trying to move downmarket is tough–Apple vs.Tiffany and Superscope (who?!?)

going downmarket:  the Superscope example

When I got my first job as a securities analyst, rookies were assigned coverage of companies no one else wanted.  So I got a bunch of firms with bad managements, poor operating procedures and/or failing strategic concepts.  I was happy to be employed, but otherwise I was less than thrilled.  But a comment by J.L. Austin turned out to be true.  I did learn a lot more about how business works by observing things going wrong than I ever would have by watching uniformly smooth sailing.

One of my first companies was called Superscope.  The company’s claim to fame was that it discovered Sony “operating out of a quonset hut” in Japan in the late 1950s.  It obtained from the then fledgling electronics giant an exclusive license to distribute Sony’s innovative line of tape recorders in the US.  The license made Superscope a fortune.

In the mid-1960s, Superscope bought Marantz which was then an ultra high-end maker of stereo systems.

In the 1970s, preparing for the reversion of the tape recorder license to Sony, Superscope decided it would replace the lost income by launching a line of inexpensive, mass-market consumer electronics devices.   It thought it would increase the odds of the line’s success by branding its offerings as “Superscope by Marantz,” thus grafting onto its boomboxes the Marantz brand qualities of exclusivity, high quality and dependability.

As the successor company website comments, “Naturally enough, the two brands became intertwined in consumers’ minds.”

Translating this marketing-speak into ordinary language, the move completely destroyed the Marantz brand.

The appearance of low-fidelity $150 stereo systems under the Marantz name shattered the image of high quality and exclusivity that had motivated audiophiles to pay many thousands of dollars for the original Marantz systems.   As I recall, it didn’t help either that the  boomboxes were very far from best-of-their-breed.

the Apple smartphone dilemma

Why this trip down memory lane?

It’s because Apple faces a somewhat similar problem with its smartphone business, which produces half the company’s profits.

As some Wall Street analysts have been point out for over a year, the market for $600+ smartphones in wealthy countries is approaching saturation.  The as yet untapped markets are in emerging nations like China or India, where older “feature” or “flip” phones still predominate.  But if your annual family income is, say, $5000, how many $600+ smartphones can you afford.  Answer:  zero.

That’s why many phone makers are collaborating with local wireless companies to develop and market smartphones that cost $100 or less.

How can Apple compete?  Should Apple try to compete in this market segment?  The risk is that it repeats the experience of Superscope.

going upmarket is easier

Oddly, experience says it’s much easier to go up-market, although often a company will create a new, upscale brand name.  That’s what the Japanese auto companies did, for example.  Nokia, too, with its Vertu brand–which consists of making ordinary phones into jewelry with precious metals and gems.

Tiffany magic

How does Tiffany come into the conversation?  It’s the only company I know that is able to be successful both at the high end of its market (jewelry at $10,000+) and the low end (key chains and trinkets for $100-).  I don’t know how the firm accomplishes it.  I offer the example only to say that the move downmarket can be done.

LVS’s 2Q12–plusses and minuses

the report

After the New York close last Wednesday, LVS reported its 2Q12 results.  Revenue came in at $2.6 billion, up 10.1% from what the company took in during the year-ago quarter.  EBITDA (earnings before interest, taxes, depreciation and amortization) came in at $844.7 million.  That’s $56.9 million, or 6.3%, less than during 2Q11.

EPS were $.44 for the quarter, vs. $.54 in the comparable three months of 2011.  The figures were also considerably below the brokerage house analysts’ consensus of $.60 a share.

Wall Street didn’t like this news. The stock dropped more than 5%, breaking through support levels that had held over the past year, before recovering somewhat.  This is despite the fact that LVS had already lost almost 40% of its market value during the past several months on worries that Chinese gamblers would pull in their horns as the mainland economy slows.  It also didn’t matter that the entire earnings “miss” was the result of random or non-recurring factors.

There was one piece of bad news, coming out of Singapore.  Nevertheless, I think the stock weakness was a knee-jerk reaction to the headline numbers, not a result of analysis of the facts.

details

US

EBITDA was down about $22 million year on year for the quarter, at $91.3 million.  Bethlehem, PA chipped in an extra $5.9 million (the first time I think I’ve ever mentioned this casino in a post).  Otherwise, the business was flattish.  The biggest single reason for the yoy decline was that table games players were much “luckier” than average in Las Vegas.  They lost 16.5¢ of every dollar bet during 2Q12 vs. 20¢ during 2Q11–and a normal loss rate of 21%-24%.

Macau

Revenues for Sands China (HK: 1928) came in at $1.48 billion during 2Q12, up 22.3% from the $1.21 billion in revenue posted during 2Q11.  EBITDA rose by $41.0 million, or 10.7%, yoy, to $429 million.

That came despite pre-opening expenses that were $25.3 million higher than a year ago, mostly due to the debut of the new Cotai Central casino during the quarter.  In addition, high-roller patrons of the Venetian Macao, who were unusually unlucky this time last year, turned the tables during 2Q12 and took home more than their long-term average amount.  Factoring these two influences out, I think EBITDA would have been up by 20% or so.

One more complication:  during the quarter Sands wrote off $100.8 million it had spent on site preparation at yet another potential Cotai casino location–one the government there has denied Sands permission to develop.  The combination of the writeoff, pre-opening expenses and bad luck pushed net income down by 40% yoy to $160.5 million.

Still another quibble (a minor one, in my view, but apparently more than that to the markets):  LVS opened a significant new casino in Cotai during 2Q12, but its market share for the quarter didn’t expand as much as its increase in gambling capacity.  If the situation stays that way, it’s a problem.  I think it’s way too soon to judge, however.

A final point:  some commentators have criticized LVS for continuing a pell-mell expansion in Macau despite the current slowdown.  Quite the contrary.  Earlier this month, LVS announced it had requested government permission to push back completion of its current Cotai project by three years.

Singapore

Revenue for the Marina Bay Sands was down 5.8% yoy, at $694.8 million. during 2Q12.  EBITDA was down by 18.5% at $330.4 million.  Two reasons:

–high-roller gambling was off by about 6% and those who played were unusually lucky.  About half of the revenue effect–but none of the back luck–was offset by mass market gains.

–the provision Marina Bay Sands made for questionable receivables–which means gamling credit advances to high rollers that may not be paid back–amounted to $39.9 million in 2Q12 vs. $11.4 million in 2Q11.

If there’s a worry in the 50+ pages of the LVS’s quarterly earnings release, this is it.  I’m not particularly concerned.  The provision boosts the company’s bad credit reserve in Singapore to about a quarter of the $822 million in receivables outstanding.  It comes from specific identification of gamblers who have not been paying their bills on time.  It presumably also coincides with withdrawal of credit from these individuals.  So the issue will likely gradually fade away.  It bears watching, though.

overall

LVS estimates that eps would have been $.08 higher if its luck had been in line with long-term experience.  Another $.08 would have been tacked on, save for the writeoff in Macau.  Arguably, then, Wall Street hit LVS earnings right on the nose.

finances

Yes, EBITDA is not growing like it was a year ago.  But it appears to be at least steady at close to a $3.5 billion annual rate.

LVS now has $9.4 billion in debt outstanding (offset in part by $3.5 billion in cash), with borrowing costs of around 3%.  This implies annual net interest expense of a bit more than $350 million.  So pretax cash flow is in excess of $3 billion a year–meaning that the company could be completely debt-free in two years if it were to devote all its cash flow to repaying borrowings.  Quite a change from late 2008.

To my mind, it makes little sense to repay more than minimum requirements of very low-cost debt.  In fact, at 3% the company should be borrowing more.  LVS will have capital expenditures for the coming year of $1 billion.  It will also pay out $825 million in dividends.  But the point still remains that LVS is highly cash-generative.

valuation

LVS has a market capitalization of $30 billion.  Its interest in Sands China has a market value of about $18 billion.  If we award the same EBITDA multiple to 100%-owned Marina Bay Sands as Sands China receives in the Hong Kong market, the former has an asset value to LVS of $18 billion as well.  This leaves the US operations of LVS–Las Vegas, PA and royalty/management fees from Asia–with a value of minus $6 billion.

Of course, I have been making essentially the same argument for some time and that hasn’t stopped the stock price of LVS from plunging.  What’s happened is that the Hong Kong market is now pricing 1928 at $23 a share vs $32 in April.  However, the stock is now trading at about 12x cash flow and yielding 5%.  And that’s with cash flow at, or close to, what I think is a business cycle low.

That’s way too cheap. (Remember, I own LVS.  I’d own 1928, too, but I don’t want to buy on the pink sheets and a glitch in Fidelity’s software prevents Americans from buying the stock in Hong Kong).

Zynga close to $3–what’s happened?

Zynga

Social games maker Zynga (ZNGA) came public last December at $10 a share.  Its stock rose to an intraday high of almost $16 in early March, before beginning a swoon that has taken it down to less than a third of its initial offering price today.

What’s going on?

There are certainly Zynga-specific factors involved.  But it’s also important to note, I think, that the relative performance of ZNGA parallels almost exactly that of Groupon (GRPN), another flawed investment concept whose stock price has also cratered.

GRPN came public early last November at $20 a share.  It reached an intraday high on its debut day of a bit more than $31, but fell quickly to $15 late in the same month.  From there, GRPN rose again, to reach almost $26 in February before falling away to the current $6.50 or so.

The businesses of the two companies have almost nothing to do with each other.  Yes, both have weak competitive positions; both companies have eyebrow-raising management practices.  But one distributes discount coupons, the other makes games.  Yet, the stock market is treating them in identical fashion.  This suggests to me that the mood of the market has a lot to do with how the stocks have traded.

What’s surprising about them both, to my mind, is not their weak stock market performance itself.  Instead, it’s the fact that both initially got such a warm welcome from Wall Street.

ZNGA’s potentially wobbly foundation

Two potential issues with ZNGA were evident long before the IPO:

–the company’s almost total dependence on FB to distribute its offerings, and

–its reliance on a small number of games for its profits.  Even more worrying, reports I read before the IPO indicated that ZNGA’s newest games were attracting fewer users, and had shorter shelf lives–therefore, were making less money–than its existing hits.  So even maintaining operating profit might be a struggle.

ZNGA’s dilemma

It seemed to me to be basic microeconomics that if ZNGA tried to strengthen itself by developing distribution apart from FB, the move would bring a competitive response from FB that might be harmful.  This appears to be what has happened during the June quarter.  ZNGA established its own game portal and began to direct users to it;  FB responded by making it easier for its users to find new games instead of just playing ZNGA’s.  The result has been a sharp drop in ZNGA’s audience.

wide stock market effects

One slightly head-scratching consequence of the release of ZNGA’s weak June quarter financials has been a subsequent worldwide selloff in smaller consumer-oriented internet stocks, especially those with any social networking associations.  This makes no sense to me.  ZNGA’s problems are mostly unique to it, in my view.  FB appears to have been caught napping by the switch to mobile use in the US.  Its woes may well be temporary.

Anyway, the fallout on other internet stocks looks to me to be a case of throwing the baby out with the bath water–an emotional reaction that may mark as extreme a negative reaction as we are likely to get, and which may the the market equivalent of 4Q11’s buying frenzy.

how cheap is MSFT? …very

MSFT…

When I was writing about AAPL yesterday and wanted to make the point that the stock is cheap, I looked around at other, much weaker, tech-related firms to see their valuations.  I wanted to illustrate that AAPL shares are not only cheap in an absolute sense but are also inexpensive relative to other tech firms with weaker managements and/or inferior business models.  I settled on CSCO as a good example of both latter characteristics.  There were lots of others, too.

…is a very cheap stock

While I was searching, I took a quick look at MSFT.  I knew it has been the darling of value investors for some time.  But I was stunned by how cheap it is–much cheaper than AAPL.

I do have some history with MSFT.  I’ve been a user of its products beginning with the 30 lb+ Compaq “portables” of the early 1980s.  I bought the stock in my portfolios for the first time in late 1990.  I held it continuously for almost a decade, before selling it in late 1999 at around double the current quote.  Yes, I have subsequently held the stock for short periods after that, at the urging of a former CIO, but without much conviction–and without much success.

details

But this is what I saw yesterday:

1.  As of June 30, 2012, MSFT had cash of $63 billion.  Against that, the company had $11 billion in debt.  So net cash is $52 billion.  8.4 billion shares are outstanding, meaning net cash amounts to $6.20 per share.

2.  During the June 2012 fiscal year, MSFT generated $31.6 billion in cash flow, or $3.75 a share.  It spent $2.3 billion of that on capital equipment and about $10 billion more on dividends and stock buybacks.

3.  Consensus Wall Street estimates are for about a 10% increase in cash generation over the coming year.

some arithmetic

The share price of MSFT as I’m writing this is about $29.  Subtract out $6.25 in cash, leaving $22.75.  Dividing by $3.75 indicates that MSFT is trading at about 6x cash flow in fiscal 2012 and 5.5x expected cash flow for the coming 12 months.  That’s an extremely low number, especially for a firm like MSFT which has negligible capital spending needs.

Why so cheap?

What is this valuation saying about the company?

Three possibilities:

–much of MSFT’s cash pile, and a good portion of its profits, are accumulating overseas, free of US corporate tax.  Returning that money to the US, where it could be used for dividends, would require that MSFT pay Uncle Sam.  To some degree, that lessens the value of MSFT’s cash flow.  But any global company is in the same boat.  And, although think it’s an issue, Wall Street doesn’t seem to mind at all.

–top management has been, well, bad, for at least a decade.  These are the same folks who wanted to pay $40 billion+ for YHOO a few years ago (they probably thank Jerry Yang every day for refusing to sell).  They just took a $6 billion+ charge for impairment of goodwill–acknowledging that the company overpaid substantially when it bought aQuantive five years ago.

On the other hand, MSFT has the dominant PC operating system.  And neither AAPL nor GOOG, nor Linux have been able to make much headway against the Office productivity suite.  So they have arguably been adequate stewards of the MSFT legacy of the last century.

In addition, poor management is often a plus for value investors eyeing a stock.  They imagine how much better things could be if competent hands were at the tiller.

–Is change of control possible?  It’s hard to say.  My impression is that MSFT has always been run for by long-time friends of Mr. Gates, whom he knows personally and trusts.  He seems extremely loyal to managers he has appointed, without much regard to their objective performance.  As the past decade+ has shown, change from within doesn’t appear to be a good bet.

Forced change from the outside?  Together, the founder and Steve Ballmer, the CEO, own 10% of MSFT.  The Bill and Melissa Gates Foundation may own more.

History shows that individual shareholders are immensely supportive of incumbent management, no matter how bad its performance may have been.  A proxy fight involving a company this large would be expensive. Its outcome would be hard to predict.  Are individual investors going to  support a movement that will effectively unseat Mr. Gates?  I’m not sure.

I think the belief that corporate change is unlikely is the main barrier to a better valuation for MSFT.  Wall Street believes–with ample justification, I think–that a dollar of cash flow in the hands of MSFT management is worth substantially less than one hundred cents.  And the market believes there’s no easy way to change the situation.  That’s certainly what I hear the stock price saying.

 

 

 

AAPL’s 3Q12: more questions than answers

the results

After the New York close yesterday, AAPL reported financial results for 3Q12 (APPL’s fiscal year ends in September).  The company recorded revenue of $35.0 billion (+22.4%, year on year) for the three months and net profit of $8.8 billion (+20.3%).  Earnings per share were $9.32 (+19.6%).

For most companies, these figures would have been great news.  But for AAPL, the results represent a marked deceleration from the growth rate it had been achieving over the past few quarters.  And, although the eps exceeded AAPL’s always ultra-conservative guidance, they fell substantially below the Wall Street consensus estimate of $10.37.

earnings revisions underway

As I’m writing this, those analysts are in the process of revising down their expectations for 4Q12.  Although the process isn’t yet complete, it looks like the 4Q12 consensus will drop by about a dollar a share, from $10.50 to $9.50.  That would leave the consensus for the current fiscal year at around $45.

Next fiscal year is a more interesting issue.  The current earnings consensus is about $55.  I don’t think there’s any particularly penetrating insight built into this number.  I view it more as an extrapolation of the earnings progress we’ve seen (until) recently, with some room left for upward revision.

If, however, we do the same kind of back-of-the-envelope calculation based on 3Q12 actuals and the new 4Q12 estimates, we get a full-year run rate–without factoring in any growth–of $40-.  We’re also looking at what would now appear to be very challenging earnings comparisons for 1Q13 and 2Q13 (the actuals for 1Q12 and 2Q12 are $13.87 and $12.30 = $26.17).  I don’t think analysts will change their year-ahead numbers today.  But I’d expect their earnings forecasts for fiscal 2013 to drift down toward $45-$48 over the next month or two.

details

–Mac sales (14% of the AAPL total) were flat, quarter on quarter, and up 2%, year on year.  That’s better performance than the PC market overall had, but not by much.  Buyers may have held back until late in the quarter when a new line of laptops, containing more powerful INTC chips, was launched.  Still…

–iPhone sales (46%) were down 26% qonq and up 28% yoy.  Here, too, results may have been negatively affected to some degree by potential buyers waiting instead for the next iPhone, rumored to appear in the fall.

–iPad sales (26%) were the high point of the quarter, growing by 44% sequentially and 84% yoy.

–the rest, which probably won’t make much difference to investors:  iTunes sales were $1.8 billion; iPod units were down 10% qonq and -12% yoy.

–Europe, which accounts for somewhat less than a quarter of AAPL’s business, showed no growth at all.

my thoughts

The strength of the dollar, buyers holding back with the expectation that fresh versions of new products will soon be on offer, and distributors shrinking their inventories all seem to have subtracted a bit from AAPL’s 3Q sales.  But I see all these as minor negatives, whose absence wouldn’t have materially changed results.  Ex the iPad, AAPL’s business has slowed down considerably from the torrid pace of the first half of the fiscal year.

The question is why?

Certainly, the slowdown in world economic growth caused by the EU financial crisis is playing a role.

Other, structural, factors might include:

–changing market dynamics in smartphones, as weaker competitors like RIMM and NOK have no more market share to lose, and the new, more difficult, struggle for customers is between AAPL and Samsung

–the development of $100 and $200 smartphones for low-end customers, a segment AAPL won’t participate in, is cutting into business in China

–the emergence of ultrabooks as lower-cost, Windows-based competitors to the Macbook Air

–higher-end buyers of tablets deferring purchase so they can see new Windows 8-based offerings in the fall.

My guess is that the main culprit–if that’s the right kind of term to use for a $8.8 billion profit–is the macroeconomy.  But I also think we’re seeing the first signs of a serious competitive response to AAPL’s market dominance of the past few years.  Usually, though, structural market share shifts don’t happen all at once.

the stock

How much does pondering about the competitive environment for AAPL actually matter for the stock?

Not much, in my view, unless you take an extremely negative view of how competition in the smartphone and tablet markets will play out for AAPL–in other words, unless you think AAPL is going to turn into a CSCO or MSFT.  My basic thought is that the worst that can reasonably be expected to happen has already been discounted by the market by the repeated reluctance of AAPL’s PE multiple to expand in response to stellar earnings reports.

To fool around with a few figures,

…let’s assume that AAPL will have eps of $45 a share in fiscal 2012.  That’s not a super-conservative number, but I don’t think it’s aggressive, either.  Were world economies to turn up over the coming year, it might end up being pretty low.

The current share price is about $575.  Subtract out the $150/share in cash AAPL will have by the end of fiscal 2013.  That leaves a price of $425–meaning a PE, ex cash, of 9.4x.

That’s too low, to my mind.

9.4x is about 10% below the forward PE on the S&P 500.  It’s about the same rating as MSFT gets, and it’s about a point above CSCO’s.  But both of these latter firms have weak management and negligible profit growth prospects.

In other words, AAPL already trades as if it has gone ex-growth.  I think that’s the reason AAPL is only down 4% as I finish this post, despite having missed the Wall Street consensus by a mile.

The risk is, of course, that AAPL somehow goes the way of MSFT or CSCO.  If it can manage to avoid that fate–and I think it will–downside appears relatively limited.  And the upside in a stronger world economy could be large.