MSFT’s March 2010 quarter

MSFT reported its fiscal third (ending 31 March) quarter earnings results on April 22.  This is what I thought was interesting from the numbers themselves and the related company conference call.

the results

Revenue, factoring back in sales that are deferred under GAAP, was up 8% year over year.   Operating earnings were up 17%.  The operating leverage is due partly to the fact that incremental copies of software cost virtually nothing to make, and are therefore almost pure profit.  It also comes from continuing strong cost control.

Operating income benefitted a bit from the absence of severance charges ($290 million in the year-ago quarter), but that was offset by higher legal expense and the costs from the search agreement recently concluded with Yahoo and okayed by government regulators in February.

Net income was up by a much larger percentage, around 36%.  Although MSFT didn’t highlight this on the call, the most important reason the number was in the thirties rather than the teens was a $589 million swing from loss a year ago to profit this March on selling investment securities.  A lower tax rate helped a bit as well.

the reasons

Windows 7 adoption has been the fastest of any Microsoft OS, with 10% of personal computers worldwide now running it. (As a frustrated former Vista user writing this on a Mac, I’m tempted to analyze this as more a comment on Vista than on Windows 7.  But I have to acknowledge that W7 seems to have stemmed customer defections.  So it must be good.)

Sales in emerging markets were up by 20%+ year on year, with sales in developed markets advancing around 5%.  MSFT has begun to notice small- and medium-sized businesses upgrading their software, with revenues in this segment up 15%+.

Piracy is down.  Part of this is MSFT’s litigation efforts to enforce its intellectual property rights abroad.  Part is the increasing market share of global branded computer manufacturers vs. independent no-name “white box” makers, where software piracy is more prone to occur.

Worldwide PC sales are up 25% year on year.  MSFT estimates that consumer purchases are up 30%- and business buys up 15$.  Netbooks, where unit revenues are lower but where MSFT currently has almost all the market, are about 10% of the total.  MSFT unit sales are outpacing market growth.

upcoming quarters

Office 2010, the new Office suite, and a number of server software upgrades launch in the June quarter.  They should provide a steady boost to revenues over the next year or two.

In MSFT’s mind (and who would know better?), large corporations worldwide are clearly preparing for a major refresh/upgrade of their computer systems.  Most have pilot or prelaunch Windows 7 efforts under way now.  They’re planning to deploy W7 as quickly as they can, on the server infrastructure they have today.

Why the holdup?  I presume it’s the usual– IT chiefs want to be sure all the major bugs have been worked out of software before risk the firm’s information backbone by using it.  That takes time.

MSFT also has a large “cloud computing” business, its Online Services Division, which looks like it will report full-year operating losses of more than $2 billion.  At some point–I have no guess as to when–those losses will likely begin to diminish and eventually turn to profit.

What does MSFT do for an encore?

This is the (perhaps cruel or ungrateful) question Wall Street will eventually ask about MSFT.  The company generates enormous cash flow, has negligible debt and is in the midst of an extra-profitable period of upgrades to its basic products—the PC operating system/user interface and the collection of Office-brand business applications.

But the consumer portion of this transition, which is bigger than the business side, is quickly closing on its peak.  And since the market lows in March 2009, MSFT’s stock has doubled.  It has outperformed the S&P 500 by about 20 percentage points over this span, which already discounts at least some of the current good news.

my thoughts

I see two striking features of MSFT:  its enormous cash flow, and how that cash flow is deployed.

On the conference call, MSFT displayed justifiable pride in the fact that March quarter cash flow was a stunning $7.4 billion.  The total for the first nine months of the fiscal year was $18.5 billion.

What is MSFT doing with this money?

stock repurchases          $7.4 billion

additions to cash          $5.5 billion

dividends to shareholders          $3.5 billion

capital spending           $1.2 billion.

If I’ve read the balance sheet numbers correctly, about half of the stock repurchases go to offset the issuance of new stock to employees who are exercising stock options.  But about $3.5 billion has been used to shrink the number of shares outstanding by about half a percent.

MSFT already has about $40 billion in cash and short-term investments on the balance sheet?  Does it need more?  I don’t think so.

Anyway, it seems to me that MSFT could easily double its current dividend (not necessarily all at once; a steady increase over a year or more would be ok), which would produce a yield of 3.5%.  To do this would require a courageous further recognition by the company’s management of the firm’s maturity–a judgment Wall Street has long since made.  My guess is that it would do wonders for the stock’s price, even from here.

My initial reaction is that chances aren’t good.  But we can watch for signs.

By the way, I tried using Firefox to access the conference call and download the 10-Q, because I knew that MSFT doesn’t like Safari.  But the 10-Q wouldn’t download, the conference call narrative broke down twice and the timeline bar to skip/rehear portions appeared only intermittently and didn’t work.  I’m sure Redmond residents find this mirthful, but the humor doesn’t travel.


How expensive is US housing?

residential real estate

Many observers (including myself) think that the housing market in the US began to bottom a little more than a year ago, as savvy property buyers began to return to key markets to pick up prime properties at prices they (correctly) thought would not go much lower.

Soon after midyear, overall housing-related indices began to bottom and then to rise.

Recently, signs of stabilization have emerged even in the worst-hit markets, like Miami, which suffered from wild speculation, massive overbuilding and heavy reliance on large multi-unit residential structures.  (In south Florida, unlike the case in most of the US, projects take longer to complete and when they’re done you don’t just have one unsalable detached house. You have maybe 100 unsalable condominium units.)

Despite all this good news, the question still arises whether this is simply an elaborate technical movement–sidewise price action based mostly on the market needing time to absorb the stunning depth of the declines of the past three years, but to be followed again by another fall off the table.

the Economist analysis

In a recent issue, the Economist observes these phenomena and addresses the valuation question.  For a variety of countries, it calculates the historical relationship between rental income and house prices.  It then uses this figure to figure what home prices should be, given today’s rents.  The results?

the US

1.  For the US, the magazine does three calculations.

Using the Case-Shiller ten-city index, house prices are 3.9% overvalued.

On on the Case-Shiller national index, house prices are 3.7% undervalued.

Taking the Federal Housing Finance Agency index, which eliminates anything financed with a sub-prime loan–in other words, is really biased to the upside–house prices are 13.1% overvalued.

If this simple measurement is close to correct, then the US housing market is on relatively firm footing.  It may not go up, but the floor is unlikely to disappear from beneath us.

undervalued markets

2.  Other fairly-/undervalued markets?

Japan, 33.7% undervalued

Germany, 14.6% undervalued

Switzerland, 7.1% undervalued

China, 2.7% overvalued.

I’m not sure where the data come for China.  This certainly cuts against the conventional wisdom, though, and lines up with the brave few who are arguing that the rise in property prices in the Middle Kingdom are just keeping pace with its rip-roaring economic growth.

overvalued markets

3.  Overvalued markets?

Australia,  56.1% overvalued

Spain,  53.4% overvalued

Hong Kong,  49.1% overvalued

France, Sweden, Britain and Belgium, all 30%+ overvalued.

Of  these, prices in Hong Kong, Australia, Britain and Sweden are rising.

what to make of this

The US, the first place where housing troubles emerged, appears to be most of the way back out of the woods.  This doesn’t mean that prices will be going back up much from here.  Who knows?  But it suggests that housing is not going to provide more negative economic surprises.

The undervalued markets are by and large in moribund economies.  China is an outlier.  It’s hard to know what to say about it.

The overvalued markets are split between fast-growing areas in the Pacific and the euro-zone.  Sounds like more potential trouble brewing in Euroland–as if they needed more.


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.