could negatively affect profitability through new surcharges. Overall, we expect a favorable earnings report.
Looking long term, the company still has room to lower its cost base and we expect profitability to improve. Too, MasterCard’s focus on mobile payment platforms, new U.S. and international banking relationships, and the global transition away from cash ought to lead to strong return on capital.
InterDigital Inc.
InterDigital engages in the design, development, and provision of technologies that enable wireless communications. Its solutions are incorporated in various products, including smartphones, tablets, and notebook computers; base stations and other wireless infrastructure equipment. Revenues are generated primarily from licensing its portfolio of approximately 1,300 U.S. and 7,500 non-U.S. patented technologies to manufacturers of 2G, 2.5G, 3G, 4G LTE and 802 products. Patent license agreements usually involve the customer paying for sales made prior to the effective date of the license and also royalties or license fees on licensed products that it will sell or anticipates selling during the term of the agreement. In 2010, IDCC recognized revenue from approximately half of all 3G mobile devices sold worldwide, including those from handset OEMs: Apple (AAPL), HTC, LG, Research in Motion (RIMM), and Samsung Electronics.
Shares of InterDigital are currently trading 8% above their 52-week low. The company recently revealed that it concluded its six-month-long review of strategic alternatives without selling its patent portfolio. Possible reasons include the lofty asking price and possible questions over the quality of the patents. General negativity and disappointment from investors surrounding the lack of a sale is likely causing an unwarranted valuation, in our view. Too, recent weak results from licensees Research in Motion and HTC are also probably contributing to unfavorable sentiment.
The news was not all bad, however. Even though an outright sale was not reached, management said it is still receiving strong interest for large portions of its portfolio. One of these may be Google (GOOG), which has expressed interest in further fortifying its patent portfolio even after announcing its intent to acquire Motorola Mobility (MMI) and all its intellectual property. The tech giant was rumored to be interested in a full purchase of IDCC prior to the MMI announcement, which suggests there are still some patents it has its eye on. Additionally, InterDigital may monetize portions of its portfolio by partnering with one of its manufacturing clients to produce devices.
Meanwhile, it’s back to business as usual for InterDigital. This includes the pursuit of licensing agreements through legal action. Its primary battles are with Nokia (NOK), Huawei, ZTE, and LG over 3G patents. Visibility into progress on the resolution of said litigation is highly opaque and will most definitely lead to a large negative or positive swing in the share price, depending on the outcome. The company feels confident, as it continues to reiterate its stated goal of $800 million in recurring revenue within three to five years. Considering past successes, we are cautiously optimistic that beneficial agreements will be made in the coming year. A leading 4G LTE (Long Term Evolution) patent position and escalating deployments of the technology should also help InterDigital renew existing agreements and record strong returns on capital over the next three to five years. We caution, though, that conservative investors may be dissuaded by this stock’s lumpy cash flows caused by its licensing business model and relatively high percentage of retail investors, which contributes to wide price fluctuations on earnings and news announcements.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.
