security monitoring services–another thought on Amazon (AMZN)

Security monitoring services have an interesting financial structure.  They wire up your home with anti-intrusion devices, which they monitor from a remote location.  They may charge an installation fee, which typically covers half or less of the actual installation cost.  And they charge a periodic, usually monthly, monitoring fee.

These companies have operating leverage in two ways:  a few employees can equally well monitor one or thousands of homes; and the company can charge for add-on services (like fire or medical monitoring) that cost almost nothing to provide.

A contract with a homeowner will work something like this (I’m making these numbers up):

–installation costs $2,000, of which the client pays $1,000

–the client signs a three-year contract to pay a monitoring fee of $50 a month

–monitoring expense (rent + equipment + salaries) is $10 a month.

On these figures, it takes the monitoring company about two years to recover its initial investment.  After that, a waterfall of money rains down into the monitoring company’s bank account.

This is a fabulous business to own, even though the initial negative cash flow may be daunting.

For the stock of a company like this,  however, it may not be the dream investment it may seem.

How so?

It isn’t that the early years look ugly from a profit and cash flow perspective.  It isn’t the issue of how to finance the initial investment in monitoring equipment.  Liberal accounting technique can pretty up the financials a bit, but–I believe–most holders see through this to understand the actual cash in/cash out relatively clearly.

Instead, investors concentrate on the asset value created by each new customer.  Let’s say a typical customer retains the monitoring service for 15 years (again, a made up number).  If so, and if both revenues and costs remain constant, each new customer adds something like $6,000 to the firm’s asset value.

For investors, then, the more new customers who sign up, the better.  The more existing customers who sign up for new services, increasing their asset value, the better.  That’s even though the more new customers, the uglier the near-term losses and negative cash flow will get.

Here’s the kicker:

–the fastest way for a company like this to show stellar earnings growth is to stop signing up new customers.  But that’s also the kiss of death–because it means the firm has gone ex-growth!!

…the stock fall apart.  Maybe it doesn’t go down in flames all at once.  But it suddenly looks an awful lot like a bond.  So PE contraction offsets the better earnings.

This is not how a startup works.  Usually incremental customers are profitable right out of the gate; the issue is getting enough of them to cover infrastructure costs.

It isn’t quite AMZN, either, which seems to require massive infrastructure spending just to tread water.  But I think holders take the large amount of spending on infrastructure as a proxy for future growth–just as holders of alarm companies do.

I wonder what would happen if AMZN suddenly entered the waterfall-of-money phase of its life that presumably owners are waiting for.  My guess is they wouldn’t find it as enjoyable as they thing they would.






thinking about Amazon (AMZN)–and concept stocks in general

I’ve watched AMZN since its inception, although I’ve never owned the stock.  What I find especially fascinating is that it has been a “concept” stock–one where the possibility of spectacular earnings growth is always there, but the reality seems to somehow always be just around the next bend–for close to two decades.

I think the stock has particular significance for investors in general–owners or not–at present, for two reasons:

–Yesterday afternoon I happened to be home and noticed a small crossover SUV I didn’t recognize parked outside our house.  After a while, an unmarked white panel truck drove up.  The driver came to our door, rang the bell and left.  It was a package from AMZN, containing–unusually for AMZN–a bunch of different stuff (gummi bears and two kinds of SD card, if you have to know) in one box.

The driver then opened up the back of the truck and began transferring packages to the crossover.  Welcome to  the newest wrinkle in AMZN’s logistics system.  No uniforms, no big trucks, no handheld package control computers.  Just guys with cars stitched together into a (low-cost) delivery network.  I’d been seeing the panel truck for months.  This is the first on-the-fly transfer I witnessed, though.

I read this as AMZN’s response to the successful campaign by bricks-and-mortar retailers to have states enforce the sales tax laws with AMZN.  I don’t think this has helped the b&m people at all.  I think it’s been a windfall for smaller online retailers, though, and for companies that use AMZN for distribution, two groups that are so far flying under the sales tax radar.

AMZN’s competitive response has been to reduce delivery costs, with (presumably negative, if it’s successful) implications for the post office, Fedex and UPS.

–More important for me, AMZN shares fall into the group of “story” stocks that have been sold off very heavily since February.  So I think we can draw conclusions about the whole group by examining AMZN (not a rock solid premise, but, I think, the best we’re going to be able to do).

Two features stand out to me.

First, nothing much has changed with the company, even though the stock has lost a quarter of its value in the selloff.

Second, the list of major holders consists of the most prominent institutional money managers in the country. So the selloff is not being induced by a small bunch of crazy, risk-prone hedge funds.  In addition, most of the big names (ex Fidelity) had already been lightening their positions late last year.

As far as trying to figure out how far the selloff might go, we can look at a fundamental component and an emotional one.  On the fundamental side, pre-Great Recession AMZN shares tended to trade at about 30x cash flow.  In recent years, that figure has been closer to 50x.  A return to 30x cash flow would imply a price of around $300, or about where we are now.  Personally, I don’t see why I should pay 30x cash flow for anything but a startup.  But arguably most of the air has already been taken out of the AMZN balloon.

The emotional side is where looking at price charts and volumes traded comes in.  In the case of AMZN, there has been a sharp pickup in volume over the past couple of days,  That’s usually an indicator of the panicky selling that marks a bottom.

From my own perspective, the selloff has gone on longer, and has been deeper, than I would have thought.  But that’s par for the course for me.  And I’m not feeling very uneasy about stocks in general–which is my go-to indicator that I should be starting to buy.  Of course, this may be because the overall market has been holding up very well. Selling has been confined to a relatively small subset of stocks.

For now, my strategy remains to ride out the storm, not buying in a big way but not selling either.  To my mind, it’s way too late for me to do the latter.  But I’d like more confirmation before becoming more aggressive.



Fidelity’s dark pool proposal–why?

Recently, Fidelity, one of the largest money managers in the world, has been sending feelers out to its peers to form a private “dark pool” in which they could all trade anonymously.

What’s this all about?

I’m not sure who made up the name “dark pool.”  But it glamorizes a pretty mundane operation.  A dark pool is a computer-driven trading network where professional investors buy and sell securities with each other in a low-cost anonymous way.

They’re meant to solve two problems that every large investor like Fidelity who’s subject to SEC regulation in the US has:

–in trading securities for their clients,money managers are required to obtain the lowest cost in making any trade as well as the best execution of the order.  Best execution, which I take to mean the most favorable price, given the circumstances at the time of the trade, is a rather vague and contentious concept.  But lowest cost, meaning the lowest commission or bid/ask spread paid to get the trade accomplished, is relatively clear.

It’s also very clear that dealing with a third-party broker isn’t the lowest cost way of doing business.  Dealing directly with another institution through a computer trading network may cut commission/spread costs in half.  As a result, increasing amounts of trade is being done through dark pools so institutions can establish that they’re working to fulfil the lowest-cost legal mandate.

–any money manager wants to keep his trading activity as secret as possible.  After all, no one wants others to be freeriding on investment ideas that a manager has developed after long and expensive research efforts.

This is a particularly pressing issue for managers with large amounts of money under management, since such a manager will often have orders that are so big they can take, say, a month to execute–sometimes longer.  The trickiest part of such trading is keeping the manager’s activity secret for as long as possible.

Again, brokerage house trading operations for third parties are not a great way to go.  They tend to leak like sieves.  Part of this is a function of order size.  The broker may approach potentially interested parties.  As/when the size of the order becomes apparent, the other party may be able to guess the identity of the institution the broker represents.

There’s mre than that, however.  Information is also a valuable resource.  In my experience, most important clients of a broker–and the broker’s own proprietary trading desk–would know the general outlines of a Fidelity order within minutes of its being placed.  The broker might not use the Fidelity name, but the description ” a large institution in Boston” would leave little to the imagination.  The idea is that smaller clients will regard this as valuable information and will compensate the broker with increased trading commissions in return for continuing access.  (My tendency would be to do less business with a broker who acts this way, but apparently I’m in the minority.)

Dark pools, though sometimes illiquid, are one solution to this problem.

It turns out, though, that the dark pools also have their issues.  One that I find interesting is that to obtain liquidity dark pools may allow high frequency traders to participate.  And, it turns out, they have found “big data” ways to figure out which orders are Fidelity’s–and to use this information to trade against them.

Fidelity’s response is to try to form a dark pool that will consist only of institutional investors, without high frequency traders.  Such a setup might have issues of its own.  If there are only, say, four major members it may be that the trading intentions of the others will be obvious to all.  But, in Fidelity’s view at least, that would be better than the current situation.



my take on Apple (AAPL)

In a comment on yesterday’s post, my friend Bruce asked for my take on AAPL. That’s my subject today.

The stock looks cheap to me.  Investors have had two big worries, I think.  One has been lack of recent earnings growth.  The other is the perception that the post-Jobs management of AAPL is completely at sea, cowed by the memory of Jobs and therefore unable to make decisions– as well as completely uninterested in whether the stock goes up or down.


–growth appears to be resuming.  Yes, modest growth, but Wall Street has understood for years that the heady days of the last decade are gone forever.

–AAPL has a stellar brand name and many rabid fans.  New products may re-energize them.

–the recent announcement of a 7-for-1 split offers the hope that management is more the simply caretaker of the Steve Jobs museum.

–in addition, conditions are right for investors to look at AAPL again.  I think 2014 is going to be a sideways year from here for the US stock market.  So a big, low-multiple, cash generative company where earnings growth is resuming and where management practices may be taking a turn for the better has a great chance to be an outperformer.  A 2.3% dividend yield doesn’t hurt, either.

To me, AAPL feels like the MSFT story, only in an earlier chapter.  MSFT has a stronger business.  But Tim Cook arguably has greater freedom to act, since he’s dealing only with the legend of Steve Jobs and not the physical presence of Steve Ballmer.  (Also, to give him credit, Cook has already fixed one of SJ’s mistaken pronouncements–that 10″ is the only tablet size anyone will/should want.  He appears to be in the process of fixing another, similar one–that the original iPhone screen size is the only choice anyone will want/need.)

Personally, I prefer MSFT.  But that may be because AAPL has historically been so uncommunicative that it’s hard to figure out what’s going on inside management’s heads.  In the strange way investors think, my attitude is arguably an investment plus for AAPL.  Better communication from AAPL would come as a positive surprise to Wall Street–and by itself result in a higher stock price.





Apple (AAPL) is splitting its stock, 7 for 1

AAPL’s 2Q14 earnings report last night was full of mostly positive surprises:

–earnings per share came in at $11.62.  That’s about 15% more than the Wall Street analyst consensus had expected, and higher, by about the same amount, than results in the same quarter a year ago.  It’s the largest margin AAPL has beaten the consensus by in years.

–the company is raising its dividend and increased its proposed share buyback amount by $30 billion

–AAPL is going to split its stock by 7 to 1.

Of these developments, I think the most important is the stock split.

stock splits

Academics will tell you two things about stock splits:

1.  Stock splits have no direct economic significance.  Its’ simply paper shuffling.  Instead of having one share that trades at, say, $560 you’ll soon have seven shares, each trading at $80.

2.  The stocks of companies that have stock splits tend to underperform for a period after the split occurs.


The second comment, while true, is, well, silly.  All the outperformance comes between the period when the stock split is anticipated by the stock market or actually announced and the date when the split takes place.

The first is also true–particularly in the United States (but not in many foreign markets).  But this doesn’t mean that the AAPL split has no relevance.

(See my post on stock splits for more details.)

Two reasons:

–stocks with very high per share prices tend to underperform.  Why?  I don’t know.  I think it’s because retail investors prefer to buy stock in round” lots (usually 100 shares).  This may be an echo from the days a half-century ago when trading costs were very high and when the commission for an “odd” lot (anything that isn’t a round lot) was particularly expensive.  For AAPL, this would be a commitment of over $50,000–too rich for a single position for most people.

Yes, it makes no sense.  But, whatever the reason, retail investors like stock splits and respond positively to them.

–more important, studied management contempt for shareholders, who after all are the owners of the company, has long been a key feature of the AAPL persona.  It’s part of the Steve Jobs legacy.  But it’s not a good one.  To me the stock split is a sign that the current management finally realizes how poisonous the Just-Like-Steve mentality has been and is beginning to shake off its shackles.

I don’t think this means AAPL returns to the super growth of its past.  On the other hand, I do think that, if I’m right about the attitude change, that the JLS discount multiple Wall Street now applies to AAPL stock will gradually disappear.  Just achieving a market multiple would imply a 30% gain in the stock.


publicly traded US companies have about $1 trillion in cash stashed abroad

That’s the best number I could come up with–admittedly through a fast internet search.

It’s not the exact figure that I find interesting, though, but the motives companies have for doing so.  Three of them are well-known, two less so.

the well-known

–Multinational companies have operations in many countries.  It may be that much of their growth–and all of their possible acquisitions–will be outside the US.  It makes no sense to move money back to the US, pay 35¢ on the dollar in Federal income tax and then resending the net amount abroad to make a foreign acquisition.  A CEO might, and probably should, lose his job for allowing this to happen.  Also the official reason companies cite for not returning cash to the US is that the funds are permanently invested internationally.

–Versus other countries, the IRS is unusually harsh in the way it taxes earnings repatriated from abroad.  There has already been one discount deal, the Homeland Investment Act of 2004, offered by the IRS to allow corporates to repatriate cash without the stiff tax bill.  The terms were:  tax at 5.25%, but all money brought back had to be invested in hiring new workers or building new plant.

As it turns out, aggregate hiring and plant construction didn’t rise during the amnesty period, even though about $300 billion was repatriated, making the case for another HIA a bit shaky.  Nevertheless, the possibility of a new HIA is a powerful deterrent to repatriation.  Who wants to be that idiot who paid $3.5 billion on a $10 billion repatriation a month before HIA II is enacted?

–Big corporates can borrow a ton of money very cheaply in the US.  APPL did it last year, for example, and the company seems to be warming up for another tranche in the near future.

the other two

–Companies have found a workaround.  It doesn’t count as repatriation if you keep the money in the US for less than 90 days and don’t get money again from the same source for a certain amount of time.  So multinationals have created daisychains of intracorporate loans, whose effect is to keep cash permanently in the US.  The first loan comes, say, from Hong Kong.  Three months later, it is repaid with cash from, say, Ireland.  That loan is repaid with money from, say, Switzerland.  And the Swiss loan is repaid with fresh funds from Hong Kong…  Ingenious, yes, but most owners would wish, I think, that corporate minds be put to more productive uses.

–In recent years, companies have boosted eps growth by tax planning, that is, by opting to recognize profits in low-tax jurisdictions.  A generation ago, investors wouldn’t have allowed this.  The market back then would only pay a discount PE for earnings that weren’t fully taxed at the rate prevailing in the firm’s home country.

No longer.  As far as I can see, investors are now indifferent to the tax rate firms pay.  The market no longer discounts earnings taxed at a low rate.  So managements have every incentive to recognize profits in low-tax countries.  After all, it takes $1.50 in pre-tax earnings in the US to produce a dollar of net.  That’s 50% more than a US firm needs to produce the same net from Hong Kong.

More than that, suppose a firm suddenly got it into its head to recognize all its earnings in the US.  What would happen to profits?  There’s an easy way to find out.  Just look at the actual corporate tax rate and adjust it to 35%.  If the actual rate is 25%, then each dollar of pre-tax becomes 75¢ of net.  At 35%, each dollar of pre-tax would be 65¢ of net–a 14% drop.  What CEO wants to report that earnings growth is slowing–or worse, disappearing–because he’s monkeying around with the tax rate?






reverse takeover or financial “inversion”

This is a followup to yesterday’s post, in which I commented that there’s something wrong with the US Federal corporate tax system.

One of the symptoms is the growing use of a type of reverse takeover, called an inversion, by US corporations to lower their taxes by shifting their headquarters internationally.  No one has to move; this is simply a legal change.

I don;t think US companies necessarily want to do this, but–aside from a few heavily tax-subsidized industries–US corporate taxes are considerably higher than those in other countries.

how a reverse takeover works

Let’s say Company A buys Company B.

In a plain vanilla , and simplified, version of the takeover/merger:

–the management and shareholders of Company A maintain control of A and add control of the combined A + B

–legally, Company B either becomes a subsidiary of Company A, or the assets of Company B are folded into Company A and

the empty shell of Company B goes out of existence.

In a reverse version of the same takeover/merger:

–the management and shareholders of company A still take control of A + B, but

–legally, the assets of Company A are folded in to Company B.  The original company A goes out of existence.  Often, B renames itself “A,” so that no one on the outside can tell that anything has changed.

why do a reverse takeover?

Why go to the extra legal trouble?


…a big reason has been to allow a private company to go public quickly.  The private company locates a moribund firm with few assets–sometimes called a shell company–that already has a public listing.  By buying it and executing a reverse merger, the private company ends up with its assets and operations inside the “clothes,” as it were, of the public firm.  All at once, it has a public quote, and  –this is the important thing–it has not had to go through the often lengthy regulatory scrutiny involved in an IPO.  Many Chinese firms, for example, have taken this route to public listing in the United States.

…and now

In recent years, this process–now termed an inversion–has been used by US companies buying foreign firms.  Many have been pharmaceuticals buying European counterparts.  The surviving legal entity has virtually always been the European firm, even though the Americans are in control.

Why do this?

Although the firms may say otherwise, I can’t help believing it’s to shift the company’s tax home away from the US, where corporate taxes are unusually high for health care.  The corporate tax rate is 35% in the US vs. 12.5% in Ireland, for example.


…which brings us to US drugstore operator Walgreen (WAG).  WAG is acquiring the Swiss-based drugstore chain Alliance-Boots.  According to the Financial Times, investors who in total own about 5% of WAG, including Goldman Sachs and  Jana Partners, are urging the company to redomicile to Switzerland.  Doing so, the investors say, would reduce the corporate tax rate from WAG’s current 37.5% to something closer to the 20% Alliance-Boots now pays.  If so, the move would increase WAG’s after-tax earnings by 80% or so–slashing the stock’s PE multiple to less than 14.  That would be considerably below the S&P 500 average.

Since in today’s world investors rarely look at a low tax rate as a negative, zeroing in almost exclusively instead on EPS, WAG shares would presumably rise to restore the PE either to its previous level or at least to the market average of about 17.  At the very least, WAG could boost its dividend substantially.

WAG probably won’t heed the Goldman/Janus advice, for fear Congress would have a fit.  Still, the “brain drain” will likely continue unless/until Washington overhauls the income tax code.