Amazon (AMZN) vs. Apple (AAPL)

I changed radio channels from the morning news to Bloomberg Radio while I was in the car yesterday.  It was about 9am, so I figured I’d get some market news while avoiding the Today-like chitchat that begins on Bloomberg at 10am.

What I heard instead was an expression of disbelief about the relative valuation of AMZN and AAPL, with the former being inappropriately trading at 3x the price/free cash flow of the latter.   The senior talking head presented this as being so self-evidently true as to need no further discussion.

I’m not sure why this howler bothered me, but it it did.

Three points:

–Both companies were formed by visionary entrepreneurs who transformed the landscape of their industries.  However, Jeff Bezos is still innovating and AAPL hasn’t produced a big new product in the past five years.

AAPL is a high-end smartphone company.  Today, that’s a mature product that depends on replacement demand.  There are no new customers.  Network operators are trying to stretch out the replacement cycle as a way of lowering their costs.

In contrast, AMZN is all about web services, a business that’s in its infancy and growing like a weed.  And the world is increasingly shifting to online purchasing.

In other words, AAPL and AMZN are very different companies.

–The accounting principles AMZN uses are more conservative than AAPL’s.  What might appear on the AAPL income statement as $1 in profit might only be, say, $.75 on AMZN’s. That alone doesn’t explain why one should trade at 3x the other.  But the comparison is far from clean.  Dollars to donuts the talking head I heard had no idea.

–I don’t get why free cash flow generation is an appropriate metric to use in making the comparison in the first place.

Free cash flow is the money a firm generates from operations minus the capital it invests in building/maintaining the business (and, for me, minus any mandatory debt repayments, as well).  Free cash flow is the “extra” that can be used to pay dividends.  Good for income-oriented investors.  If it’s very large, free cash flow may even attract potential acquirers in related industries who have investment opportunities that are greater than their ability to fund.

At the same time, large free cash flow can signal that a business has no new investment opportunities.  So the large free cash flow may simply mean the company has gone ex growth.  That’s bad.  On the other hand, a firm may have little or no free cash flow because it has lots of new investment opportunities and huge capacity to grow.  A growth investor will pick the second over the first any day of the week.

Personally, I don’t have a strong opinion on AMZN vs. AAPL.  For years I’ve been bemused by the strength of AAPL shares despite the clear evidence that the smartphone market was nearing saturation.  I’ve also been surprised by how well AMZN shares have done.

My point is that there was a children-playing-with-matches aspect to the discussion I heard.  There was no recognition that AMZN and AAPL are very different kinds of companies and the comparison metric was, yes, a little more sophisticated than PE–but completely wrongly used.

Maybe CNBC isn’t so bad, after all.


oil at $80 a barrel–a Saudi plot?

I don’t think so  …and if the Saudis are trying to keep oil prices low in order to drive American shale oil out of business, it’s a pretty pathetic one  (Tom Randall of Bloomberg, for example, recently wrote an otherwise excellent article in which he supports the plot view).

Here’s why:

Any oil project starts with geology work to locate prospective acreage for drilling.  The oil firm then purchases mineral rights from the owner of the land where it intends to drill.  Next comes the actual drilling, which can cost $5 million – $10 million a well.  The driller also needs some way of getting output to market, which may entail building a spur to the nearest pipeline, or at least paving the local roads so that trucks he hires can get to the wellsite.

All that outlay comes before the exploration company can collect a penny from the oil or gas that comes to the surface.

In other words, the project costs are significantly front-end loaded.  This is important.  It means the economics of the situation change dramatically according to whether you’ve already made the up-front investment or not.

An example:

I took a quick look at the latest 10-Q for EOG Resources, a shale oil driller.

Over the first six months of the year, EOG took in $6.5 billion from selling oil and gas, and had net income of $1.4 billion.  That’s a net margin of 21.5%.  At first blush, it looks like a 20% drop in prices would put EOG in big trouble.

Look at the cash flow statement, however, and a different picture emerges.  The $1.4 billion in net comes after a provision of $1.9 billion for depreciation of some of those upfront expenses and after another provision of $479 million for deferred (that is, not actually paid yet) income taxes.  So the actual cash that came into EOG’s hands during the period was $3.8 billion.  That’s a margin of 58.4%–meaning that prices could be more than cut in half and EOG would still be getting money by continuing to operate existing wells.

Yes, at $70 a barrel, new shale oil projects are probably not sure-fire winners.  But oil companies will continue to operate oil share wells, even at prices below this in order to recover capital investments they have already made.  The right time for Saudi Arabia to throw a monkey wrench in to the shale oil works would have been three or four years ago, not today.

The wider point:  once a new entrant has made a big capital investment to get into any industry, it’s very hard to get the newcomer out.  Even if incumbents make the new firm’s position untenable, the latter’s goal just shifts away from making money to minimizing its mistake by extracting as much of its capital as it can.  It will be willing to destroy the industry pricing structure if necessary to do so.




Ron Johnson out at J. C. Penney (JCP): implications

Yesterday, only a few weeks after major shareholder Bill Ackman gave Ron Johnson a ringing endorsement as CEO of JCP, Mr. Johnson is out.

Former CEO, Mike Ullman, who was unceremoniously dumped not that long ago to make room for Johnson, is back in.


What can we make of this?     …quite a lot, I think.

1.  The change comes right after monthly sales results for JCP in March, the second month of the company’s fiscal year, would have been available.  Presumably they’re really bad (the Wall Street Journal is reporting that quarter-to-date sales are down at least 10% year on year).

This is a big problem.  JCP marks up merchandise by about 50% over what it pays.  It uses the gains from sales, called gross income, to cover the costs of running the store network (like advertising, rent, utilities, salaries…).  What’s left over is profit.

JCP’s sales in fiscal 2010 were $17.6 billion;  its pre-tax profit was $581 million.

In fiscal 2012, sales were $13.0 billion, or 26% lower than in fiscal 2010.  My back of the envelope calculation is that JCP lost just under $800 million from retailing last year–offset by a number of non-recurring gains (see my post).

To my mind, the largest factor in the profit decline is the loss of sales.  The March figures suggests sales may not have bottomed out yet.

2.  Since the company was quick to boot Mr. Ullman not so long ago, he’s probably not the company’s first choice as the new CEO.

I can see two possibilities:

–he may be the only experienced executive willing to take the job, or

–JCP may have been pressured into making the change quickly and Mr. Ullman was available on short notice (I’ve heard he was first contacted last weekend).

Neither possibility is encouraging.

3.  Where would outside pressure come from? The two main sources, as I see it, would be:

–suppliers.  Last year JCP generated $140 million in cash by getting suppliers to agree to wait longer to be paid. As the perceived riskiness of dealing with JCP rises, the standard response by suppliers would be to rethink a decision like this.  In a more extreme situation, suppliers would start to reconsider the amounts and types of merchandise they send to a customer.

–banks.  In its 4Q12 earnings conference call, JCP highlighted the fact that it had negotiated a $500 million increase in its bank credit lines, to just over $2 billion.  The message from this seemed to me to be that JCP had ample funds to weather any problems it might encounter in 2013.  Again, the standard response to continuing deterioration in sales would be for banks to reassess their exposure.  All it would likely take to reduce a credit line–something that would doubtless have adverse effects for JCP–would be one credit committee meeting.

There’s no direct evidence that either suppliers or banks have started down this road.  It’s conceivable, though, that one or both told JCP they’ll have to change their thinking if sales don’t perk up soon.  That might have been the final straw for Mr. Johnson.

one company, three sets of accounting records

In almost all countries publicly traded companies maintain three sets of accounting records.  They are:

–tax books in which the firm keeps track of the taxable income it generates, and the taxes due on that income, according to the rules of the appropriate tax authority.

Keeping the tax records may also involve a tax planning element.  A company may, for example, decide to recognize profits, to the extent it can, in a low-tax jurisdiction.  Or, as is often the case with US companies, it may decide not to repatriate profits earned abroad, at least partially because they would thereby become subject to a 35% tax.

Tax considerations can also have operational consequences.  For instance, a firm may choose to locate factories or sales offices in low tax jurisdictions over similar high tax alternatives mostly for tax reasons.

–financial reporting books, in which publicly traded firms keep track of profits, and report them to shareholders, according to Generally Accepted Accounting Principles (GAAP).

If the purpose of tax accounting is to yield the smallest amount of taxable income, and thereby the smallest amount of tax, the intent of financial reporting books can be seen as trying to present the same facts in the rosiest possible manner to shareholders.

The main difference between the two accounting systems comes in how long-lived assets are charged as costs against revenue.  Financial accounting rules allow such costs to be spread out evenly over long periods of time.  Tax accounting rules, which may be specifically designed to encourage investment, typically allow the firm to front-load a large chunk of the spending into one or two years.

The end result is that for most publicly traded companies, the net income reported to shareholders is far higher than that reported to the tax authorities.

management control books, kept according to cost accounting rules.  These are the records that a company’s top executives use to organize and direct the firm’s operations.  They set out company objectives and incentives, and are used to assess how each of its units are performing against corporate goals.  Not all parts of a firm are supposed to make profits.  Some may have the job of making, at the lowest possible cost, high quality components used elsewhere in the company.  A mature division may not have the job of growing itself anymore,  but of generating the largest possible amount of cash.

investment implications

Investors normally don’t get to see either a company’s tax books or its management control books.

Financial reporting books can sometimes give a picture that’s too rosy.  The two main culprits are deferred taxes and capitalized interest.  “Capitalized” interest is usually the interest on construction loans taken out for a project than’s underway but not yet finished.  Even though money is going out the door, under GAAP it’s not shown as a current expense.   I’ll explain deferred taxes next week.

In a very practical sense, you don’t need to understand either one too much (although it might be nice to).  Turn to the company’s cash flow statement in its latest SEC earnings filing.  Are there deferred tax or capitalized interest entries?  Do they add to cash flow or subtract from it?   …by how much?  If the answer is no, or that they add to cash flow, there’s nothing to worry about.  If they subtract–and a lot, on the other hand, there’s a potential problem.

return on equity (II): cleaning up a mess

a company as a project portfolio

Every company can be seen as a collection–maybe a portfolio–of investment projects, each with its own risk and return on investment characteristics.  This is not the only way of looking at a business.  And it’s probably not the best way, as the ugly collapse of the conglomerate craze in the US during the 1960s illustrates.  Nevertheless, looking at the business as a project portfolio highlights an issue that the top management of a firm can face.

the BCG growth/cash matrix

One common way of sorting projects  is to use the growth/cash generation matrix invented by the Boston Consulting Group in the 1960s: stars = high growth, high cash generation cash cows = low growth, high cash generation questions marks = high growth, low cash generation dogs = low growth, low cash generation. loaded with canines What do you do if you’re a company with a boatload of dogs?  ..or just one really big dog. To see the issue clearly, let’s simplify: –let’s say that equity is your only source of funding (no working capital or debt), and –let’s say you have only two projects, with 100 units of equity invested in Project 1, which earns 20/year, and 100 units in Project 2, which earns 1/year. the problem: the sterling 20% return on equity of Project 1 is obscured by the near breakeven status of Project 2. The overall return on equity for the company of 10.5%. Why is this bad? Wall Street loves high return on equity–and loathes low return.  And the computer screens that even many professional investors use to narrow down the vast universe of available stocks into a more manageable number to investigate will toss a company like this on the reject pile.  So you’ll be overlooked. What should management do? The possibilities: 1.  eliminate inefficiencies in Project 2 and in doing so raise the ROE to a respectable figure 2.  if that’s not possible, sell Project 2 to someone else who, mistakenly or not, thinks he can do #1 3.  close Project 2 down and write the equity off as a loss, or 4.  divide the company in two, and either (a) spin Project 2 off as a separate entity (that is, give it to shareholders) or (b) gradually sell it to the investing public.

cutting to the chase

Let’s skip down to #4, since what we’re ultimately concerned with is what motivates a company to create a REIT.

why #4?

How can a company get into a situation where solution #4 is the best alternative? In my experience, this almost always involves long-lived assets, where the investment is big, and a company puts all the money in upfront, in the hope of getting steady income over 20 or 30 years.  Examples: a chemical plant, container ships, hotels, or mineral leases. One of two things happens –either the company soon discovers it has wildly overpaid for the assets, or –some unforeseen change, like technological change or a sharp increase in input prices, alters the economics of the project in a fundamentally negative way.

two forms of cash generation

Any project generates cash in two ways: –a return of the capital invested in the project, and –profits. In describing Project 2 above, I said it produces 1 unit of profit per year.  But that profit is after subtracting an expense of, say, 5 as depreciation and amortization. D&A are ways of factoring into costs the gradual wearing out of the factory, the machines or the other investment assets that are used in making the project’s output. In the case of a motel, D&A is a charge for the gradual deterioration of the structure over the years, until the building is too shabby to be used any more and must be razed and rebuilt.  Similarly, big machines either wear out or become technologically obsolete. The key fact to note is that depreciation and amortization aren’t actual outflows of cash–they’re inflows.  But they’re classified as return of capital, not as profit.  (I think this make sense, but I’ve been analyzing companies for over 30 years.  Don’t worry if it doesn’t to you.  Fodder for another post on cash flow vs. profits, and why it makes a difference to investors.)

In the case of Project 2, the actual cash inflow is probably 6/year (depreciation and amortization of 5 + profit of 1).  That’s a 6% yield.  But it’s also a millstone around the neck of the company that launched the project.  It’s return on equity–a key stock market screening factor–will be depressed for as long as it owns the project. On the other hand, to an income-oriented buyer a yield of 6 units/year for the next 20 years is nothing to sneeze at.  At a price of 85, the yield would be an eye-popping 7%.

this has happened before

In the early 1980s, T Boone Pickens, a brilliant financial engineer if no great shakes as an oilman, wildly overpaid for a number of oil and gas leases in the Gulf of Mexico.  Once he realized these properties would struggle to make back his initial lease payment and would never make money, he repackaged them as a limited partnership and spun it off. Around the same time, Marriott did the same thing.  It made a similarly unwise decision to build a number of very expensive luxury hotels.  When bookings started to come in, the company saw the properties would provide large cash flow–but never any profits.  So it rolled them all up into a limited partnership, which it sold to retail investors. In both cases, management “repurposed” assets to emphasize their cash generation characteristics rather than their lack of profitability.  Both also used a tax-minimization structure to enhance the assets’ attractiveness to income-oriented individual investors. REITS do the same thing. More tomorrow.