End game for growth stocks: nasty, brutish but not very short. How does AAPL fit the mold?

the growth stock life cycle, in brief

The Wall Street cliché is that the key to successful growth investing is how skillfully you sell the stock (as opposed to value investing, where the key is how you buy it).

The idea is that most growth stocks have a very short life in the stock market sun–five or so years.  The best growth companies continue to reinvent themselves and create new lines of business–as WMT or MSFT did.  But most aren’t able to.

As the company demonstrates surprisingly strong earnings growth, the stock market attitude gradually changes from one of disbelief to fandom–extrapolating the period of superior profit expansion much farther into the future than will likely pan out.  This tendency shows itself in a huge price earnings multiple–both absolute and relative to the rest of the market.

Normally, the seeds of future earnings disappointment–and consequent price earning multiple contraction–are already being sown in a qualitative sense at least.  But many investors ignore, or explain away, these early warning signs even when they begin to be evident in reported earnings.  At some point, disillusionment, and subsequent underperformance, begins.

MSFT as an example

MSFT is a good example of this phenomenon.  In the four years from 1995 to 2000, MSFT’s reported profits per share grew at a 40% annual rate,  meaning they quadrupled over that span.  The price earnings multiple expanded from 29 to 53, and advance of 83%, over the same period.  Therefore, more than two fifths of the total 10x stock gain came from p/e expansion.

Over the subsequent decade, MSFT’s eps grew at a little more than a 10% clip–and the stock’s p/e contracted steadily from 53 to 13 (or 3.5x the market average multiple to .9x currently).  Despite the doubling in earnings the  stock price has been cut in half, more than all of which is due to p/e contraction.

If we look at MSFT in general conceptual terms, the stock was first driven by the acceptance of the MS-DOS operating system, then by the Office suite, and finally by successive iterations of the Windows graphical user interface–all in an expanding PC market.  Then the market for its products matured, MSFT came late to the Internet, its diversifications earned little money and…  Nevertheless, it’s important to note that MSFT lasted as a growth stock for such an unusually long period because of its successive waves of innovation from MS-DOS on, not just because the PC market was growing quickly.

How does AAPL fit this model?

Looking in the most general terms, AAPL was a moribund personal computer firm with a cult-like following among individuals using PCs that had a change of management.  New leadership introduced a portable music player, the iPod, that was so successful it quickly doubled the size of the company.  AAPL subsequently introduced a revolutionary smartphone, the iPhone, which again doubled the size of the company.  Now it’s introducing a third product, the iPad in a hope of doing the same trick again.

What AAPL has done over the past decade is truly remarkable.  Earnings per share have grown at a 60%+ annual rate, and are now 10x what they were in 2005. The company is now one part PCs, one part iPod, and two parts iPhone, three of which weren’t there five years ago.

Two potential questions about AAPL’s future performance have emerged:

–One is the “concept” observation that to have the same positive effect on the overall company as the iPhone has had, the next product, presumably the iPad, has to be twice the size of the iPhone.  This is just a fact of the company’s recent growth.

–Android phones are emerging as a potential competitor to the iPhone; iPod unit sales are slipping; Chrome-based tablets are potentially going to be on the market for this year’s holiday season.  Wall Street is presumably thinking that Chrome products will end up being a case of the Zune redux.

one big difference

In 2005, AAPL’s stock was trading at 26x earnings per share.  Today, after a period of extraordinary earnings growth, AAPL’s stock is trading at under 17x eps, a pe multiple contraction of 30%.  AAPL’s relative pe was 1.4 in 2005.  It’s 1.1 now.

Unlike the typical growth stock, more than 100% of AAPL’s stock performance has been driven by earnings growth.  The pe contraction means investors have been increasingly forcefully betting that the company can’t continue its present rate of expansion.  In fact, one might argue that a pe multiple of 17- means the market thinks AAPL won’t grow earnings by more than 15% from now on.

my thoughts

Personally, I think tablets will create a new revolution in computer usage.  I’m not sure the AAPL will get the market share with the iPad that it has been able to achieve with the iPhone or the iPod.  Still, if my reading of the stock price dynamics is correct, I think Wall Street is being much too pessimistic about AAPL’s prospects.  Hard as this is to say about a stock that has had 15x the market return over the past five years, that’s what the numbers tell me.

big week for news: NYT the most interesting?

Some aspects of the quarterly financial reporting season now underway are coming in about as one might expect.  The foreign arms of US multinationals are doing better than their domestic counterparts.  Firms whose main customers are businesses are reporting higher earnings gains–and eliciting a more favorable response from Wall Street–than those that cater to the consumer.

Of all the corporate announcements this week, three jump out at me, though.  They are:

–Citigroup announced yesterday the results of one of its periodic surveys of the consumer, based on telephone conversations with 2,005 individuals last month.  The real attention-grabber is the conclusion that almost two-thirds of Americans don’t believe the economy has “hit bottom” yet.  Most think it will take several years for things to return to normal for them.

Normally, ordinary people are much savvier than Wall Street gives them credit for.  And survey participants’ ideas of when the country is back to normal coincides closely with that the Fed thinks.   But it’s hard to figure what to make out of the “hit bottom” idea, since the domestic economy did hit bottom about a year ago and has been bouncing back since.  Maybe it’s just a poorly phrased question.  Maybe it means that most people don’t have clear evidence that their family fortunes have turned up yet (as opposed to the idea the headline portrays that things are continuing to get worse).  Maybe it’s not a comment about the families’ individual situation but about the country as a whole and the size of the government deficit.

In any event, it suggests that a US consumer spending boom isn’t right around the corner.  Le’s hope C goes for less shock value and more information the next time it asks the questions.

–On July 19th, three days before announcing (disappointing) June quarter financial results, AMZN issued a press release about its sales of e-books on Kindle.  Over the past three months, AMZN’s overall unit sales of e-books have been 43% higher than its sales of hardcovers;  in the past month, e-book unit sales have been 80% higher than those of hardcovers.  In addition, the (unspecified) growth rate of Kindle e-readers has tripled since AMZN cut the price from $259 to $189.

The timing of the announcement says AMZN wanted to make sure this information made a separate impact on investors/consumers and didn’t get lost in the welter of data contained in an earnings release.

I don’t think this development can be good for AMZN’s near-term profits from books–not that AMZN’s management it too worried about that.  What’s interesting is that e-books now appear to comprise well over 10% of total book sales in the US–and accelerating.  Only AMZN knows for sure what its market share in e-books is, but the Kindle press release makes it sound like AMZN is getting three-fourths of the business.

–The most interesting announcement, to me anyway, is that made by the New York Times Company in its quarterly earnings announcement yesterday.  NYT’s online advertising revenues, which grew by 21% year over year, were enough to offset a 6% decline in print advertising sales, leaving overall ad revenues flat.  I don’t know NYT well as a company and I’m not sure this does much for the stock.  But I wouldn’t have guessed that the newspaper company’s painful transition into a new world was this far along.

Apple’s June 2010 quarter: another (ho-hum) stellar performance

AAPL reported June quarter 2010 results after the close on Tuesday.  Per share earnings were $3.51, way above the Wall Street consensus, suggesting the company is on track to post eps of about $14+ for the current calendar year.

The company’s press release and conference call, as usual, contained a laundry list of all-time highests and significant milestones passed.  For example, in the June quarter AAPL posted its highest three-month revenue ever (even better than last holiday season) at $15.7 billion.  That was up 61% year over year, by the way.  Mac sales were also a quarterly record at 3.47 million units, up 33% year over year.  As my brother in law, a long-time Apple devotee, put it the only thing the AAPL report seemed short on was superlatives to describe the operating performance.

the details

–AAPL sold 9.4 million iPods during the quarter, down from 10.2 million in the corresponding period of fiscal 2009 (ends September).  But higher-priced iTouch units were up 48%, raising the average selling price for all iPods by 12%.  This meant iPod revenues were up 4% despite the sharp decline in unit volume.

–AAPL sold 8.4 million iPhones, including 1.7 million+ iPhone4s.  This was 61% year over year growth, substantially above the estimated 38% expansion rate of the global smartphone market.  AAPL could have sold more phones, except that: a) it deliberately ran down inventories of older phone models in preparation for the launch of new ones, and b) it ran out of iPhone4s to sell.

At $5.33 billion, iPhone revenues were up 74% year on year, and implied an average selling price during the three months of $595.

–Mac sales, as noted above, were a record 3.47 million units.

–iPad sales were 3.47 million units in the June quarter, totaling a bit under $2.1 billion, with maybe $80 million in accessories to boot.  ASP was about $640.

–the Apple Stores booked $2,58 billion in sales during the period.  That was 73% higher than in the June period of last year.  Average revenue per store was $9 million vs. $5.9 million a year ago.  Half the Mac buyers in the stores were new to AAPL computers.

–iTunes generated over $1 billion in revenue.  The app store now has over 225,000 selections, including 11,000 for the iPad.  there have been over 5 billion downloads to date.

–AAPL’s margins were 3.1 percentage points higher than it had expected.  The biggest single reasons were surprisingly brisk sales of iPhone accessories  and higher iPhone sales than expected (this must mean that older models sold unusually well, since iPhone 4 has lower margins).  Yes, the iPad did depress overall margins by the expected 150 basis points.

AAPL is also lowering its full year tax rate slightly, implying higher than expected sales in low tax rate areas (read: non-US sales).

what caught my eye

–Apple Store sales.  No sign of recession here.

–AAPL is selling iPhone4s and iPads as fast as it can make them.  This means the company doesn’t have a firm idea of what true demand for either is–just that it’s a lot bigger than AAPL planned for.  Also, both devices carry lower than company average margins.  I think this is a tale of two different devices, namely:


iPhone4s are selling as fast as AAPL can make them. So all the company really knows about demand is that it’s greater than AAPL can fill.  Therefore, AAPL doesn’t know whether it is losing market share to Android-based phones or not.

Returns of the iPhone 4 so far have been lower than for previous versions of the iPhone.  Virtually none of the returns are being identified by the user as being due to antenna problems.  (These problems apparently arise from the fact that antennas of different lengths for different frequencies are embedded in a bezel around the edges of the phone.  Poorly placed fingers can connect two antenna segments, thereby lengthening the antenna and losing the signal.)  Despite this, AAPL is offering all iPhone4 buyers a free case that fixes the issue.  AAPL will defer what it thinks will be $175 million in revenue that would otherwise be recognized in the September quarter from iPhone4 sales where the owner hasn’t responded to the offer of a case.  Not a big deal, but might slow AAPL’s growth rate this quarter by a percent.

Why the lower margins for iPhone4?  After all, it’s the best iPhone yet?  I think it’s competition–actual or anticipated–from Android.  If so, it signals a maturing of the cellphone business, the source of the largest part of AAPL’s profits.


The iPad is also selling as fast as AAPL can make the units.  So, just as is the case for the iPhone4, the company knows only that demand is higher than AAPL is able to fill.  AAPL management thought is was being very aggressive in assuming it could find buyers for a million units a month.  But that turns out to have been too conservative.  In its first three months, iPad is already well over 10% of AAPL’s business by revenue.

So far–admittedly a short time–there’s no apparent cannibalization of other AAPL products by iPad.   Mac had a record sales quarter and iPod Touch was up 48% year over year.  AAPL seems to be almost hoping that iPad begins to cannibalize PC sales, however.

The arithmetic is pretty straightforward.  If, say, 10% of current PC users would prefer a tablet like an iPad, then AAPL would lose sales of 3 million-4 million yearly Mac units, which would be offset to some extent by an equivalent number of iPad purchases.  Consider, however, what happens in the 90% of the PC market that AAPL doesn’t have.  A 10% shift toward tablets gives an addition sales potential for iPads of about 30 million a year. So cannibalization could well translate into a loss of $3-5 billion in Mac revenue, but a gain of $20 billion in iPad sales.  Not a bad tradeoff.

Why the low margins?  Unlike the situation with the iPhone, there’s no formidable competitor to the iPad in sight.  But AAPL wants to penetrate the market a deeply as possible, in the hope the iPad can become the de facto industry standard before a competitor emerges.

investment conclusions

I’ll elaborate in a later post, but I think the stock still looks to be reasonable value.  Growth stocks rarely have more than five years or so in the limelight.  Wall Street analysts seem to me to be clearly worried about this–about the possibility of competition in AAPL’s main business lines and about what AAPL can possibly do to replicate the fabulous earnings growth of the past half-decade.  On the other hand, growth stocks typically peak at outrageously high price earnings multiple.  The deadly combination, then, is earnings shortfall + elevated multiple.  In AAPL’s case, the former seems unlikely for now.  At 17-18x calendar 2010 earnings, the latter doesn’t appear to me to be the case, either.

Harley Davidson (HOG) as economic barometer–positive signs

Harley Davidson (HOG) is an iconic American company. Harley Davidson motorcycles have typically been an aspirational purchase for men over 35 (maybe 50+ and having gray hair might be a more accurate characterization). They carry echoes of Easy Rider, The Grateful Dead, and the Sixties Generation, as well as a hint of the power/danger of the biker gangs whose staple ride they are.

HOG is a particularly interesting company operationally, in my opinion. It is trying, with some success, to broaden its image to appeal to younger riders, women and minority group members. The company is also rationalizing its manufacturing operations and gaining better control over the workings of HDFS, its credit arm. All these moving parts present opportunities for a careful researcher to find evidence of potential positive earnings surprise.

And, of course, Warren Buffett, himself an icon, has recently become a significant shareholder.

In this post, however, I’m more interested in HOG as an economic indicator than as a stock to buy. Motorcycles are perhaps the ultimate discretionary (read: frivolous or unnecessary) durable purchase. A Harley may cost $20,000 and, though it may be a joy to ride, it’s not particularly useful. Boats probably top the list for frivolity, but they don’t appeal to as wide a demographic as bikes. (I own a small runabout and a couple of Harley t-shirts, but no bike—so far.)

HOG reported its June quarter results yesterday morning. They contain two positive signs for the US economy.

The first positive is in domestic motorcycle sales. Although they remain at only about 60% of the pre-financial crisis level, they are up slightly year on year.


2008           -13.0%     +7.9%            -2.0%

2009          -25.8%      -3.4%            -12.8%

2010          -15.7%      11.2%            +1.3%

On the one hand, the growth in sales comes from purchases of used motorcycles. But they are sales nonetheless. And they are coming after HOG significantly tightened up the credit-granting standards of its finance subsidiary, HDFS, which makes bike purchase loans to about half of domestic Harley buyers.

Shipments of new bikes from HOG to its dealers are also up slightly in the first half.  Overall dealer inventories are down by over a third vs. this time last year, with only supplies of used bikes higher than normal.

All this is good news for HOG. For the economy, the interesting thing is that men are becoming comfortable enough about their personal financial circumstances to be starting to buy Harleys again (without fearing divorce or severe bodily harm from their wives).

The second piece of good news comes from HDFS. It concerns loss experience and loan delinquencies.

At 4.5% of outstanding loans, those with payments more than 30 days overdue is somewhat higher than Harley’s pre-recession experience (3.6% in 2Q06 and 4.4% in 2Q07), But its not that far above- and it’s lower than at this time last yea ror the year before.

Loss experience is better, as well.  The current annualized rate of 2.04% is better than in either of the past two years.  It’s also within striking distance of the 1.63% posted in the first half of 2007 and the 1.20% of the first six months of 2006.   This good performance is partly because 85% of HDFS’s loans are now prime (5%-10% higher than pre-2009), partly because used bike prices, which plunged during the worst of the financial crisis, have begun to rise again.  But it must also be in part due to the fact that money isn’t so tight as it was during the worst of the recession.

I’m of two minds about the stock.  I don’t regard the Warren Buffett endorsement as a plus.  Mr. Buffett, one of our profession’s true geniuses, saw much earlier than anyone else that brand names and established distribution networks–in other words, intangible assets–had an immense value that was neither listed on the corporate balance sheet nor a factor in the thinking of his contemporaries.  So you could in effect buy them for free.  –and that’s what Mr. Buffett did.

But the insight came almost a half-century ago.  Everybody knows it now, just as well as everyone knows about Benjamin Graham.  So the Buffett touch isn’t enough any more, in my opinion.

In the case of HOG, however, a genuine corporate turnaround appears to be underway.  More in a later post.

retraining workers–but for what?

When I was in college in Boston in the Sixties, my school had a long-tenured and widely known hockey coach–and, despite a cast of excellent players, a thoroughly mediocre team.  According to my friends on the team, whenever they went to this coach for advice on any technical aspect of the game–skating, puck handling, shooting–his standard reply was, “Practice!”  Not very helpful, but that exhortation exhausted his knowledge base.

A lot of the recent commentary on the unemployment situation in the United States–and, by extension, anywhere else in the developed world–reminds me of that college hockey coach (thankfully, long since retired and succeeded by a line of much more skilled coaches).

The current situation is well-known.  Actually, I’m not sure it is.  The facts have been around for a long time.  And most people probably can dredge up the information if pressed.  But I’m not sure enough people in the developed world have passed from purely intellectual awareness to emotional commitment to act on the challenges they represent.

The working populations of China and India are gradually entering the labor force available to international firms, swelling its ranks by about 50%.  These workers are happy to work for a year for the wages their counterparts in the developed world demand for a month’s labor.  So, the latter are priced out of the market, and are being replaced by the former as quickly as possible.

The “insight” of the typical commentator on the “decline of the West” is limited to the suggestion that displaced workers be given temporary government support and retrained for new jobs.  I believe that’s right.  It’s also the orthodox prescription that can be found in any first-year economics text. But it’s also a “solution” as unhelpful and as devoid of content as “Practice!”  Retrain for what?  The commentators, many of them insulated by ivory-tower tenure that insulates them from the reality of the situation, offer (…have?) no clue.

There is some justification for stopping at framing the problem without offering any solutions.  Generally speaking, high-level industrial policy of the kind Japan’s MITI was once famous for hasn’t worked there, or anywhere else.  When the Cold War ended and the defense industry in the US collapsed, many scientists working in exotic metals used for weapons systems ended up designing golf clubs.  Who’d have guessed?–no one.

But I think there are some conclusions that can be drawn.  For instance:

1.  The tendency of Washington to prevent, say, Chinese industrial companies from making investments in the United States means that these firms continue to service US customers from abroad.  The associated job creation remains in China instead of migrating to the US.

2.  As Fiat’s Italian auto workers are now showing, and as west coast port workers in the US demonstrated several years ago, beneficiaries of an older order can be highly resistant to change.  In the developed world, it seems to me the most urgent need is to reform an education system that creates newly-minted graduates prepared to succeed in the world of 1960 (which no longer exists), but which is controlled by professionals who have been granted jobs for life.  Charter schools, anyone?

3.  I’m worried that the long-term unemployed are going to prove a particularly intractable problem.  Take a hypothetical  fifty-five year old high school graduate with no computer skills,  who has bounced from job to job during the housing boom but has been laid off from an assembly line or some other physical labor job eighteen months ago.  He will likely live another thirty-five or forty years.   What are his chances of getting another job?

Over a million young workers enter the labor force each year.  If the Fed projections are right, it will be at least a couple of years before the economy is healthy enough to absorb this flow.  By that time, our hypothetical worker will be approaching sixty–and a prime target of age discrimination.

Yes, retrain this worker.  But have computer skills eluded him for all this time because he didn’t need them, or because he’s been unsuccessful at past learning attempts?  I don’t know.

I suspect, though, that the US is going to experience a period of European-style chronic high unemployment–with the potential creation of a new underclass–for a long time.

investment implications

On the one hand, unemployment and education are political and social issues.  But they have a direct investment significance in that they influence the trend growth rate of GDP.  In extreme cases–not likely in the US, I think–economic stagnation has led to a “brain drain,” where the best and the brightest leave their home countries in search of better economic prospects elsewhere.

As far as Wall Street is concerned, I think the implications are clear–shade strongly away from the 25% or so of the stock market where earnings are closely linked to the fortunes of the overall domestic economy.  Until investors are clear that 75% of the market’s earnings are not, however, I suspect that stocks will continue to react en masse–though (I hope) with decreasing amplitude–to bumps along the road to economic recovery.