thinking about Apple (AAPL)

setting the stage

(I should say at the outset that, although at one time I owned AAPL for years, I don’t hold it now and haven’t for a long while (except for a couple of days in January).

Q:  What does AAPL do for a living?

A:  It makes smartphones and other mobile computing/consumer electronics devices targeted at affluent consumers willing to pay a premium price for the perceived superior aesthetics and more user-friendly software.

A mouthful.

in other words, a niche player…

If my definition is correct, AAPL has decided to carve out a niche for itself in the high end of the mobile device market.  It’s a very desirable and lucrative niche, one it dominates.  But AAPL is a niche player, nonetheless.  It’s a little like TIF or WYNN.

Like any market strategy, this one has its pluses and minuses.  Anyone listening to the AAPL earnings calls over the past few years can’t help having heard the persistent questioning from Bernstein about what the company would do once everyone who can afford a $600 smartphone already has one.

Move downmarket?  Unlikely.  TIF is the only company I’m aware of who has taken this path and not completely destroyed its brand image–thereby losing its original customers.  Better to lose low-margin sales in the mass market than to kill the goose.

Absent new blockbuster products, however, the price of maintaining the upmarket strategy for AAPL is that sales slow as volume-oriented manufacturers ride down the cost curve and churn out smartphones that retail for $100-$300.

That’s where we are now.

Tons of publicly-available-for-free data has been available for years showing where the smartphone marke, and AAPL, have been heading.  So this outcome can’t have been a surprise.

…with an “ecosystem”

Another characteristic of AAPL devices is the “ecosystem,”  which has tended to make customers more sticky.  All AAPL devices work well together.  All reside in a “walled garden” created by AAPL software–reminiscent of the way AOL worked back in the infancy of the internet.

on this description…

…the current PE of 10.8x–8.0x, after adjusting for cash on the balance sheet–seems crazy low.  It’s less than INTC’s, for instance.

is there more to the story?

There’s an obvious risk in securities analysis of taking the current stock price as the truth and trying to come up with reasons why  it is what it is, rather than taking out a clean sheet of paper and trying to imagine what the future will be like.  The Efficient Markets hypothesis taught in business schools despite overwhelming evidence that emotional storms of greed and fear that routinely roil financial markets, encourages this thinking.

Admittedly possibly being influenced by the recent swoon in the AAPL share price, I’ve been asking myself recently whether the conventional wisdom about AAPL, which is my description above, is correct.

I have two questions.  No answers, but questions anyway.

my questions

1.  Is the high-end niche defensible?

In most luxury retail it is.  In consumer electronics, it clearly isn’t.  Think: Sony.  Based on the (small) number of entrants in the mobile appliance market and the (small) number of products sold, AAPL may be closer to Sony than to Hermès.

2.  Is the “walled garden” a mixed blessing?

It certainly worked for AOL for a long while. But then the Wild West of the early internet was gradually tamed and customers discovered there was a much more interesting world outside the garden.

I don’t think AAPL aficionados have any intention of tunneling out–at least not yet.  But the inaccessibility of AAPL customers to GOOG has prompted the latter to introduce the “hero phone” later in the year through its Motorola Mobility subsidiary.  The idea seems to be to create an attractive, user-friendly, high-end smartphone, load it with GOOG software and sell it at cost.

The “Made in USA” label and the management description of the “hero” seem to me to indicate it’s targeted directly at the large concentration of AAPL customers here in the US.  It’s an open question whether GOOG/Motorola can create a smartphone that’s attractive to iPhone users, or whether they’ll consider switching.  But a technologically inferior PC sure did undermine the Mac with consumers in the 1980s almost solely because it was a lot cheaper (btw, the Mac lost out to IBM with corporate customers because it had no clue how to sell to them).  And the wireless carriers will certainly welcome the “hero,” assuming it works well.

a promising 1Q13 for Tiffany (TIF)

my bottom line on the stock

I no longer hold TIF.  Great company, expensive stock (the current 22x fiscal 2013 eps is at the high end of the company’s historical PE range).  Also, thematically, I’d prefer to get Consumer Discretionary exposure through firms that cater to average Americans, the segment where I think spreading economic rebound will bring the best year-on-year earnings gains, rather than the affluent.

Nevertheless,

TIF is an important bellwether

for how the wealthy, foreign tourists and China are feeling. So the results are well worth monitoring.   All three  groups appear to be starting to come out of their recent spending funk.

April quarter results

Tiffany reported 1Q13 (ended April) results before the bell yesterday.  They were surprisingly good.  Worldwide sales were up by 9%, yoy.  Eps came in at $.70, also up 9% over the $.64 posted in the year-ago quarter.

The figures were massively better than the consensus estimate of Wall Street analysts, who had penciled in $.52 for the April period.  This is also the first quarter in the past five where yoy earnings gains have been significant.  And 1Q13 exceeded the previous high water mark for the first quarter of $.67 a share set in 2011.  Good news.

all regions looking up

Here are TIF’s yoy sales gains by region:

US          +6% in 1Q13   vs    +2% in 4Q12

Asia Pacific          +15%   vs     +13%

Japan          +2%    vs     -6%

Europe          +6%     vs      +3%

Total         +9%  in 1Q13     vs.     +4% in 4Q12

a dividend increase

Two weeks before the earnings report TIF’s board increased the quarterly per share dividend from $.32 to $.34.  On the one hand, the rise comes at the normal time of year for TIF.  And the bump up is smaller than 2012’s.  On the other, if we make the reasonable (to me, anyway) assumption that the board of directors is targeting a payout of 25% of cash flow and/or a third of profits, the dividend increase signals there’s still upside to the Wall Street consensus.

More important, the board is comfortable that business is improving.

thinking about big integrated oils

hedge funds attacking Big Oil?

Over the weekend I read a blog post (which I can no longer find) in the Financial Times pointing out that activist investors are getting set to attack the large integrated oils.

Why?  

They persist in investing in massive long-term, risky, low-return oil exploration and development projects.  It’s what they do.  In the view of the hedge funds, this makes no sense.  The oils would be better off finding better things to do with their cash flow, returning it to shareholders if nothing else.

I doubt that this will happen   ..not that hedge funds may not try to change oil company investing plans, but I don’t think they’ll be successful.

Big Oil is important in developed countries because the companies spend a ton of money securing access to petroleum.  Nations are heavily dependent on oil to fuel industry.  The oil firms get huge tax breaks for finding and developing oil deposits because these nations are heavily dependent on oil to fuel commerce and for heating.  This is especially true in the US, which is unique among richer nations in not responding to the oil shocks of the 1970s by taxing oil to control consumption.  We do this to support our globally non-competitive, but politically powerful, auto industry (most of which went bankrupt in the Great Recession anyway).

Given the strategic importance of oil,

why are the returns to oil exploration low?

A generation ago, they weren’t.  Drilling took place mainly in the developed world, often on parcels leased to the driller by the government.    The landowner got an initial payment plus a modest percentage of any finds.  Projects that made good economic sense when oil sold for $7 a barrel are bonanzas today.  Big Oil got most of that.

In contrast, major exploratory drilling today is done in emerging economies, where the big untapped pools of oil are.  But ever since the first nationalizations of drilling projects in the Middle East in the 1970s showed how one-sidedly favorable production agreements were to the oil majors, terms have been tilted much more heavily toward the host nations.  Today’s production agreements provide little more than a specified return on capital to the oil explorer.  Price hike windfalls go to the host, not the big oil.

In the face of less favorable economics,

why continue to drill?

Three reasons:

–it’s still profitable

–it’s what the oils do best.  The last round of oil company diversifications, admittedly a long time  ago, were unmitigated disasters, and

–the home countries of the major oils need a steady supply of oil to keep industry humming and citizens warm in winter.

It’s this third reason that I don’t think activists see.   

At some point, shale oil may change the situation.  Even so, I figure it would be politically unacceptable for any big integrated to dismantle, or even substantially curtail, its exploration and development efforts.  The worry would be that in times of shot supply, oil would go solely to project developers.  In fact, Asian countries are concerned about this possibility that they’ve designated their big oils as “national champions,” whose job is to secure oils supplies for the home country.  Profits are secondary.

I don’t think Washington, or London, or Paris would allow its oil exploration firms to drop out of the race, even if short-term economic returns to the companies and their shareholders might be better if they did so.

 

 

owning property vs. leasing: investment possibilities

asset heavy to asset light

A generation or two ago, the style in the US was for companies to own the premises their businesses operated in–hotels, department stores, restaurants and the like.  One major disadvantage of this approach, however, is that it takes a huge amount of capital to be able to expand.

About the time I was entering the stock market, American hoteliers had worked out that they could sell their properties to the local doctor, dentist, accountant, or oil sheikh and take back a management contract.  They found the buyers were more interested in the prestige of ownership than in profits.  They were willing to pay very high prices for the properties, while ceding virtually all the hotel cash flow back to the management company.  The “asset light” movement was born.  (Around a decade later, European hotel firms caught on and began to do the same thing.)

Hotels are admittedly an extreme example.  In my experience it rarely has made economic sense to own a hotel.  Better  an office building if you want to own real estate.  Still, asset light is the current style in many industries.

hybrids are potentially interesting

Many hybrids–a mix of leased and owned properties–remain, however.  They can sometimes present interesting investment opportunities.

An example:

At one time a friend pointed out the W Company (not the real name) in Hong Kong.  It was (and still is) a publicly traded, family run department store in Hong Kong, located in the heart of the high-end Central district.  The financials showed that the company was consistently, and highly, profitable.

But when I went to visit the department store itself, it looked more like K-Mart than Neiman Marcus.  The merchandise was undistinguished, the premises dowdy, customers few and far between (observing this last on a company visit is seldom a reliable indicator, though).  The store was surrounded by more modern, glitzy alternatives.  And Hong Kong is all about glitz.

How could this straw-into-gold story be true?  Looking a little closer, I noticed that the department store showed no rental expense on its income statement.  That’s because the company itself owned the building it operated out of.

I checked rents on nearby retail premises.  It turned out that W would probably be paying HK$100 million to a third party to rent the space it was in.  But the department store was only making HK$30 million in annual operating profit. (I don’t remember the exact numbers so I made these ones up.  But they’re roughly correct.)

The economic reality …

…was that W had two separate businesses:

–property ownership, which should have been generating HK$100 million in income, and

–department store retailing, which should have been adding to that.

The company was actually losing HK$70 million from retailing and subsidizing the department store by forgoing the rent it could have earned.

That was, in theory at least, the investment opportunity.  Either the family elders would wake up one day and realize they could triple their profits by closing down the department store and renting out the premises, or a predator would come along and bid for the firm.  The big question in the second case was whether the family would sell.

not alone

In the case of W when I was looking at it, my impression was that the family had never analyzed its business and was perfectly happy with the status quo.  When potential bidders came calling, the elders just said no.

My first instinct is to say that this behavior is crazy.  On the other hand, except for the location and the family owners blocking a change of control, this is the J C Penney story in a nutshell.

equity, debt and leases: an important balance sheet change in prospect

financial strength

There’s a line of thought in academic finance that argues it doesn’t matter for a publicly traded company’s stock price how much of the capital in the business comes from equity (the owners’ cash) or debt (borrowed funds).

In the real world, that idea couldn’t be much more wrong.  Banks won’t lend to a firm that has too little cash put up by the owners.  They may even make a new equity offering a prerequisite for further loans.

Also, one of the main reasons I’m so fanatical about making a projected cash flow statement is to make sure that a company I’m interested in will have the money to service its debt, pay the dividend and still run the business.  My own rule of thumb, based on experience with a wide variety of companies, is that if a firm has so much debt that if it were to devote all its cash flow to paying back loans but couldn’t do so within three years, it’s potentially in real trouble.

debt vs. leases

Oddly, traditional financial accounting doesn’t consider leases as debt.  Even though leases may be ironclad promises to rent property or equipment for decades at a fixed price, they don’t appear on the balance sheet of the lessee as liabilities.  Lease information is disclosed, but there isn’t as much data as for bank loans or bond offerings.  What there is contained in the footnotes to the financial statements, not on the balance sheet itself.  Or course, every sensible investor should read the footnotes carefully as a matter of course.  But the reality is that even some professional securities analysts don’t.  And only the most expensive data services for screening stocks–out of the financial reach of individuals like you and me–will allow you to include leases when calculating debt/ equity ratios.

capital vs. operating leases

One exception:  at some point before my time on Wall Street began, someone got the bright idea of dressing loans up to look like leases, so they wouldn’t appear on the balance sheet.  The lessee would then appear (to anyone who didn’t read the footnotes) to be in better financial health than it actually was.

To remedy this abuse, the Financial Accounting Standards Board, the financial accounting industry watchdog, developed four tests to detect loans in lease clothing.   If the lease:

1.  calls for the leased asset to be turned over to the lessee at the end of the lease term, or

2.  allows the lessee to buy the asset at a bargain price at lease end, or

3.  lasts more than 75% of the useful life of the asset, or

4.  has payments with a total present value of over 90% of the purchase price of the asset,

then the lease is classified as a capital lease and has to appear as a liability on the balance sheet.

Leases that don’t meet any of the four criteria are called operating leases and can remain in the footnote shadows of the financials.

…until now

I haven’t made much of an attempt to find cases where the current way of accounting for leases creates a problem in company analysis.  But…

–most strip mall big box stores are stuck with long-term lease commitments for much more store space than they need.  If they can’t sublease store locations they’d like to close, however, or sublet portions of the locations they want to keep, they’re stuck paying for space they can’t use.  Borders is a case where this was an unusually difficult issue.

–on the other hand, one of the attractions of JCP (though not the most important) to its current hedge fund holders is its bargain-priced leases on retail locations.

new FASB rules…

…now in the process of being formulated would require that all leases that extend for more than a year must be shown on the balance sheet.

why this is important

Two reasons:

1.  The risks to bricks-and-mortar retailers contained in their long-term leases will become much more apparent once the new rules are in place.  Same thing for restaurant chains.  Airlines, too.  Small, fast-growing firms will likely be the worst impacted.

2.  This is a geeky, under-the-radar topic.  It probably won’t get much publicity until late this year.  Lots of time to check the lease footnotes for stock we own to make sure there are no nasty surprises lurking there.