FIN724/824 The Stock Market

Company Recommendation

Marsel J. TadgerKyle M. Ward-Dahl

Ke WangAdam J. Wilson

3/2/2010 1

Size and Composition of Financial Sector

• Market Cap: 1.6 Trillion• 16.00% of S&P 500• Industries

– Banks– Consumer Finance– Diverse Financial Service– Insurance– Multi-sector Holdings– Real Estate Investment

Trust

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Largest Companies (Market Cap in Billions)• American Express (AXP) $44.8• Bank of American (BAC) $150.8• Berkshire Hathaway (BRK) $234.6• Citigroup (C) $93.8• Goldman Sachs (GS) $76.5• Bank of NY Mellon (BK) $35• JP Morgan Chase & Co (JPM) $153.4• Morgan Stanley (MS) $36.4• U.S. Bancorp (USB) $48• Wells Fargo (WFC) $145.3

Recap of Sector Presentation• Increase 100 basis points for Financial Sector• Sold 241 basis points for Berkshire Hathaway

– New underweight: 234 basis points

• Feb 28th S&P Value=16.00%• Feb 28th SIM Value=8.98%• Necessary SIM Value=13.66%• Additional needed=468 BP’s

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S&P Index and SIM Weights

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Current Sector Setup

JPM – 172 bpGS – 305 bpTCB – 270 bpHCBK – 152 bpTotal – 898 bpUnderweight to expected– 468 bp

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Recommendation

• Increase holdings of Goldman Sachs (GS)• Increase holdings Hudson City Bancorp Inc.

(HCBK)• SELL ALL TCF Financial Corp (TCB)• BUY Progressive Corp. (PGR)• Hold JP Morgan Chase & Co (JPM)

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Proposed Setup

• After Selling TCB– Underweight to expected by 468+270=738

• JPM – 164 bp (stays the same)• GS – 493 bp (increased by 188bp)• HCBK – 452 bp (increased by 300 bp)• PGR – 250 bp (New Stock)

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Recommendation 1: GS• Market Cap: $80.38 B• Outstanding diluted shares: 550.9 M• Stock Price: $158.75• Beta: 1.74• Market Consensus: $215• Lines of Businesses:

– Investment Banking (10.62% of total sales)– Trading and Principal Investments (76.09% of total sales)– Asset Management and Securities Services (13.29% of total sales)

• Competitors:– JP Morgan Chase Co.– Morgan Stanley– Merrill Lynch (privately held by Bank of America)

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Historic Prices of GS

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Relative Performance of GS

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Sales of GS• Sales

Red numbers are forecast in Assignment 2 Strong rebound in Trading and Principal Investments

FY 2011 2010 2009 2008 2007 2006 2005 2004

Investment Banking 7,131 6,665 4,797 5,179 7,555 5,613 3,599 3,286

Trading & Principal Investments 30,430 28,439 28,879 8,095 29,714 24,027 14,996 11,583

Asset Management & Securities Services 5,585 5,219 4,090 4,672 4,731 4,527 3,090 2,655

Total 49,206 45,987 45,173 22,222 45,987 37,665 24,782 20,550

Consensus 47,333 45,414 45,678

EPS 20.41 19.07 22.13 4.47 24.73 19.69 11.21 8.92

Consensus 20.47 18.60 18.95

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DCF of GSTerminal Discount Rate = 13% Terminal FCF Growth = 3%

Year 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019ERevenue $45,173 $45,987 $49,206 $52,404 $55,549 $58,604 $61,534 $64,303 $66,875 $69,216 $71,292

% Growth 1.8% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0%Operating Income $19,829 $16,898 $18,081 $19,256 $20,411 $21,534 $22,610 $23,628 $24,573 $25,433 $26,196

Operating Margin 43.90% 36.74% 36.74% 36.74% 36.74% 36.74% 36.74% 36.74% 36.74% 36.74% 36.74%Taxes $6,444 $5,491 $5,876 $6,258 $6,633 $6,998 $7,348 $7,679 $7,986 $8,265 $8,513

Tax Rate 32.5% 32.5% 32.5% 32.5% 32.5% 32.5% 32.5% 32.5% 32.5% 32.5% 32.5%Preferred Stock Dividends $1,193 $898 $961 $1,023 $1,085 $1,144 $1,202 $1,256 $1,306 $1,352 $1,392

2.64% 1.95% 1.95% 1.95% 1.95% 1.95% 1.95% 1.95% 1.95% 1.95% 1.95%Net Income $12,192 $10,508 $11,244 $11,975 $12,693 $13,391 $14,061 $14,694 $15,281 $15,816 $16,291

% Growth -13.81% 7.00% 6.50% 6.00% 5.50% 5.00% 4.50% 4.00% 3.50% 3.00%Free Cash Flow $12,192 $10,508 $11,244 $11,975 $12,693 $13,391 $14,061 $14,694 $15,281 $15,816 $16,291

% Growth -13.81% 7.00% 6.50% 6.00% 5.50% 5.00% 4.50% 4.00% 3.50% 3.00%

NPV of Cash Flows 70,269 59% Current P/E 6.7 7.8 7.3 Terminal Value 167,795NPV of terminal value 49,431 41% Projected P/E 9.8 11.4 10.6 Free Cash Yield 9.71%Projected Equity Value 119,700 100% Current EV/EBITDA 14.7 17.3 16.1 Terminal P/E 10.3Free Cash Flow Yield 14.88% Projected EV/EBITDA 16.6 19.5 18.2 Terminal EV/EBITDA 14.4

Shares Outstanding 550.9

Current Price $149Implied equity value/share $217Upside/(Downside) to DCF 46.1%

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Valuation of GSRelative to Industry High Low Median Current

P/Trailing E 1.2 0.05 0.96 0.05

P/Forward E 1.1 0.13 0.94 0.82

P/B 1.5 0.8 1.0 1.0

P/S 1.2 0.3 0.6 0.8

P/CF 1.8 0.5 1.1 0.6

Relative to S&P 500 High Low Median Current

P/Trailing E 2.1 0.38 0.70 0.38

P/Forward E 1.4 0.52 0.72 0.56

P/B 1.1 0.4 0.7 0.6

P/S 2.1 0.5 1.1 1.5

P/CF 1.7 0.5 1.1 0.6

Absolute Valuation High Low Median Current #Target Multiple *Target E, S, B, etc/Share Target Price (F x G)

A. B. C. D. E. F. G. H.P/Forward E 21.5 8.0 12.2 8.0 11 $19.07 $210P/S 3.6 0.4 1.7 1.7 1.7 $89.77 $153P/B 5.7 0.7 2.1 1.3 2 $114.4 $229P/EBITDA 4.01 0.52 2.30 3.09 3.2 $48.13 $155P/CF 21.3 3.9 12.1 5.7 12 $26.09 $313

Target price to buy: $213 (average of DCF and Valuation prices)3/2/2010 13

Key Ratios of GS

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Catalysts of GS• The increase of employees

• Global and emerging markets– Opened offices in Mumbai, Moscow, Sao Paulo, Dubai, Qatar, Riyadh and Tel Aviv– Became licensed broker-dealer in Russia, India and China– Opened banks in Brazil, Ireland and Russia– Entered asset management business in South Korea and India

• The recovery of economy and financial markets

FY 2009 2008 2007 2006 2005 2004

No. of Employees 36,200 30,067 30,522 26,467 22,425 20,722

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Risks of GS• Uncertainties

– Real estate market– Interest rates

• Lack of investors’ confidence– Record high unemployment rate

• Regulations– Liability tax bill (0.15%)– Limitation of proprietary trading– Prohibition of Private Equity business

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GDP Forecast

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Interest Rate Forecast• Federal Reserve is going to keep the current interest rate• Interest rate rise is beneficial in the long term

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Quantify key risks or benefits• Liability tax

– -$1.17 B, -$2.12 per share• Prohibition of Private Equity Investment

– $14 B of PE holdings, 2% of $849 B total assets– Probably spin-off if the bill is passed

• Limitation of Proprietary Trading– Hard to determine the definition and size– Probably not being passed

• Preferred Stock of Sumitomo– Converted to Common Shares– $1.1 B, not included in financial statements, $2 per share

No material impact on Goldman Sachs 3/2/2010 19

Recommendation 2: PGR

• Mitigate risk– SIM has no insurance industry stock.– Hedge against Goldman Sachs– PGR = Auto Insurance– No mortgages, no hurricanes, no bailouts.– Focused strategy vs. nearly all competitors are vertically

integrated.• Low cost

– Companies such as Nationwide and AllState are losing customers to no-agent based player like Progressive.

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Progressive DCF

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PGR (000)

Analyst: Marsel Tadger Terminal Discount Rate = 12.0%

Date: 02/23/2010 Terminal FCF Growth = 5.0%

Year 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E

Revenue 13,096,902 13,358,840 13,626,017 13,898,537 14,454,479 15,032,658 15,934,617 16,731,348 17,567,916 18,446,311 19,184,164

% Grow th 2.0% 2.0% 2.0% 2.0% 4.0% 4.0% 6.0% 5.0% 5.0% 5.0% 4.0%

Operating Income 1,801,600 1,837,632 1,874,385 1,911,872 1,734,537 1,803,919 1,912,154 2,007,762 2,108,150 2,213,557 2,302,100

Operating Margin 13.8% 13.8% 13.8% 13.8% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0%

Interest and Other 108,600 110,772 112,987 115,247 119,857 124,651 132,130 138,737 145,674 152,958 159,076

Interest % of Sales 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8%

Taxes 510,500 520,710 531,124 541,747 468,257 486,988 516,207 542,017 569,118 597,574 621,477

Tax Rate 28.3% 28.3% 28.3% 28.3% 29.0% 29.0% 29.0% 29.0% 29.0% 29.0% 29.0%

Net Income 1,182,500 1,206,150 1,230,273 1,254,878 1,146,423 1,192,280 1,263,817 1,327,008 1,393,358 1,463,026 1,521,547

% Grow th 1.0% 2.0% 2.0% 2.0% -8.6% 4.0% 6.0% 5.0% 5.0% 5.0% 4.0%

Add Depreciation/Amort 417,500 425,850 434,367 443,054 462,543 481,045 509,908 535,403 562,173 590,282 613,893

% of Sales 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2%

Plus/(minus) Changes WC (50,400) (51,408) (52,436) (53,485) (55,624) (57,849) (61,320) (64,386) (67,606) (70,986) (73,825)

% of Sales -0.4% -0.4% -0.4% -0.4% -0.4% -0.4% -0.4% -0.4% -0.4% -0.4% -0.4%

Subtract Cap Ex 136,300 139,026 141,807 144,643 144,545 150,327 159,346 167,313 175,679 184,463 191,842

Capex % of sales 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0%

Free Cash Flow 1,413,300 1,441,566 1,470,397 1,499,805 1,408,797 1,465,149 1,553,058 1,630,711 1,712,247 1,797,859 1,869,773

% Grow th 2.0% 2.0% 2.0% -6.1% 4.0% 6.0% 5.0% 5.0% 5.0% 4.0%

NPV of Cash Flows 8,719,886 49%

NPV of terminal value 9,030,254 51% Terminal Value 28,046,600

Projected Equity Value 17,750,141 100%

Free Cash Flow Yield 12.36% Free Cash Yield 6.67%

Current P/E 9.7 9.5 9.3 Terminal P/E 18.4

Projected P/E 15.0 14.7 14.4

Current EV/EBITDA 7.8 7.7 7.5 Terminal EV/EBITDA 10.0

Projected EV/EBITDA 8.5 8.3 8.2

Shares Outstanding 672600

Current Price 17.00$

Implied equity value/share 26.39$

Upside/(Downside) to DCF 55.2%

Debt 2,180,000Cash 1,080,000

Cash/share 1.61

Correlation of GS and PGR

Correlation -.603/2/2010 22

Progressive has a strong correlation to auto sales (.79)3/2/2010 23

Automotive sales are expected to increase significantly in next 5 years.3/2/2010 24

Valuation of PGRRelative to S&P 500

High Low Median Current

P/Trailing E 34.2 .6 .8 .60 P/Forward E 2.4 .65 .85 .81 P/B 1.5 .3 1.1 1.0 P/S 1.3 .4 .9 .7 P/CF 6.5 .7 1.1 .8

Absolute Valuation

High Low Median Current #Your Target Multiple

*Your Target E, S, B, etc/Share

Your Target Price (F x G)

A. B. C. D. E. F. G. H. P/Forward E 56.5 8.6 14.1 11.8 14.1 1.45 20.49 P/S 2.0 .6 1.4 .8 1.4 21.44 30.01 P/B 4.8 1.6 3.2 2.1 3.2 8.17 26.13 P/EBITDA 57.43 4.59 9.07 5.71 9 3.00 27.03 P/CF 81.5 6.4 12.8 8.2 13 2.09 27.19

Average = $26.173/2/2010 25

Recommendation 3: HCBK

• Add 300 basis points to Hudson City Bancorp (HCBK)

• Remarkably safe bank-stock• No exposure to commercial real estate• Comparatively very low foreclosure risk• High yield

Safe Bank Stock

• During the recent credit crunch, while competitors were consolidating losses, HCBK was able to grow its assets substantially

• Only fell ~50% from peak to trough, as opposed to 90%+ for many of its competitors

• No risky investments (CDS, derivatives, foreign assets etc)

No Commercial Real Estate

• HCBK has no exposure to any commercial real estate risk

• Solely focused on consumer loans• HCBK focuses on one distinct asset class

– High-value jumbo home loans– Wealthy areas of New York, New Jersey, and

Connecticut

• Able to specialize in this asset class

Low Foreclosure Rate

• Low acceptance rate– They finance only top value clients– Most clients have the net worth that they could

finance the home with their own personal assets

• Very high down-payments– 30% down payment is their most common variety

Example (Homes bought at peak in 2006)

HCBK• 1 loan to high wealth

customer• $1,000,000 home• $300,000 down payment• Loan value=$700,000

Competitor• 5loans to unknown value

customers• $200,000 homes• $10,000 down payment per

house• Loan values=$950,000

Housing Market Falls 35% From Peak to Trough in 2009

HCBK• Loan value=$700,000-

principal already paid• Home value=$650,000• Negative equity=~$25,000

– Average customer still has plenty of net worth to ride out the storm

Competitor• Loan value=$950,000-

principal repaid• Home values=$650,000• Negative equity=~$250,000

– I think we know the result here

Expanding Markets

• Looking to purchase a bank in Florida, where many of its high-value customers have summer homes

• Looking to expand its banking operations in the New York Metro area, to further serve its high-value customers

High Yield

• HCBK Yielding 4.44% as of 02/09• HCBK has consistently and rapidly increased

its dividend since its IPO in 2000– Company expects these increases to continues

DCFCurrent Price 13.30Implied Equity Value/Shr 24.54Upside/(Downside) to DCF 84.5%

Terminal Discount Rate = 11.50%Terminal FCF Growth = 4.00%

Multiples ValuationAbsolute Valuation

High Low Median Current #Your Target Multiple

*Your Target E, S, B, etc/Share

Your Target Price (F x G)

A. B. C. D. E. F. G. H.

P/Forward E 31.6 9.8 19.8 11.2 18 1.18 21.24

P/S 19.4 4.4 12.9 5.5 12 2.41 28.92

P/B 5.7 1.1 1.8 1.3 1.75 10.21 17.87

P/EBITDA 15.46 1.29 10.16 2.91 6 4.56 27.36

P/CF 33.5 10.9 24.1 11.5 20 1.15 23.00

Average=23.67

Q&A

3/2/2010 36