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The Friday Five

Fri, 28 Mar 2014

Not crushing on IPOs, Facebook's virtual strategy, a setback for Citi, and more.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five: five big stories from the market this week and Morningstar's take.

Joining me, as always, with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Jason.

Stipp: Your first big story this week: Candy Crush maker King had its IPO, and it was not seen as such a sweet deal by the market. You say this is not terribly surprising.

Glaser: If you'll excuse me, they really got crushed in the first day, losing over 15% from that IPO price.

What's happening here is that the market is recognizing--in my view, correctly--that King just doesn't have a competitive advantage or a sustainable economic moat in any way. They have this one franchise, Candy Crush, that's doing extremely well, and some other games that aren't doing quite as well, that are producing an incredible an amount of cash right now, but it's not clear that they can sustain that for any period of time.

We're in the infancy of mobile gaming, and we've already seen any number of franchises become incredibly large before shrinking very, very rapidly, and there is no saying that Candy Crush isn't going to do the same thing, or that management has any kind of special expertise to use that cash to buy other games that people are going to be interested in. So the market dumped these shares pretty quickly.

The big takeaway for individuals is that maybe the IPO market isn't always the place to be investing, or a place to be looking for investing ideas. Those companies are there selling shares [in an IPO] because it's a good time for them, not because it's a good time for you. And even if it's the case that a company has a great competitive advantage, a great business that you might want to own, you're probably better off waiting for the market to give you an opportunity to buy it at a discount, to buy it at when it's being beaten down because of a bad quarter, versus buying it right at the offering, and then you could hold it from there.

Stipp: Facebook announced this week they are going to spend $2 billion on a company called Oculus, which is a virtual reality company. But why Jeremy? What's the strategy behind this acquisition?

Glaser: I think you might need some virtual reality goggles to totally understand what's going on here.

They are spending $2 billion. That's much less than the $19 billion they spent on WhatsApp, and the real question is how this really fits into the broader company. With WhatsApp or with Instagram before it, those are still social networks in a lot of ways. You can see how that fits in the company's mission. The virtual reality space is a little bit different. Facebook might see it as an emerging technology, something that they want to control or have a big say in it, if it becomes a more popular medium. Right now it's really focused on gaming, but Mark Zuckerberg said he could see it in communication and in other areas as been potentially a very powerful tool.

Facebook has been pretty successful in running Instagram pretty much as an independent entity. You don't see a lot of Facebook branding, or Facebook intruding on that Instagram experience. I think that Facebook will give Oculus the room and the capital they need to see if they can reach that potential that they have for it. The question for Facebook shareholders: Is Zuckerberg and the rest of the executive team up to really managing all of these separate businesses--presumably there will be some more acquisitions in the future--while still staying focused on the cash generation from Facebook. So far, the answer has been yes, and we'll see if it continues to be that way.

Stipp: The Fed this week released its review of the big banks' capital plans, and most of the banks reviewed got a green light on those plans. A few did not, and one of the notable ones was Citigroup.

Glaser: Citi was the big surprise out of that comprehensive capital analysis review.

What the Fed said was not that Citi had a dangerously low level of capital or anything like that. On the quantitative side, things looked OK. But the Fed also made a qualitative assessment of the bank's internal controls, risk management, internal stress test. They said that although Citi is making some pretty good progress in getting those [metrics] up to the Fed's standards, in some of their foreign subsidiaries, it's not quite there yet. This comes on the heels of some highly publicized problems in Mexico that may have played into this a little bit.

So Citi won't be able to increase their dividend this year, as they wanted. It's another sign that even after Citi paid back their bailout money, they're still not totally out of the regulatory crosshairs yet. There's still some concern about their ability to be so big and to manage that very effectively.

Most of the other big banks did get their plans approved, as you mentioned, so there will be some dividend increases and some capital being returned over the next year, which is a good sign for some bank shareholders who have been waiting for that for some time. But Citi really was the one that most analysts did not see coming.

Stipp: Pharma firm Baxter announced this week that it's going to split off its biopharmaceutical segment. So what might the two resultant companies look like?

Glaser: Our analyst has really seen Baxter as being undervalued for some time, and I think management has agreed and thought that this spin-off would help unlock some of that value, and let people see that the biotech side of the business, the medical device side of the business are both very valuable and have potentially good competitive advantages.

Sometimes you see spin-offs where you have a wide-moat firm, like Baxter is, and they have a spin-off that just doesn't have that same level of competitive advantage. For instance, if Berkshire Hathaway spun off See's Candies, See's Candies wouldn't be a wide-moat business by any stretch of the imagination.

But in this case, at first glance--we still don't have all the financial information yet, as this deal won't be complete until the middle of 2015--it does look like both companies are going to have pretty good sustainable competitive advantages. They'll have those intangible assets that will keep competitors at bay, and really let those management teams focus on doing a better job in those two different verticals.

Even though there might be some extra costs, Karen Andersen, whose is our Baxter analyst, thinks that overall this would probably be a pretty good deal. She's not planning on making any major changes to her fair value estimate right now. She doesn't think that this should be a major cause for concern for shareholders, and there's probably some upside.

Stipp: On Morningstar.com this week, we released our quarter-end package. When you look back on the quarter as a whole, the market didn't really move that much, but that's not to say it was exactly a placid quarter.

Glaser: It was not. We had a lot of volatility, even if we ended up back about where we started. That was driven by any number of factors: You had the political issues that were happening between Russia and Ukraine, and the tensions that were building there. Economic data was quite mixed, and there were concerns about: Is this really weather-related and will it bounce back? Or is this real weakness? There were continued question marks about what the Fed is going to do, and what's going to happen with the taper. What's Yellen going to do, as she firmly takes the helm? You put all this together, and we saw some pretty big moves, intraday moves and even over longer periods.

But given where valuations are, maybe it isn't a huge surprise that we saw this volatility. When stocks are priced for perfection, and then it looks like perfection is not in the cards, we'd expect to see a pretty big sell-off. I think as long as valuations remain about where they are, we could see some more volatility in the coming quarters, as items like this continue to pop up.

Our analyst staff thinks this might be a time to start thinking about looking at more defensive plays, continuing to look at undervalued stocks, maybe take some profits in names that have run up a lot, and get ready to take advantage, potentially, of some of this volatility to come.

Stipp: Stocks go up, stocks go down, but The Friday Five is always a good bet for investors. Jeremy, thanks for joining me again.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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