thinking about the second half

I’ve been staring at this page for a while, trying to figure exactly what to put down.  Then I realized that my inaction neatly sums up what I think the consensus view is about stocks for the second half of 2013.  Gains have been so strong since January 1st that most equity portfolio managers can’t imagine that the second half will bring more gains.  They mostly intend, I think, to nurse the gains they already have into autumn and then coast to the finish line by making their portfolios look as much  like their benchmark index as their clients will let them.

I’m caught between two conflicting ideas.

On the one hand, the stock market as a whole looks reasonably valued.  Stock have weathered the rise in payroll taxes at the beginning of the year, the imposition of the sequester and the announcement by the Fed that it’s warming up to being raising interest rates.  Earnings growth next year will be flattered both by healthier economies around the globe and the absence of payroll tax hikes and the sequester as depressants.  And history has shown that the S&P goes sideways to up as the Fed raises interest rates to normal from recessionary emergency lows.  That’s all good.

On the other hand, I’ve been making a big effort to find new stocks to buy but I’m not bowled over by the cheapness of the candidates I’m turning up.  I’ve added one or two to my holdings recently, but nothing has really started to work so far.  That’s bad enough to outweigh the good–except that everyone goes through periods when he doesn’t see the sweet spots of market activity very well.  So this could be me.  And, except for a brief bout of nervousness a couple of months ago, I’ve been happy to remain fully invested.

I haven’t been hearing or reading about market strategists who are seeking to trumpet their bullish views, either.  One exception–Sam Stovall, chief equity strategist for S&P.  He’s another proponent of the flat-to-up thesis.  But he’s more bullish than I am.  He says that there’s a good chance the S&P could be up by another 5% by yearend.  What’s most interesting about his view is that Mr. Stovall has had his finger on the pulse of the market more solidly than anyone else this year.  In January he was calling for a 20% increase in the S&P for 2013–a number I thought was a very big stretch.  It’s comforting that the “hot hand” continues to think that risks are to the upside.


Intel’s 2Q13–the waiting game continues

2Q13 earnings

Intel (INTC) reported 2Q13 earnings results after the close on Wednesday. Revenue came in at $12.8 billion, down 5.1% year on year.  Earnings per share were $.39, flat quarter on quarter but off by 28% from INTC’s performance in 1Q12.  The figures were in line with the company’s previous guidance.

The company also lowered guidance for the second half, saying that this normally seasonally stronger period, while up vs. the first six months, won’t show its usual revenues gain.  INTC now sees full-year revenues for 2013 as flat–or about 2% lower than its previous view.

How so?

The cloud continues its explosive growth.  The server business is fine.  But the PC market is weaker than INTC expected.  For the first time INTC sees PCs as being as soft as consultants Gartner and IDC do.

During the quarter, INTC bought back 23 million shares of stock, paying an average of $23.91 each for them.

INTC shares were down almost 4% yesterday on the news.

the near-term investment case hasn’t changed much…

The big question is still whether the newest generating of INTC microprocessors, the first designed especially for mobile devices, will gain widespread acceptance.  A sub-plot, or maybe a necessary condition for this to happen, is the question of whether manufacturers of computer devices and operating systems are going to be able to deliver new “wow factor” products that people want to buy.


I’m content to hold INTC shares to see what happens, even though the tone of INTC’s comments suggests to me that we won’t see the new chips in full flower until early 2014.

..but INTC may be remaking itself in a more fundamental way

Yes, what I’m about to write may be making mountains out of molehills–but that’s what analysts do.

It looks to me that new CEO Brian Krzanich believes INTC is not in one, but rather in two, separate but complementary businesses.  One is researching and designing proprietary computer chips.  The other is manufacturing chips, either for itself or for others.

Although promoting foundry operations to equal status with making x86 chips is a simple and sensible change of viewpoint, it’s also potentially earthshaking for some INTC veterans.

I can imagine a lot of possible reasons (some of them mutually incompatible) for making this change of focus, but two consequences stand out to me.  Both derive from the fact that INTC is by far the most accomplished chip manufacturer in the world–one whose edge over the competition is increasing:

–to the extent that INTC picks and chooses the firms it makes chips for, it may be trying to turn the ARMH vs. INTC decision into an “eco-system” one.  A device maker can either have INTC parts + very fast, highly compatible chips from its partners or ARMH + a hodge-podge of less well-made, not so compatible parts from others.  Presumably this tilts the playing field considerably in INTC’s favor.

–investors like foundries better than chipmakers.  Look at the PE multiple on TSMC vs. INTC.    TSMC is 10% higher–even without considering the quirkiness of TSMC’s financials.



contribution margin

several sets of corporate books

As I’ve written in a previous post, publicly listed companies have three sets of books:

–financial reporting books, which tend to portray a rosy picture to shareholders,

–tax books, that tend to show a relatively grim picture of profitability to the taxman, and

–management control or cost accounting books, by which the company is actually run.

Contribution margin is an important concept for this last set of books, the management control ones.

what contribution margin is 

The first thing to be clear on is that people call contribution margin is not always a margin, that is, a percentage.  More often a contribution margin is expressed in absolute dollar amounts.  Don’t ask me why.

But what is it?

It’s the amount by which the revenue from selling an item exceeds the direct cost of production and thus “contributes” to defraying corporate overhead. It can be positive or negative.  Negative is very bad. The concept can be used at every level of corporate activity, from an individual widget made in a plant, to the total output of the plant, to a mammoth division inside a multi-line company. It’s not a measure of profit; it’s the basic measure of cash generation.  The question it answers at any level is, “Does this operation generate a positive return,  before loading in charges for corporate ‘extras’ –like the CEO’s salary, R&D, image advertising, the corporate jet fleet…”

why it’s an important concept

It makes you focus on incremental cost, not total cost.  For example,

1.  It tells you the point at which a company begins to consider shutting an operation down–namely, when the contribution margin turns negative.

I was reading a report the other day about the gold industry that maintained the gold price was in the process of bottoming because the “all in” or “fully loaded” price of producing an ounce of gold for the global gold mining industry is about $1,100 an ounce.  How embarrassing for the author!  That’s not right.  Yes, at under $1,100 an ounce, a generic mine may be showing a financial reporting loss.  But it’s still generating cash–in fact, the lowest-cost mines are probably generating $500 in cash an ounce.  Only the highest cost operators will think about ceasing mining.

What will firms do instead?  They’ll cut corporate overhead, for one thing.  If they decide that the value of their plant and equipment is permanently impaired, they’ll write off part of the carrying value of this investment on their balance sheets.  That will lower ongoing depreciation charges, by. let’s say, $100 an ounce (a number I just made up).  That will magically transform the financial accounts from red ink to black.  But this change won’t alter the cash flow generation from operations.

2.  It highlights an operation’s value.  Suppose an operation has a contribution margin of $1 million a year, but all that–and more–is eaten up by corporate charges.  It can be sold to, or merged with, another operation in a similar situation.  The ” synergy” of eliminating duplicative administrative functions may turn two apparent losers into a combined money-maker.  In any event, the $1 million yearly contribution to overhead has a significant value.

3.  It invites you to look at breakeven points–and the often explosively strong effect that finally covering overhead costs can have on profits.  Hotels are the example I often thing of.  As a general rule of thumb, a hotel is breakeven on a cash flow basis at 50% occupancy.  It breaks even on a financial reporting basis at 60% occupancy.  Above that, profit flows like water into the accounts.  IN this case, a relatively modest shift in occupancy can change the profit picture dramatically–and that’s without regarding the possibility of room-rate increases.

thinking about PCs

Yes, I think the traditional PC is dying.

Desktops are already relics.  Waiting for any PC to boot up is a chore–especially if you get caught in one of those seemingly interminable update cycles Windows is so fond of.  Experiencing instant-on tablets just makes the PC look slower.

If you own a Dell or an HP, it’s worse than just the hardware limitations.  You’re also saddled with a heavy, clunky-looking machine that breaks a lot and where customer service is poor.

But the current slump in PC sales is considerably more shallow than the headline numbers imply.  Those include the crashing and burning of the netbook (I own one but thought that as a concept the netbook had long since died.  Apparently not until 2013).  Ex netbooks, global PC sales are down by 5% or so, year on year.

Consumers switching to tablets is a key reason for the lack of oomph in PCs.  Tablets are smaller, lighter, cheaper.  They’re instant on.  You can play tons of casual–or, like Kingdom Rush, not so casual, games on them.  By the way, my friend Pam told me about appsgonefree, an app whose sole purpose is to introduce you to free apps (Art Race is my favorite so far.)

I don’t think current tablets are the device of the future either, however.  They’re underpowered.  Invariably, apps are truncated versions of PC applications.  If  I want to do anything in depth, I invariably find that I have to leave the app and go to the “full” site via Chrome.  It’s hard to type on a tablet.  For iPads, the lack of a USB port makes it a pain in the neck to import anything.

That’s what makes the newest generation of Intel chips–with better to come as time goes on–so potentially interesting.  They the first Intel offerings tailored specifically for mobile devices.  They won’t cure Dell or HP’s lack of design flair or customer awareness.  But they will enable either much more useful tablets or cheaper, next-generation PCs  that we should begin to see this holiday season.

I suspect part of the weak PC sales story is that many potential PC buyers are awaiting the arrival of these new devices rather than purchasing soon-to-be dinosaurs.


Moffett Research, Vodafone’s financials, Wall Street’s security analysts

The “Heard on the Street” column of today’s Wall Street Journal talks about the purchase commitment Verizon Wireless had to make to Apple in order to be able to offer the iPhone on its network.

a footnote in the Vodafone financial statements

The information comes from newly-formed Moffett Research LLC, a venture headed by Craig Moffett, the truly excellent (former) telecoms analyst at Bernstein.  Mr. Moffett points to a footnote in the financial statements of  Vodafone plc, a Verizon Wireless co-owner, that implies Verizon Wireless has committed to buy a minimum of $44.7 billion worth of iPhones during 2011-2013.  The company spent only $18.5 billion on iPhones through the end of last year, however, and still had $2 billion worth (Mr. Moffett’s number) in inventory.

That leaves $26.2 billion worth of iPhones to be bought this year (my arithmetic–HotS says the shortfall is $23.5 billion).

I find three aspects of this story interesting:

1.  Neither Verizon Wireless nor Verizon disclose this information.  It took a sharp-eyed telecom specialist combing through the back pages of a UK company’s financials to spot the figures and realize their significance.

This example illustrates what security analysts do for a living, as well as the depth of information that traditionally has been at the fingertips of any professional investor who does business with the major brokerage firms who employ these analysts and furnish their research to customers.  In other words, no matter how dull-witted the pro and how smart we as individual investors are, the pro has a huge information advantage starting out.

2.  Mr. Moffett started up his new firm two months ago.  It may be that he’s decided he can make more money as an independent than as an employee of Bernstein.  More likely, if past Wall Street form follows true, is that Bernstein has started to dismantle its high-powered equity research effort.  Why do so?  Wall Street believes that research is a money losing business.

3.  What happens if/when Verizon Wireless falls short of its $44.7 billion purchase commitment?

HotS doesn’t say.

Using (very) round numbers, the shortfall will likely be $10 billion or so.  In contracts of this type that I’m familiar with, Verizon Wireless would have to pay that amount to Apple shortly after the end of the year.  Verizon Wireless would, however, get a credit against future purchases of a gradually declining percentage of the shortfall payment.

Given the popularity of the competing Samsung Galaxy phone line, I imagine the shortfall payment will be a prominent element in negotiations over supply arrangements in 2014.

On another note,  I wonder how Apple and Verizon have been accounting for the minimum purchase contract.   HotS says the minimums for 2011-13 are:  $13.7 billion, $14 billion, $17 billion, respectively.  The actual purchases have been $8.4 billion and $10.2 billion in 2011 and 2012.

Both firms are most likely using the actuals, not the contracted minimum amounts.  Might be a little awkward for Apple, though, if it isn’t.

junk bond ETFs underperforming in a down market: it’s the nature of the beast


ETFs are a great innovation, in my view.  Legally, they’re set up as investment corporations, like mutual funds (read my posts on ETFs vs. mutual funds for more details).  But, unlike mutual funds, which process buys and sells in-house (and charge a recurring fee to holders for doing so), ETFs outsource this market-making function to Wall Street brokerage firms.

This difference has several consequences:

–no recurring fee, so lower overall fund expenses,

–you can buy and sell all through the trading day, instead of selling at closing net asset value,

–unlike a mutual fund, an ETF holder has no guarantee he can transact at NAV, and

–you pay the broker a commission and a bid-asked spread when you transact (the second is an “invisible” cost that may offset the advantage of lower fund fees).

If you’re a buy-and-hold investor (the wisest course for you and me, in my opinion), ETFs have it all over index funds, especially for very liquid products like an S&P 500 index.

what about junk bond ETFs?

Why, then, have junk bond index ETFs been seriously underperforming their benchmarks during the current period of rising interest rates?

Several obvious factors:

–junk bonds aren’t particularly liquid.  Many don’t trade every day.  In fact, junk bond fund and ETF managers employ independent pricing services, which estimate the value of bonds that haven’t traded that day, in order to calculate daily NAV.

This means that if redemptions come, a junk bond index fund/ETF has to go hunting for buyers and won’t get the best prices for the bonds it’s selling.  The sharper-than-benchmark falls in ETF NAVs suggests they’re taking big haircuts on the positions they’re liquidating.

–ETFs attract short-term traders, who are more prone to redeem

–ETFs can be sold short, adding to downward  pressure

–ETFs don’t accept dribs and drabs of redeemed shares from the investment banks it uses as middlemen.  Brokers hold until they have minimum exchangeable quantities.  While they’re waiting, they may hedge their positions–meaning they may short the ETF, too.


One not-so-obvious one:

Unlike a mutual fund, the broker you’re buying and selling through has no obligation to transact for you in an ETF at NAV.  Quite the opposite.  Your expectation should be that the broker will make a profit through his bid-asked spread.

The broker typically has a very good idea what NAV is on a minute-to-minute basis.  Individuals like us usually don’t.  NOt a great bargaining position to be in.

In addition, in contrast with an S&P 500 index fund, where the broker gets an up-to-date NAV every 15 seconds, no one knows precisely what a junk bond fund NAV is at any given time (certainly the broker has a better idea than you and me, but that’s another issue).  This uncertainty makes the broker widen his spread.

On top of that, when a broker is taking on more inventory of shares than he feels comfortable with, he’ll widen his spread further, to discourage potential sellers from transacting.

Brokers know how much money they make through these spreads.  No one else does.  We do know, though, that in past times of stress the last trade of the day in a less-liquid ETFs has often been substantially below NAV.  My guess is that recent junk bond ETF sellers have paid a hefty price through the bid-asked spread to get their transactions done.  If you’re one, compare your selling price with that’s day’s NAV and see.