Monthly Archives: October 2010

AAPL’s 2Q10 earnings: a raft of records, followed by an aftermarket fall

October 19, 2010 By in Current Market Thoughts, e-readers, earnings conference calls, emerging markets, Industry Analysis, Recent Market Action, Stock ideas, Technology Tags: , , , , , , , Leave a comment

the report

After the close last night on Wall Street, AAPL reported its 4Q10 (the fiscal year for AAPL ends on September 30) results.  At $20.4 billion, quarterly revenue was a record high, as were net profit, at $4.31 billion, and eps, at $4.64.  The company also had record unit sales of Macs, iPhones and iPads.  AAPL guided to December quarter eps of $4.80.

Despite the stellar numbers, AAPL’s stock fell by about 6% in aftermarket trading.   This same fate befell the shares of IBM and VMW, both of which also reported above consensus results after the bell.  So this weakness may simply be the reaction of short-term traders whose plan has been to “sell on the news”–no matter what the news was.  In AAPL’s case, there are one, maybe two, sore points with investors, though–iPad sales and the tax rate.

details

AAPL sold 3.9 million Macs during the quarter.  That was 440,000 more than in the previous record quarter (3Q10) and a 27% gain vs. the year-ago period.  This compares favorably with the overall PC industry, which grew by 11% vs. 2009.

iPod units fell by about 11% year over year, to 9.1 million.  Hardware revenue fell by only 5.5%, however, as consumers continued to gravitate toward higher-priced models.  Throw in the iTunes store and sales of accessories, and revenues in this very mature segment and revenues were up 5% vs. the comparable quarter of 2009.

With iPhone4 available for the full quarter, iPhone units were up a stunning 91% year over year, compared with a 64% global advance by the smartphone category.  Despite the huge gain, AAPL was capacity-constrained during the quarter and thinks it could have sold more iPhones if it could have manufactured them.

In its second quarter of existence, iPad sold 4.188 million units vs. 3.27 million in its inaugural three months.  Manufacturing capacity, now reportedly at 2 million+ units monthly, appears to have caught up with demand in the major markets where the tablet was launched.  AAPL ended the quarter with an extra 500,000 units in channel inventory.  My guess is that AAPL has about 1.2 million iPad units in stock.  The company’s only comments are that supply and demand are in balance in the markets where iPad is available so far; and that inventories are 3-4 weeks supply, below the 4-6 weeks it would prefer.

The Apple Stores continue to expand rapidly.  At $3.57 billion, up 75% year over year, store revenues were a record.  Sales of Macs totaled 874,000 (another record), half of which went to customers who had never owned a Mac before.

AAPL ended the quarter with no debt and $51 billion in cash.

The fourth-quarter tax rate was 21%, about 5 percentage points below company guidance and about 3.5 percentage points below the full-year rate.  This is partly because sales were stronger than expected in low tax-rate jurisdictions outside the US, partly due to year-end adjustments between what the company estimated (and recorded in its quarterly income statements) its tax liability would be and what it actually turned out to owe.

why is the market upset?

After all, sales of the iPhone4 were at least a couple of million units better than the consensus had expected.  Macs were strong, as well.

The main issue is the iPad, I think.  After all the hype about the device and recent stories by industry experts attributing at least a portion (maybe even most) of the current weakness in consumer PC sales in the US and Europe to cannibalization from the AAPL tablet, expectations were very high.   Investors thought they’d hear that the company was still struggling to meet demand and it had sold about 5 million units in the quarter.  What they heard instead was that inventories were starting to accumulate and that sales were a bit under 4.2 million.

Yes, the “shortfall” in units sold was more than made up for by iPhone strength.  But the iPad market has been transformed in analysts’ minds from one where they can imagine boundless growth for a long time to one where available information forces them to think demand is 1.5-2 million units a month.  To some degree, the “dream” is punctured.

The tax rate is also a potential issue, for me anyway.   The actual 21% meant after-tax income was about 7% higher than it would have been under the 26% rate AAPL had guided to.  But operations were very strong on a pre-tax basis.  And I don’t think today’s Wall Street pays more than fleeting attention to the tax rate in any event.

should it be?

I don’t think so.

Before the earnings announcement, analysts were estimating that AAPL could earn a bit over $18 in the 2011 fiscal year.  That number will probably rise to $19 as the factor the strength of Macs and the iPhone into their numbers.  At $300 a share, that would mean AAPL is trading at under 16x prospective earnings, with over 30% earnings growth in prospect.

Yes, maybe the iPad and iPod results, plus the increasing importance of foreign markets, mean that AAPL products don’t all have immunity from economic weakness in the US and Europe.  Yes, maybe thinking about AAPL’s earnings has lost some of the element of boundless upside.  But, as I’ve pointed out elsewhere, AAPL sports nothing like the 35x-50x PE multiple that a growth stock usually carries.  In anything other than the panic conditions of late 2008 and early 2009, the very low multiple limits any downside, I think.

liquidity trap: what is it? are we in one?

October 18, 2010 By in Current Market Thoughts, economics, liquidity trap, Recent Market Action, Strategy, Vocabulary Tags: , , , , , , Leave a comment

liquidity trap

Over the weekend, Charles Evans, president of the Federal Reserve Bank of Chicago, said at a Fed conference in Boston that he thought the US is in a “bona fide liquidity trap.”  His prescription to cue this situation:  a second round of quantitative easing (basically, the Fed trying directly to push down longer-term interest rates) plus inflation-level targeting (promising to continue loose money policy until inflation reaches 2%).  The purpose of the second is to try to assuage fears of deflation by money market participants.

What does all this mean?

what it is

When the Fed, or any central bank, lowers short-term interest rates, the move has a whole series of effects:

–the initial move signals that the short-term direction of policy is reversing;  the money authority wants to encourage faster economic growth, not slow down inflation

–lower returns on savings instruments tied to short-term rates encourages people to spend money rather than to leave it in the bank

–lower rates on lending money tend to encourage consumers to borrow to finance consumption;  to the extent that younger people tend to be borrowers and senior citizens savers, economic power undergoes a demographic shift that puts money in the hands of those more likely to consume

–arbitrage extends the lowering of rates to longer-maturity debt instruments; lower long-term rates make company investment projects more economically attractive and thus encourage spending on capacity expansion and new hiring.

You can, in theory–and, looking at Japan over the past twenty years, in practice–envision circumstances where this process of lowering interest rates to stimulate economic activity won’t work.  That’s a liquidity trap.  The money authority lowers rates but gets no economic response.

Economists have, not always clearly, distinguished between two types of liquidity trap:

1.  deflationary, sometimes called the “zero bound” case.  The goal of accommodative money policy is to lower nominal rates until they are negative in real terms.  The idea is that once the saver realizes he is no longer even preserving his purchasing power by holding short-term deposits, he will boost his consumption and look for (riskier) investments where he can earn a positive real return.

But nominal rates can in practice only be reduced to zero.  If prices are falling (which is what deflation is), real rates stay high despite the best efforts of the money authority.  If prices are dropping by 3% a year, for example, a zero nominal rate is a 3% real rate.  As a result, savers don’t budge.

There have been instances of negative nominal interest rates–like in Hong Kong in the late 1990s, when the government there announced plans to charge a recurring fee to foreigners for holding bank deposits.  But they’re a practical impossibility.

2.  a “true” liquidity trap, or “pushing on a string.”  The idea is that a point might be reached where central bank action in pumping ever larger amounts of money into the economy would have no further positive effect.  The economy would, in a sense, be saturated with money.  The original thought was that interest rates would remain above zero but would not decline further, despite the efforts of the central bank to push them down.  But the idea can easily be expanded to include other cases where money polity is ineffective:  the transmission mechanism may break down if economic entities are frightened and want to hold precautionary balances even though they earn no economic return; or there may be enough regulatory or government policy uncertainty that it’s hard to identify viable projects to invest in.

where we are now

In the US, inflation has been running at about 1% over the past year or so.  The sharp decline in the dollar over the past several months suggests that, if anything, inflation will rise a bit as we head into 2011.  So, although policy makers and economists may fear deflation, we’re not in that situation today.  That means type #1 above doesn’t apply to us.

There’s a lot of liquidity sloshing around in the US–in the whole world, for that matter.  Several private companies have been able to borrow money at a fixed rate for fifty years or more.  Mexico, despite its history of economic meltdowns and its internal political difficulties, has recently successfully issued a hundred year fixed-rate bond.

This leaves us with breakdown in the transmission mechanism as the reason why money policy has become ineffective.

Mr. Evans of the Chicago Fed seems to think that fear of deflation is the main problem, or at least that’s what his remedy of in effect having the Fed promise to create 2% inflation suggests.  Other economists lack of enthusiastic support suggests his is a lone voice.

This leaves the possibility that attractive investment projects are hard to find.  In a recent speech, the head of the Minnesota Fed, Narayana Kocherlakota, suggested that the gating factor may be lack of skilled workers.  The sound bite the press picked up was his observation that the Fed has no ability to turn construction workers into machinery workers.  He also pointed out that Bureau of Labor Statistics data indicate the economy has about 800,000 more unfilled jobs now than it did in March 2009.

It’s also at least a logical possibility that uncertainty about medical care costs or about future taxes is at the root of companies’ reluctance to invest domestically.  Given that the Fed members are political appointees, though, I think there’s a pragmatic limit to what they’re willing to say in print.  To me, however, it’s clear the Fed thinks a dysfunctional congress and an ineffective president are the reasons the current liquidity trap persists.

I think adjustment to the new economic circumstances is already taking place.  Lack of effective regulation and supportive legislation will just mean the transition process is a longer one.

ETFs, synthetic reconciliation and counterparty risk

October 17, 2010 By in ETFs Vs. Mutual Funds Tags: , , Leave a comment

the issue…

Most ETFs are index-tracking investments.

A key decision for the ETF’s managers is how they will mimic the index while dealing with inflows and outflows of money.

There are two basic choices:

–physical replication, a strategy followed by US-based ETFs: and

–synthetic replication, favored by Europeans.

The fund’s offering documents will spell out what a given ETF intends to, and is allowed to, do.

Physical replication means mimicking the relevant index by buying the constituent elements. In the simplest case, it means buying and selling all the index constituents, in appropriate amounts, as needed. A modified strategy is to use index futures to allow the manager to control the timing of purchase and sales, while still responding immediately to inflows and outflows.

With an index with a lot of members like the S&P 500, it’s also common to find a subset of the index that tracks the overall index with a high degree of accuracy and use it as a substitute for holding the entire index. The ETF can thereby avoid potential problems with trading in illiquid index constituents. Typically, this strategy will be disclosed to investors in the offering documents.  Differences between ETF and index performance that’s attributable to “tracking error” is a risk shouldered by the ETF holder.

Synthetic replication is an extension of the idea that you can use derivatives to supplement holdings of physical securities that are index constituents. In its extreme form, synthetic replication means that the ETF manager negotiates a derivatives deal with an investment bank. The manager agrees to invest the ETF capital in a specified basket of securities and swaps the return on that basket for the return on the ETF’s index.

Synthetic replication has a number of aspects:

–ETF management is simplified substantially, meaning, among other things, that the ETF manager can concentrate on marketing its investment product rather than managing it,

–control of execution of the investment strategy is, in effect, transferred to the investment bank

–the issue of  tracking error can be negotiated away

–the investment bank typically is able to collect income from lending out the securities held by the ETF (presumably influencing the bank’s position about what securities the ETF should hold).

…is always counterparty risk

Synthetic replication also has consequences you should be aware of before buying.

— The swap arrangement negotiated with the bank by the ETF doing synthetic replication is an OTC derivative. This means it’s a contract whose value depends crucially on the financial soundness of the counterparty.

–In the event that the bank is unable to fulfill its obligations to the ETF, shareholders are left with an interest in the securities held in the ETF portfolio. This may, or may not, be the equivalent of the index. In addition, it’s possible that securities lent out to third parties may be involved in litigation and difficult for the ETF to recover and sell.

The risks inherent in synthetic replication are doubtless disclosed in the offering documents.  I’d characterize the risks as having low probability of actually occurring, but potentially having severe negative effects if they do.  The fact that everything is disclosed in the ETF’s official filings suggests that the holder will have no legal recourse against the ETF manager should the counterparty fail.  In selecting this type of ETF, he has taken the risk on himself.

As is the case with leveraged or inverse ETFs, the unwary buyer may only find out about the product’s characteristics when it’s too late to do anything about them.

Start getting ready for 2011 now

October 15, 2010 By in Constructing a Portfolio, Current Market Thoughts, Portfolio management, Strategy Tags: , , , , , , Leave a comment

it’s not too early

We’re now in the middle of October.

The second half of December is a completely lost time for professional equity investors. Volumes shrink considerably. Most professionals know their year has long since been either made or broken, so they’re on vacation. Many markets are shut down for part of the period. Accountants are starting to tot up the official score. Yes, there are sometimes very profitable anomalies to watch for (moe on this in another post). But, practically speaking, the party’s over and the lights have been turned out, so it’s much too late to be starting to reorient a portfolio.

In the first half of December, it starts to become much harder to talk to companies or to brokerage house analysts. They’re all involved in their internal pushes to close out the year, so they don;t have a such time as the would in other months. And they’re either out of the office or planning an imminent holiday departure, as well.

This means thinking about next year and acting on new strategic thoughts is starting to happen in world stock markets now, and will take place in the six or seven weeks left before December rolls around.

That’s our main investment job from this point on.

what to do

Two approaches:

1.  Develop/update your strategic plan. This is a high-sounding name for trying to figure out what the world will look like and how stocks (and maybe bonds and cash) will behave as investments after 2011 dawns. Stuff like: will it continue to be better in the US to bet on companies with a lot of foreign earnings or should one switch some money to thus-far underperforming domestic-oriented names? (I’ll be posting my thoughts for next year in a week or two

2.  Mechanical housekeeping. Three aspects to this:

—position sizes.    2010 has been a year of widely varying performance by different world stock markets and by individual stocks within them. If you’ve been very lucky or skillful, you’ll have positions that are up 50% relative to your overall portfolio. Some may violate your personal position guidelines. In my opinion, no one should have a stock, or mutual fund/ETF position (except index positions) that’s more than 10% of his total wealth. Your ideas may differ. But there can easily be positions that, when you sit down to look at them, are too risky because they’re too big. You should fix that.

—losers. Take a hard look at what’s gone wrong. We all play mental tricks with ourselves to rationalize away underperforming areas of the portfolio. But chances are, deep down inside, we know when something is a mistake. Sell and redeploy the money.

—asset allocation. This is the most important item under heading #2. I’ve saved this for last because I find it the most difficult decision to make. If you started with a 50/40/10 model allocation among stocks bonds and cash, you almost certainly are underweight cash and are likely underweight bonds. Neither of these asset categories look even remotely attractive to me. What to do? I’ve decided, as recent market action says many others seem to be doing as well, to substitute high dividend-yielding stocks for part of my stocks/cash allocation. In reality, you should be aware, if you also do so, that this is a change in asset allocation and an increase in the risk level of your holdings. At the very least, this means watching the consequences of the decision very carefully; it should probably also mean dialing down the risk level in your pre-existing equity holdings to compensate for the additional allocation to this category.

 

Intel’s 3Q2010 earnings: about as expected

October 14, 2010 By in Current Market Thoughts, earnings conference calls, Industry Analysis, Stock ideas, Technology Tags: , , , , , , Leave a comment

the results

INTC reported September quarter 2010 earnings after the market closed on Tuesday.  Revenue was a company record at $11.1 billion.  Operating income for the three months was $4.1 billion and net was $3.1 billion or $.52 per share. That last number was $.01 above the Wall Street consensus.  Figures also exceeded the company’s previous best result, in the June 2010 quarter, by about 3%.

guidance lowered in August

If you recall, on August 27 INTC lowered its 3Q guidance–initially offered on July 13th, when it announced June quarter results.   It said revenue would be around $11 billion, down from around $11.6 billion.  It also said its gross profit (meaning after deducting manufacturing expenses) would be 66% of sales rather than 67%.

Why?  …because sales of computers to consumers in the mature markets of the US and Western Europe were proving unexpectedly weak.  A 5% fall in INTC’s overall revenue estimate implied that such sales would end up 20%-25% worse than INTC–and its computer manufacturing customers–had thought.

details

The 2.8% quarter on quarter sales growth that INTC ultimately achieved, while a quarterly record, fell significantly below the normal seasonal quarter on quarter increase of 9%.

Other than the consumer in the US and Europe, all other areas of the company’s business were very strong.  The company said that the fact that 3Q sales ended up $100 million stronger than its base case should be interpreted as indicating some improvement of the consumer PC business in September.

INTC’s tax rate was 1.5% lower than the company had anticipated, implying that a large amount of the softness in demand occurred in high tax rate areas, presumably the US.

forecasts

INTC is guiding to sales of $11.4 billion, +/- $400 million for 4Q2010.  This would be another record, but below the normal seasonal bounce of +8%.  Consumer weakness in mature markets is again part of the reason.  In addition, demand for INTC’s newest generation of chips, named Sandy Ridge and scheduled to be launched in 1Q2011, has been “much” better than anticipated.  Customers will try to run down their existing inventories of older chips as much as they can so they can offer Sandy Ridge chips as soon as possible in the new year.  This means purchases will be below normal this quarter.

The company believes worldwide microprocessor demand will be up by 15% or so in 2011.  Several reasons:

–strong growth from emerging markets,

–continuing rolling replacement of older corporate computers and servers,

–stabilization, and maybe pickup, in demand from consumers in mature markets

(Implied but not stated is that INTC will retain its dominant market share.)

cannibalization by the iPad?

INTC’s answer:  not so far.  It’s reasoning (filled in a little by me) is straightforward.  Worldwide, third quarter PC shipments were around 90 million.  They fell by about 5% below expectations.  Therefore, expectations were for shipments of about 95 million.  The difference is about 5 million, the shortfall being entirely in the US and Europe and mostly in low-end laptops and desktops–many for back-to-school.

AAPL probably sold 5 million iPads during the quarter.  (Here’s where I start making stuff up.)  Suppose 1 million of them were sold outside the US and Europe, leaving 4 million.  For iPad cannibalization to have been a more important factor than overall economic weakness, you’d have to believe that at least half the buyers of iPads during the quarter started out to get netbooks or low-end laptops they were going to use for high school or college but ended up with iPads instead.  I find it hard to believe that cannibalization could be so widespread so soon, especially since many buyers would be trading up in price.

Also, the demographics may not overlap between PC and iPad users.

Yahoo, admittedly not a young person’s site, has published the most detailed demographics I can find about iPad owners.  Relative to other Yahoo users, people accessing from iPads tend to be more heavily concentrated in ages 30-54.  US users are roughly 50% male, 50% female (as opposed to American colleges, which skew heavily female).

Nielsen also recently released a study of 5,000 US connected device users, of whom 500 were iPad users.  The research firm characterizes the iPod respondents as young, male and very receptive to advertising.  Look at the chart Neilsen supplies, however.  It’s true that iPad users skew far younger than iPhone users, 83% of whom are over the age of 24.  But 64% of iPad users are over 24 as well.  Neither represents the back to school crowd.

How do respondents use their iPads?  They listen to music and read news, just as they do on their smartphones, but they also look at movies and TV shows and read books and magazines.  No one uses the iPad as a content creation device, to research and write term papers for classes.

my thoughts

INTC will likely earn about $2 a share for 2010.  If you believe the company forecast for semiconductor devices in 2011 and assume INTC will retain its current market share, then it will likely earn about $2.40 a share next year.  The stock now yields about 3.3%.  If the company were to raise the payout in line with earnings expectations implied by a 15% revenue increase, it would have a prospective yield higher than a 30-year Treasury bond’s.

Why, then, is the stock trading at under 10x current earnings?  It’s because the median analyst estimate for INTC for 2011 and 2012 is (slightly) under $2 a share.  The numbers say Wall Street thinks the company’s profits are at a cyclical–and maybe secular–peak now.

Actually, I think analyst opinion is more negative than that but that researchers are unwilling to voice their bearish thoughts in print.  Here’s why.

If we consider INTC’s processors as dollar-denominated commodities, then the slide in the US$ over the past several months should be beneficial.  Emerging markets’ demand will likely continue to be strong.  The company’s cloud computing and imbedded chip lines are booming.  Corporations will likely keep on slowly and methodically replacing their oldest servers and PCs.

Based on a stable to strengthening world economy next year, it would be hard not to pencil in around 10% eps growth from these business areas alone.  I think the reason analysts aren’t doing so is that they fear that the current weakness in consumer PCs is just the tip of the iceberg.  They may quibble with a 15% growth assessment, but their real concern is that we are on the doorstep of a change from the Windows/Intel axis that has ruled the PC world for decades to a new Apple/Arm or Android/Arm one where INTC is not yet able to compete.  They are tacitly forecasting a decline in the INTC consumer business next year.  They’re just keeping the magnitude small enough that the change in direction isn’t apparent.

A potential investor in this stock on any basis other than the dividend has to have a satisfactory answer to two questions, I think.  The first is whether there’s enough evidence to conclude we’ve reached a tipping point in the consumer PC business where the market is changing in such a way that INTC can’t compete effectively any more.  The second is, if so, how bad can things get and how much of that is already baked into the INTC stock price.

I’m a growth stock investor, so answering questions like this is not what I do (or, at least, not well enough to earn a living at).  My instinctive reaction is that we don’t know enough yet to say the consumer is lost to INTC, and that, in particular, we haven’t yet seen a competitive response to the iPad from INTC’s customers.  One might think that at under 10x earnings, quite a lot is already discounted, but the crucial issue is whether in bearish circumstances what is the minimum that INTC is likely to earn.  The $2 figure that analysts are putting forward is probably the least helpful number, since I think it’s the least likely to be correct.  INTC will either earn significantly more or much less, depending on how it fares with the European and US consumer.