AAPL’s March 2010 quarter: strong non-US iPhone sales

The AAPL quarter

I listened to the AAPL March quarter conference call yesterday and looked at the financials.

the numbers–really good

“CUPERTINO, California—April 20, 2010—Apple® today announced financial results for its fiscal 2010 second quarter ended March 27, 2010. The Company posted revenue of $13.50 billion and net quarterly profit of $3.07 billion, or $3.33 per diluted share. These results compare to revenue of $9.08 billion and net quarterly profit of $1.62 billion, or $1.79 per diluted share, in the year-ago quarter. Gross margin was 41.7 percent, up from 39.9 percent in the year-ago quarter. International sales accounted for 58 percent of the quarter’s revenue.”

the highlights

It was reassuring to hear that, as usual,  AAPL executives are “thrilled” over just about everything and customers of all products in all countries are, like the McDonalds ads say, “lovin’ it.”

But it was an outstanding quarter, AAPL’s best non-holiday three months ever, featuring an all-time high for iPhone sales.  The company sales highlights:

–2.9 million Macs sold during the quarter, up 33% year on year vs. 24% growth for the PC industry.  50% of Mac buyers are still first-time users.  The company didn’t exactly answer the question put to it, but it sounds like the “halo effect” of the iPod and iPhone on Mac sales is a global phenomenon, not just a US one.

–10.9 million iPods sold vs. 11 million in the year-ago period.  But iPod Touch showed 63% year on year growth, creating a 12% revenue gain for this product line.

–8.75 million iPhones sold vs. 3.8 million in the march quarter of last year.  This is 133% growth, or 4x the rate of market expansion.

–AAPL is “shocked” by high demand for the iPad in the US, so much so that AAPL had to postpone the foreign launch of the product so that it would have enough manufacturing capacity to roll out the 3G version of the device on time in the US.  What was the problem?  Other than DRAM, components are easy to get on short notice at reasonable prices.  And there’s lots of AAPL-quality contract manufacturing capacity available.  But it takes a period of weeks to get everything lined up–and more time to get the finished goods into stores.

It sounds as if AAPL has already ramped expanded production up, so it looks like an unrestricted flow of iPads will be coming from the company for the June quarter.

AAPL responded to questions about possible cannibalization of other AAPL offerings by saying that it’s too soon to tell–which it is (and Macs and iPod Touches are the only areas where you might be able to notice)–but that there’s no evidence of it to date.

what I thought was interesting

the geographical breakdown of operating income (in $millions)

US          $1674       up 20% year on year

Europe     $1661         up 102%

Asia-Pacific   $892     up 320%

Japan      $441       up 80%

Only about a third of operating profits, not counting retailing income from the Apple stores, are coming from the US.

AAPL said on the conference call that first-half revenues from “greater China,” that is, the mainland + Taiwan + Hong Kong were up 9x year on year, at $1.3 billion.  This is presumably the introduction of the iPhone there.

the iPhone

If we figure that AAPL gets $600 for each iPhone it sells to a carrier, that amounts to $5.25 billion in sales for the quarter, or close to 40% of the company total.  That number understated the importance of the iPhone to AAPL, because it doesn’t include the share of revenue from carriers that AAPL also gets.

You may remember that AAPL recently changed the way it accounts for the carrier revenue.  It used to show this money more or less as it came in, over a two-year contract period.  Now it does a present value calculation and recognizes it all when the contract is signed.  (I think the new way is the better accounting method, but AAPL actually provided more information under the old method, when it also gave the new method results in footnotes.  Oh, the exciting life of an analyst!!!)

This time last year, AAPL was using the old method.  This year’s financials restate those results.  The restated number show a gross profit that’s $656 million higher than what was originally reported.  If we assume that’s all the present value of carrier contracts, and that present contracts have the same profitability, then the comparable number for carrier payments for the March 2010 quarter is a gross profit of $1.5 billion.  If AAPL takes the same manufacturing markup on iPhones as on other products, then the iPhone is producing 55% of AAPL’s gross income.  You can do more refining that would imply that the “real” percentage is actually higher, but the point would remain the same–AAPL has transformed itself in just a couple of years into a smartphone company that happens to do other stuff.  This is an almost unbelievable achievement.

the tax rate (a minor point, but an accounting thrill)

AAPL estimated three months ago that its full-year tax rate would be 29%, based on its forecast of the geographical composition of revenues.  Now it realizes it wildly underestimated foreign sales, presumably in the Pacific.   Its new estimate for the year is 27%.  To offset the first quarter tax rate being too high, AAPL had to make the second quarter rate low enough (at 24%) so that the first half as a whole was back on track.  This had the effect of shifting some profit recognition from the first quarter to the second.

the iPad

AAPL believes that the market potential for the iPad is huge. As a result, it says, it is pricing the iPad in an “extremely aggressive” manner.   Even so, it was caught by surprise by the high level of demand for the device in the US.

AAPL expects sales of the iPad to depress gross margins in the June quarter by 1.5%, or 25% of the gross margin drop from 41% to 35% that it is guiding analysts to expect for the next three months.

Question:  how many iPads do you have to sell, and at what sub-par markup to make such a big dent in gross margins for a firm as big as AAPL?

AAPL’s answer:  we’re not saying.

What I think:  if AAPL marks up the iPad by a third over its manufacturing cost–remember, there are a lot of marketing expenses for a new product–then it has to sell about 2 million in the June quarter to move the gross margin down that much.  Depending on the model chosen, that could end up being $1.5 billion in sales.  Wow!

other stuff (not on the conference call)

The iPad is banned in Israel, because it uses too much mobile bandwidth.  Tourists have to leave them at the border.

An AAPL employee left a test model of the yet-to-be-released iPhone 4.0 in a bar in Redwood City, California.  Whoever found it sold it to the blog Gizmodo, where you can see an analysis.  Interestingly, just like Mission Impossible, AAPL caused the phone operating system to self-destruct when it discovered it was lost.

AAPL doesn’t like netbooks.  No surprise here.  But the company said on the conference call it “couldn’t think of a single thing a netbook does well.”  I guess we have to wait for ASUS or Acer to release Chrome-compliant models.

more thoughts on the Goldman Sachs indictment

I’ve been reading and listening to everything I can about the Goldman indictment by the SEC over the past few days.  The talking heads on financial TV are, as usual, verbose but clueless.  What’s more interesting is I find that legal experts being interviewed are unusually vague about what statute or principle of law Goldman is supposed to have violated.

And the more I think about the SEC complaint, the more I find myself agreeing, not with the SEC, but with Goldman.

My observations:

1.  Goldman doesn’t think it did anything wrong.  The tone of all its public statements conveys this.  Also, as a practical matter, the vast majority of the “toxic” derivative transactions were done in the UK, not the US, in order to take advantage (I think) of the more permissive regulatory environment there.  If Goldman had any qualms about this deal, it would have happened in London.

2.  No one seems to be disputing the general outline of the deal in question:  Paulson asked Goldman to find institutions (perhaps “patsies” or “schlemazels” would be better words) to take the long side of a sub-prime mortgage derivative transaction that it wanted to be the short side of.  Goldman located two, a bank and a financial services firm, both supposedly well-versed in sub-prime mortgages, who seemingly jumped at the chance.

3.  No one, other than Paulson and its clients, is arguing that designing this transaction was a nice thing to do to the long side.  But, then, it’s not nice when the opposing pitcher humiliates the home team in front of a stadium full of fans by striking out 15 and not allowing a run in a visiting-team victory.  It wasn’t nice when the UCLA men’s basketball team defeated 88 other teams in a row, either.  The Flyers aren’t being nice to the Devils.

That’s not the point.  The real issue is whether any parties acted illegally.

4.  The case may hinge (in this non-lawyer’s opinion) on a court deciding whether Goldman’s role in the transaction was to be an agent/middleman or to be a fiduciary for the bank, IBK, and the financial service company, ACA.  In other words, did Goldman have an obligation to disclose Paulson’s plans and intentions to IBK and ACA?

Goldman is clearly saying that it was only an agent.

Four points:

–both buyers, IKB and ACA, were institutional investors who had prior experience with sub-prime mortgages and who asserted to their own clients that they were experts in this area.  No one so far is claiming that this representation was fraudulent.  And generally an investor is regarded as “sophisticated” in the US if he has $100 million under management.  So although they may not have been the most skilled players in the game, both IKB and ACA probably have to be regarded as professionals.

–even the SEC complaint says Goldman farmed out the function of advising on the reasonableness of the deal to ACA, the bond insurance company that had the final say on what bonds were backing the Paulson transaction.  The biggest buyer of the actual transaction was an affiliated company of ACA, which presumably relied primarily on the ACA research and judgment.  This seems to me to reduce Goldman’s role to that of a facilitator or agent in the deal.

–Goldman arguably had an obligation not to disclose Paulson information to ACA or IKB and vice versa.  But Goldman also got Paulson and ACA into at least one fact-to-face meeting and kept them in communication with each other.  So ACA knew who Paulson was.

ACA could have asked Paulson about what it was doing and where it stood in the transaction.  What kind of analysts wouldn’t have? (Answer: bad ones.)  A blush or a stammer would have been enough information.  Maybe ACA understood Paulson’s intentions and thought the firm was wrong, or simply didn’t care.

–According to the Washington Post, the Paulson role in selecting “bad” securities may not have mattered anyway.  Any 2006-vintage sub-prime mortgage securities would have imploded.  I wonder if any has checked to see if the ACA-selected portfolio was better or worse than the original Paulson one.

6.  The more I look at it, the weaker and more Spitzer-like (go for the headlines; don’t worry about the trial) the SEC case seems to me.  The ramifications of losing the one action the agency finally brings after all the adverse publicity of Madoff, BofA-Merrill and similar cases can’t be good.

7.  The Goldman professional who oversaw the deal has just been put on paid leave.  This is the most sensible thing to do.  Keeping him in his job likely angers the SEC further.  His mind probably isn’t on his work anyway.  Even if he has done something wrong, firing him only turns him into a cooperative source for the SEC.

The action may be Goldman opening the door to negotiating a settlement, rather than enduring a steady stream of negative publicity.

a word on current troubles in Thailand

Bangkok in 1985

1985 is when I made my first visit, as an investor, to Thailand.  I stayed in the un-airconditioned wing of the Oriental Hotel in Bangkok, which seemed to me to have changed very little from the 1920s when Somerset Maughan wrote there.  It took 90 minutes for the hotel operator to get a telephone collection to the US so I could tell my family I had arrived.  I paid US$25 (?) a day for the use of a car and driver to visit companies.

reverence for the king

The most striking aspect of my trip, however, was that every office I came to had at least a corner devoted to pictures of the family of the king, Bhumipol Adulyadej, often surrounded by flowers or votive candles.  While not quite the same as early-morning devotees praying to the emperor on the grounds of the imperial palace in Tokyo, these shrines were evidence of the deep reverence and affection in which the Thai population hold their monarch.  Quite a difference from the US or UK.

This situation has allowed for a most unusual form of government in Thailand.  The country is a constitutional monarchy with a parliamentary democracy.  Change of government, however, has very often come through military coup (usually bloodless).

the elite

A typical career for a member of the political elite in Thailand would run as follows:  attendance at the Thai military officers college, a career in the armed forces, a move from the army to a top management position, and finally, if the individual were so inclined, a high place in the national government.

the ritual of coups

Change of government might occur through elections, but it could just as easily happen through a military coup.  Over the years, the latter course has been highly ritualized.

A group of serving armed forces officers, doubtless prompted by former mentors now in business or politics, would conclude that the sitting government had outlived its “use by” date.  The group would request an appointment with the king, explain the reasons for change and what the proposed new composition of government would be, and ask the monarch’s permission to go ahead with the coup.

The coup would proceed only if the king gave his approval.  Word of the king’s permission would be disseminated.  On the day scheduled for the coup, the military would make a show of force and the government would change–almost always quietly and peacefully.  Occasionally, there have been acts of violence during coups.  These have traditionally been occasions of national disgrace, discussed and rued for years afterward.

Coups invariably involved replacement of one faction of the military-based elite with another.

what has changed?

1.  As Thailand has shifted from agriculture to manufacturing, as the overall population has become more affluent, and as ordinary citizens have become more vocal about the privileges (and perceived corruption) of the traditional elite, they have wanted to have a greater voice in government.

2.  The king, now 82, has been ill.  A strong lèse majesté law prohibits any criticism of the royal family, but it is clear that people do not have the same strong reverential feeling for the king’s son and putative successor.

the catalyst

Thaksin Shinawatra, a former policeman and telecom entrepreneur from a wealthy family in Chang Mai, formed the Thai Rak Thai political party in 1998 and was swept into office as prime minister in a landslide victory in 2001.  Thaksin immediately began to strengthen his populist power base–and therefore to undermine the position of the traditional elite–with the introduction of universal health care, programs to eliminate rural poverty and an anti-corruption drive.

Thaksin was reelected in 2005 in another landslide.  He was deposed in a military coup the  following year and the TRT party disbanded, while he was on a trip abroad.  He returned to Thailand after his supporters won the subsequent election under the banner of the People’s Power Party, but has remained outside Thailand from mid-2008 on.  Thailand’s highest court dissolved the PPP in late 2008 and banned key leaders from politics for five years, effectively returning government to the traditional military elite.

Large amounts of Thaksin’s wealth have been seized by the government since, and he has been convicted of various crimes.

no easy answers

The military factions now in power–but previously being “disenfranchised” by Thaksin’s populism–do not want to relinquish the reins of government.  Nor do they want to lose for themselves or their families the “entitlement” to rule in the future.  These are the “yellow shirts.”  On the other hand, although not in Thailand, Thaksin remains a symbol for, and a financial supporter of, those who are demanding a greater political role for non-elite citizens.  These are the “red shirts.”

Confrontations between the two sides have begun to involve violence, which is very uncharacteristic of Thai politics.

Unfortunately for Thailand, the typical international investor’s conclusion will probably be something close to what mine is:  the political situation is too difficult to figure out but is crucial to the success of any Thai investment.  Therefore, unless for some reason you must have money in Thailand, stay away.

financial indictments: suppose the worst is true?

The Goldman indictment

This morning’s Wall Street Journal has an article in it which, while neatly summarizing the SEC case against Goldman Sachs, also states that the SEC is investigating other investment/commercial banks for similar possible violations.  (By the way, the WSJ is also running an opinion column arguing that the indictment is a mostly political move, and more a “water pistol” than a “smoking gun.”)

how true? how pervasive?

Stock market reaction around the world to the Goldman indictment has been immediate and negative, giving rise to the question:  what happens to the overall stock market if the worst turns out to be true?

I would define “worst” as meaning

–that ultimately most big bank are brought up on charges similar to Goldman’s (a JPM indictment would be particularly bad) and

–that legislation is enacted that restricts the future profit-making activities of the banking sector.

My guess is that convictions and fines would be much less important for the fate of the financial sector on Wall Street than a loss of trust in the companies and a shrunken future stream of profits.

how I handicap the issue

1.  Start by observing that the financial sector makes up 16.5% of the S&P 500.  Just to pick a number out of the air, let’s say that if the combination of social stigma and legislation that limits growth were factored into today’s prices, that would take a third off the sector’s market capitalization.  That’s too much, in my opinion, but let’s just say.

This would amount to a fall in the S&P of 5.5%.

2.  We might reasonably argue that the transactions in question didn’t do much overall economic good and might have actually been damaging.  That is to say, they moved money from the pockets of one set of brokerage clients to another, but provided no real other economic benefit.  To the degree that they helped the housing bubble to expand, they might have been harmful.

If so, requiring fuller disclosure or otherwise making them harder to do wouldn’t really hamper economic growth.

3.  If we lived in the simplified world that academics inhabit, and if we knew 1. and 2. for certain, investors would probably make a very swift adjustment in the prices of financial firms (and no others), dropping the S&P to 1130 or so in a couple of days.  As far as the S&P is concerned, that would be the end of the matter.

In the real world, we don’t know many things for sure, however.

uncertainty has consequences

Uncertainty has two main consequences:

–although I think that whacking a third of the value of all financials is much too much, the market–an emotional beast–could overreact

–declines are almost never isolated to a single sector.  There are always relative value arbitrageurs, who will regard financials as cheap and sell other sectors to get the money to buy them.  This process means the entire market, not just the financials, will go down.

two conclusions

The first is that while the SEC action may not exactly be a tempest in a teapot, I don’t see that it is anywhere near important enough to undermine the case that we’re in a bull market–or to be anything more than a temporary setback to the market’s advance.  Ultimately, the simple-minded 5%-6% drop in the S&P will likely prove correct.  But we probably get there by a roundabout route.

My guess is also that financials won’t regain in the near future the stock market leadership role they have played so far this year.  IT is my candidate for its replacement, but that’s been my position for a long while.

the timing of the case?

The Goldman indictment comes at a delicate point for the market.  After declining in late January-early February, the S&P has been marching upward very consistently, to the point last week where it had achieved almost all the gains that even bullish market commentators had predicted for the full year.  The index was also flirting with its (technically/psychologically important) levels just before the Lehman collapse in September 2008.  So it was arguably due for some sort of correction.

To some degree, then, the Goldman indictment should be seen as the trigger, or excuse, for something the market was going to do anyway, rather than the cause.  But the correction will likely be deeper and more prolonged than it would be otherwise.  Maybe we have a repeat of the January-February decline.  One positive sign I’ll be looking for would be that other sectors would perk back up even though financials languish.

The SEC accuses Goldman Sachs of fraud

Goldman charged with fraud

The SEC announced Friday that it is charging the investment firm Goldman Sachs and one of the professionals in its bond area with fraud in connection with the creation and sale of a collateralized debt obligation (CDO) where the ultimate backing was a collection of  sub-prime mortgages.

The details

As I read it, the SEC complaint contends that in this particular issue the odds were stacked against investors in the CDO, because:

1.  the hedge fund Paulson & Co. did an extensive study of sub-prime mortgages early in 2007, identifying over a hundred mortgage-backed securities that its analysis concluded would most likely face financial difficulties.

2.  Paulson approached Goldman with the list and paid it $15 million for help in creating a CDO whose performance would be tied to most or all of the securities.  Paulson also intended to effectively sell this CDO short.

3.  Goldman got ACA Management, a firm experienced in managing credit risk with residential mortgage-backed securities, to act as the official selection agent for the securities linked to the CDO.  Goldman served as a middleman between Paulson and ACA in negotiations over the mortgage securities that would underlie the CDO to make sure they were satisfactory to both.  Goldman also knew that ACA had the mistaken belief that Paulson wanted the CDO to succeed, rather than fail, assuming Paulson would buy part/all of the riskiest tranche, but did not correct that misapprehension.

4.  Neither the offering document nor any of the CDO marketing materials contain any mention of Paulson’s role in selecting the sub-prime mortgages underling the CDO or of Paulson’s economic interest in seeing the mortgages fail.

As Paragraph 3 of the complain puts it:

“3. In sum, GS&Co arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.”

In short order, virtually all the underlying mortgage-backed securities were downgraded.  Investors lost $1 billion.  By shorting tranches of the CDO, Paulson gained $1 billion.

Goldman’s response

The company has denied the charges, calling them “completely unfounded in law and fact.”

In addition, Goldman issued a press release after the close on Friday, in which it said (with some added interpretation from me):

a.  no matter what “help” it received from Paulson, ultimately ACA agreed to the CDO structure and put its name on the dotted line as Selection Agent

b.  Goldman never told ACA that Paulson was going to be a long investor in the transaction.  Further, as a middleman its duty is to protect the identities of both sides of any trade.  (I read this as a very narrow statement; as saying that, yes, Goldman may have known what ACA thought–and may not have put any obstacles in ACA’s way in going down that road–but it never said “Paulson” and “long investor” in the same sentence.  The SEC, in contrast, seems to be saying that the offense is in the failure to set ACA straight about Paulson’s role.)

c.  The investors, ACA and German bank IKB, are sophisticated professionals with a lot of experience with sub-prime.  They had all the materials they needed to analyze the relevant mortgage-backed securities themselves.  They made an independent (though horribly incorrect) judgment about the quality of the deal.

Besides, there’s always a guy on the other side of the transaction.  ACA and IKB knew that.  His identity and intentions aren’t relevant.

d.  Goldman itself lost over $90 million on this deal (no details on what this means; in particular, does this figure include any offsetting hedges?).

What the SEC is not saying (as I see it)

The SEC is not complaining that Goldman is

–acting as an agent In almost every trading situation, both buyer and seller think they know more than the other side.  Neither is obligated to educate the other, either before or after the fact.  When I bought AAPL at $13, I didn’t have to tell the seller I thought the iPod would transform the company.  He didn’t have to tell me what an idiot I was to take off his hands shares in a firm that was doubtless headed for Chapter 11.  No one wants the broker who acts as a middleman to put his two cents in, either.   Knowing more than the other guy isn’t acting against the other’s interests in the sense the SEC is talking about.

–providing liquidity Sometimes, when no “natural” counterparty can be found, a big client will ask a broker to facilitate the trade by either buying the securities itself or shorting them to the client.   The trade may, or may not, turn out to be a good idea.  In the latter case, and depending on how he trades out of the position (long or short) he has taken on, the broker may make a lot of money.  This isn’t acting against a client’s interests in the way the SEC means, either.

–trading against a client In some markets outside the US, it is the custom, when a broker provides research support that has a material influence on the client’s buy or sell decision, to transact through that broker.  The thought is that this will encourage the broker to provide more investment ideas, as well as to ensure the flow of maintenance research on this particular one.

The US custom is the opposite—to sever the connection completely between trading and research, so that brokers will have as little clue as possible about a firm’s intentions.  If the client’s traders are skillful enough, even if brokers wanted to act against its interests, they would have only a vague idea of what they are.

(Note that a trading issue came up last year when someone (my money is on analysts who thought the practice is unethical) leaked information about its trading “huddles” to the press.  These were weekly meetings that generated short-term trading recommendations that sometimes went against Goldman’s “official” recommendations and were only made known to a select group of big clients.  Goldman pointed to fine print in the Disclaimer section of its publications that said it might do this.)

What the SEC is saying

If I understand the Goldman statements, it’s saying it was acting in this private placement as a marketer/trader/middleman.  The SEC, I think, is maintaining that Goldman was an originator/underwriter of the security and therefore must comply to the higher standard of full and complete disclosure of all material facts.

The fact that Goldman knew Paulson was trying to put as many holes as it could into the bottom of the boat is presumably material.

my thoughts (so far)

1.  I’m not a lawyer.  I have no idea how this will play out in court.  It would be interesting, however, to see a list of Goldman’s clients by revenue generated.  My guess is that Paulson is on the first page or two and ACA and IKB are afterthoughts.

2. Given all the high-profile financial crisis-related cases where the SEC has declined to prosecute and settled instead, in part judging that it didn’t have enough evidence to prevail in court, it may consider this case a slam-dunk.  Or it’s under enormous pressure to do something and it’s just Goldman’s bad luck to be in the firing line.

3. Any good marketer tries to take a purely commercial relationship with his customers and turn it into one of friendship and trust.  For the best companies, they actually mean what they say.

For Goldman, the pitch has been something like–we’re very smart and have good ideas; you have assets and a distribution network; let’s team up to generate great investment performance and we’ll grow rich together.  The SEC account of this incident reads more like a chapter out of Liar’s Poker, where the broker’s intent was more to suck the client dry and toss him on the junk pile.

The real damage to Goldman is reputational, not the lawsuit.

4.  Goldman’s response so far is to say it has broken no laws.  I think a better tack would be to say (assuming the SEC complaint is more or less factually accurate)–yes, what we did was legally correct.  But it doesn’t live up to our high ethical standards.  It’s an isolated incident by rogue employees.  We’re going to punish those involved and make restitution.

Of course, this is a problem if the SEC has a dozen more similar cases lined up or witnesses who will testify that this deal was approved at the highest levels.  It’s also a problem if the SEC won’t allow Goldman to settle, or if Goldman is completely blameless.  According to Bloomberg, talks had already been going on for nine months about the case before the SEC made its lawsuit announcement last week.

Also, reporters are already beginning to ask how “political” the SEC decision is in this matter.  Is the desire to prosecute this case and right now based solely on its merits?  or is it a response, perhaps the first of a series, to the deep dissatisfaction of many Americans with the apparent lack of interest by Washington in investigating those who caused the financial crisis?  We’ll know better if further SEC complaints are filed against other financial companies in the coming weeks.

Russell Napier on the future of the US?

Who is Russell Napier?

Russell Napier of CLSA wrote the Market Insight column that appeared on Wednesday in the Financial Times.

Mr. Napier is a highly skilled, very thorough financial analyst.  He also has a bearish temperament.  I started to write that he’s a “professional bear,” but that’s not right.  Unlike doomsayers who are always available with a quote about how the world is about to go to hell in a handbasket–usually the same sentiment they have been furnishing to reporters for the past twenty-five years (think: Marc Faber or Andrew Smithers), Mr. Napier is not a publicity hound.

That makes his analysis of the future for the US and European economies, which I find eerie, even more disturbing.

His argument:

1.  The US and Europe have already saddled themselves with so much government debt that they are incapable of lowering it in any meaningful way.  At the very least, there is no political leadership (Germany possibly excepted, and they’re stuck with the rest of Euroland) willing to address the problem.  It may also be that there is no national political will among citizens to pay the money back.

2.  Simply servicing the existing debt will end up with new government debt issues crowding out private capital-raising activities.  To raise more funds, as well as to make government securities look more attractive, governments will levy new taxes that reduce the earning power of private securities.

3.  Private capital will respond by trying to leave the country, but will be prevented from doing so by newly-legislated capital controls.

4.  Mr. Napier concludes his article with the statement that “The ‘new normal” is not sub par economic growth.  The new normal is the roll back of the free markets.”

I’d add a #5.  Assuming #1-4 come to pass, our children will emigrate to countries that offer better economic prospects, much as Europeans came to the US after WWII or as high taxes and limited opportunities caused educated Australians and New Zealanders to seek foreign jobs a generation ago.

What caused our present sorry state?

–in Napier’s opinion, the “North Asian” economic growth model with its emphasis on overproduction in manufacturing made us the parasite to their host.  (I don’t believe this, but that’s what he said.  In any event, I’m not sure diagnosing the cause of our heavy indebtedness is that important.)

too bleak?

What a bleak outlook!

Is the “fall” of the West already written in stone?  I don’t think so.

Certainly, many in the Pacific and Latin America already look at the US in the same way many Americans regard the UK–as a place that time has passed by, whose citizens console themselves in dreams of their past glory.  But that’s just the inevitable consequence of their recent rise to world economic prominence.

One thing has changed, though, in my opinion.    Sixty years ago, Wall Street figured that Republicans were good for business and Democrats were bad, but that perception has long since been relegated to the junk pile.  It has been replaced by what my thirty+ years as an investor have taught me–that Washington is basically like Disneyworld, a collection of strange characters, an interesting and entertaining place to visit that’s largely irrelevant to the running of the economy, and therefore to the rise and fall of stock prices.  Gridlock is the optimal political state, since that minimizes the possibility of bizarre government ideas messing up commerce.

We now know that picture isn’t right, either.  Somehow, with the tacit approval of voters, professional politicians have succeeded in pretty much maxing out our national credit cards.  And for what?–McMansions in Miami and Las Vegas, Vietnam-like wars in the Middle East, and entitlements.  The lightbulb is just starting to come on about how deeply in debt–both through outstanding Treasury bond issues and promises of future retirement and medical benefits–we are.

Suddenly, what Washington does is important.  The picture Mr. Napier paints is what happens if we stick with business as usual.

investment implications

There are investment implications.  The most obvious, and the most important for us today, are that diminishing economic growth prospects in the US and Europe imply emerging markets will do relatively well and that in developed markets multinationals will be better performers than their Europe- or US-centric peers.  This is the strategy I see most investors following anyway.

The next thing to monitor is whether, as Mr. Bernanke has been calling for repeatedly, Washington is able to come up with a credible medium-term roadmap for reducing the government deficit.  If not, as crazy as it sounds to an American, the beginnings of capital flight may not be far behind.

Stay tuned.

Intel’s March 2010 quarter–another good one

March quarter earnings

INTC reported march quarter results after the close on Tuesday.  The company earned $.43 a share on record revenues for a first quarter of $10.3 billion.  Sales were down 3% quarter on quarter from the $10.6 billion posted during the December 2009 period, or about a third of the typical seasonal decline.  Nevertheless, laptop-related revenues were at a quarterly all-time high.

The company said demand was “incredible” and raised its guidance for the rest of the year.

Two parts

I’m going to write this post in two sections.  The first will deal with INTC comments that bear on the state of the world economy or the overall technology industry.  The second will deal with INTC-specfic issues.

Part one:  general

–During the quarter, INTC saw the first indications of a pickup in corporate buying of PCs.  For some time, companies have been swapping out older servers for newer, faster, lower operating cost models.  But now they’re starting to replace aging desktops (average age: 5 years) and laptops (4 years).

This isn’t a mass replacement, at least not yet.  That won’t come, if it does, until corporations have done enough testing of Windows 7 that they feel comfortable substituting it for the aging XP operating system that most are still using.  But it does indicate that corporations feel they have more money to spend.

–INTC is also seeing the first signs of life in “transactional volumes,” that is, sales through distributors to small- and medium-sized businesses.

–Demand was strongest for INTC’s newest 32 nanometer chips.  Despite a faster-than-expected rampup of 32nm factories, INTC couldn’t keep up with client orders.

–INTC itself feels good enough that it will be doing net hiring for the first time in five years.

–I think the regional breakdown of sales for the quarter is very revealing.

——————% of total sales       q on q sales change

Asia ex Japan           57%                            -1%

Japan                          11%                          +10%

Americas                     18%                           -9%

Europe                         14%                            -8%

Given INTC’s dominant position in the logic chip business, this chart shows how radically this business depends on Asian demand.  The Americas and Europe now comprise less than a third of the total.  The Pacific was actually up in slaes for the quarter, which typically shows a seasonal decline of 9% vs. Q4.

INTC expects the corporate tax rate to rise as the year progresses, implying that it expects sales from higher tax-rate places like the US to begin to accelerate.



With a 19% quarter on quarter drop, sales of Atom chips for netbooks experienced an unusually sharp decline–although that might not be the right word for such a new computer market segment.

INTC says that it sees netbooks as a purely individual consumer phenomenon.  There is no corporate market.  It now comprises about 20% of laptop sales, a figure INTC expects will remain steady.

I see the sales falloff as coming from a combination of several factors:  new firms entering the market, a desire by all participants not to miss the big yearend selling season, and uncertainty about the true size of demand.   Now that we have a better handle on the last item, netbook producers are adjusting their production plans but will presumably begin reordering during the second quarter.


INTC sees the tablet market as being today where the netbook market was two years ago.  It thinks demand for tablets won’t cut into traditional laptop demand but will, like netbooks, be additive.  The company says lots of Atom-based tablets are going to be introduced shortly, using both Android and Windows 7 operating systems.

Part two:  INTC itself

INTC is surprising itself with the speed and efficiency of its changeover from producing chips with a spacing of 45 nanometers between lines to the newer-smaller-faster 32 nm.  At the same time, customers who want to be the first on the block with cutting-edge PC speed are willing to pay high prices for the privilege.

On top of that, while 2009 was the year of the consumer’s return to buying PCs (China in the first half, Europe and the US in the second), 2010 is giving every indication of being the year when corporates finally upgrade their PCs that in IT years (2.5x dog years?)  are fast approaching decrepitude.

The first factor means higher than expected operating margins; the second means higher revenues.  The two combined are the force behind INTC’s surprisingly good earnings performance in the March quarter.

There’s no reason to think performance won’t get better as the year progresses.  If corporations decide to adopt Windows 7 during the second half–a bit faster than might be typical, but XP is getting long in the tooth (no one adopted Vista)–2010 could be a truly memorable year.  If not, the earnings party will continue well into 2011.

One probably shouldn’t get too carried away with speculation about how good earnings might be in 2010.  Prior to this report, the Wall Street  consensus was that INTC would earn about $1.65 a share this year.  When the latest round of revisions are in, that figure will probably be a lot closer to $1.80.  $2 a share might even be in striking distance, given that INTC’s highly automated factories have a lot of operating leverage.  But that would likely require a 20%+ increase in unit sales.  And, offsetting some of the resulting gross margin gain, the company has already indicated that it will spend $600 million more than planned on R&D and marketing.  That figure would doubtless increase if revenues do.

What really strikes me is how much free cash INTC is currently throwing off.  The company had $16.4 billion of cash and near-cash assets at the end of last year.  It added $2.4 billion to that total in the first quarter.  Absent another dividend increase or an acquisition, INTC is on track to exit the year with a total of $27-$28 billion on the balance sheet.  Even after repaying the company’s $2 billion in long-term debt, that would amount to 20% of INTC’s market capitalization.

As I wrote after INTC’s last quarterly earnings report, the present company management seems to understand that the company is mature and is managing it appropriately.  One should expect a continuation of the steady dividend increases that have been approved by the board since 2003.  Trading at a pe discount to the market and a dividend yield preference as well, INTC seems to me to be part of a group that would include MSFT and WMT (I own this one) that should be very attractive to Baby Boomers.