developments on the e-book front

There are two interrelated struggles going on over the potential revenues from e-book publishing.  One is among the sellers of dedicated e-readers, like the Kindle, the Nook or the Sony e-reader–each with one another, and all with AAPL, the creator of the iPad.  The last is a general internet content consumption device that hopes e-books will be one of many profitable sales opportunities for it.

The second is between authors and their publishers over who possesses the e-book rights to older “backlist” titles, whose contracts don’t spell out explicitly who owns them.  This “software” situation is at least as muddled as the “hardware” one.  Some literary agents and publishers have made their negotiations public; most have not.

The ones I know about on the publishing side seem to separate into two camps:  Random House and everyone else.  The issue is the royalty rate at which authors will be paid for backlist titles sold as e-books.  Authors’ agents point out that the incremental cost of selling an e-book is negligible, and that the e-book question is not addressed in the book contracts.  They conclude that their clients should get a higher percentage of such sales revenue than their contracts specify, since those implicitly factor in a physical publishing cost element.

Smaller publishers have been quietly striking deals with agents.  Random House has not.  It has taken the stance that it already owns the e-book rights to older titles because the contracts don’t explicitly exclude them.  It has also been conducting a gentle op-ed campaign to suggest that a book is really a collaboration between author and editor–and that the final product may be far different from the original manuscript acquired by the publisher.  I take it the suggestion here is that the book may not be the sole intellectual property of the author, to do with as he pleases, even if Random House were to be eventually found in court to have misinterpreted its older book contracts.

Last week, both battles reached a higher public profile when powerful literary agent Andrew Wylie, who represents a stable of hundreds of prominent authors, agreed to sell the exclusive e-book rights to twenty classic novels, including Norman Mailer’s “The Naked and the Dead,” Philip Roth’s “Portnoy’s Complaint,” and Salmon Rushdie’s “Midnight’s Children” to Amazon for the Kindle.  These are all titles under contract to Random House.

Random House has responded by stopping all new English-language book negotiations with Wylie.

This will be an interesting situation to watch.  The Wylie action only includes twenty books.  The Amazon deal is for a limited, two-year, time.  Presumably Wylie has chosen the titles with care–meaning authors/estates with the weakest ties to Random House.  So it is more a shot across the bow than a declaration of all-out war.  Random House’s action seems to me to be an overreaction.

Both moves may have unintended consequences.  I don’t see what Wylie has to lose, however, or what Random House has to gain, from their current positions.

Suppose sales of the twenty titles through Kindle are much better than anyone expects?  Then more authors will want to jump on the Kindle bandwagon and Random House will either have to backtrack or make a more draconian response.  If the latter, will it risk angering Wylie clients and losing them permanently to other booksellers .

Suppose sales are awful?  This is the “good” outcome for Random House–discovering that the e-book rights it is so ardently defending have no value.  I suspect this won’t be what happens, though.

End game for growth stocks: nasty, brutish but not very short. How does AAPL fit the mold?

the growth stock life cycle, in brief

The Wall Street cliché is that the key to successful growth investing is how skillfully you sell the stock (as opposed to value investing, where the key is how you buy it).

The idea is that most growth stocks have a very short life in the stock market sun–five or so years.  The best growth companies continue to reinvent themselves and create new lines of business–as WMT or MSFT did.  But most aren’t able to.

As the company demonstrates surprisingly strong earnings growth, the stock market attitude gradually changes from one of disbelief to fandom–extrapolating the period of superior profit expansion much farther into the future than will likely pan out.  This tendency shows itself in a huge price earnings multiple–both absolute and relative to the rest of the market.

Normally, the seeds of future earnings disappointment–and consequent price earning multiple contraction–are already being sown in a qualitative sense at least.  But many investors ignore, or explain away, these early warning signs even when they begin to be evident in reported earnings.  At some point, disillusionment, and subsequent underperformance, begins.

MSFT as an example

MSFT is a good example of this phenomenon.  In the four years from 1995 to 2000, MSFT’s reported profits per share grew at a 40% annual rate,  meaning they quadrupled over that span.  The price earnings multiple expanded from 29 to 53, and advance of 83%, over the same period.  Therefore, more than two fifths of the total 10x stock gain came from p/e expansion.

Over the subsequent decade, MSFT’s eps grew at a little more than a 10% clip–and the stock’s p/e contracted steadily from 53 to 13 (or 3.5x the market average multiple to .9x currently).  Despite the doubling in earnings the  stock price has been cut in half, more than all of which is due to p/e contraction.

If we look at MSFT in general conceptual terms, the stock was first driven by the acceptance of the MS-DOS operating system, then by the Office suite, and finally by successive iterations of the Windows graphical user interface–all in an expanding PC market.  Then the market for its products matured, MSFT came late to the Internet, its diversifications earned little money and…  Nevertheless, it’s important to note that MSFT lasted as a growth stock for such an unusually long period because of its successive waves of innovation from MS-DOS on, not just because the PC market was growing quickly.

How does AAPL fit this model?

Looking in the most general terms, AAPL was a moribund personal computer firm with a cult-like following among individuals using PCs that had a change of management.  New leadership introduced a portable music player, the iPod, that was so successful it quickly doubled the size of the company.  AAPL subsequently introduced a revolutionary smartphone, the iPhone, which again doubled the size of the company.  Now it’s introducing a third product, the iPad in a hope of doing the same trick again.

What AAPL has done over the past decade is truly remarkable.  Earnings per share have grown at a 60%+ annual rate, and are now 10x what they were in 2005. The company is now one part PCs, one part iPod, and two parts iPhone, three of which weren’t there five years ago.

Two potential questions about AAPL’s future performance have emerged:

–One is the “concept” observation that to have the same positive effect on the overall company as the iPhone has had, the next product, presumably the iPad, has to be twice the size of the iPhone.  This is just a fact of the company’s recent growth.

–Android phones are emerging as a potential competitor to the iPhone; iPod unit sales are slipping; Chrome-based tablets are potentially going to be on the market for this year’s holiday season.  Wall Street is presumably thinking that Chrome products will end up being a case of the Zune redux.

one big difference

In 2005, AAPL’s stock was trading at 26x earnings per share.  Today, after a period of extraordinary earnings growth, AAPL’s stock is trading at under 17x eps, a pe multiple contraction of 30%.  AAPL’s relative pe was 1.4 in 2005.  It’s 1.1 now.

Unlike the typical growth stock, more than 100% of AAPL’s stock performance has been driven by earnings growth.  The pe contraction means investors have been increasingly forcefully betting that the company can’t continue its present rate of expansion.  In fact, one might argue that a pe multiple of 17- means the market thinks AAPL won’t grow earnings by more than 15% from now on.

my thoughts

Personally, I think tablets will create a new revolution in computer usage.  I’m not sure the AAPL will get the market share with the iPad that it has been able to achieve with the iPhone or the iPod.  Still, if my reading of the stock price dynamics is correct, I think Wall Street is being much too pessimistic about AAPL’s prospects.  Hard as this is to say about a stock that has had 15x the market return over the past five years, that’s what the numbers tell me.

AAPL’s March 2010 quarter: strong non-US iPhone sales

The AAPL quarter

I listened to the AAPL March quarter conference call yesterday and looked at the financials.

the numbers–really good

“CUPERTINO, California—April 20, 2010—Apple® today announced financial results for its fiscal 2010 second quarter ended March 27, 2010. The Company posted revenue of $13.50 billion and net quarterly profit of $3.07 billion, or $3.33 per diluted share. These results compare to revenue of $9.08 billion and net quarterly profit of $1.62 billion, or $1.79 per diluted share, in the year-ago quarter. Gross margin was 41.7 percent, up from 39.9 percent in the year-ago quarter. International sales accounted for 58 percent of the quarter’s revenue.”

the highlights

It was reassuring to hear that, as usual,  AAPL executives are “thrilled” over just about everything and customers of all products in all countries are, like the McDonalds ads say, “lovin’ it.”

But it was an outstanding quarter, AAPL’s best non-holiday three months ever, featuring an all-time high for iPhone sales.  The company sales highlights:

–2.9 million Macs sold during the quarter, up 33% year on year vs. 24% growth for the PC industry.  50% of Mac buyers are still first-time users.  The company didn’t exactly answer the question put to it, but it sounds like the “halo effect” of the iPod and iPhone on Mac sales is a global phenomenon, not just a US one.

–10.9 million iPods sold vs. 11 million in the year-ago period.  But iPod Touch showed 63% year on year growth, creating a 12% revenue gain for this product line.

–8.75 million iPhones sold vs. 3.8 million in the march quarter of last year.  This is 133% growth, or 4x the rate of market expansion.

–AAPL is “shocked” by high demand for the iPad in the US, so much so that AAPL had to postpone the foreign launch of the product so that it would have enough manufacturing capacity to roll out the 3G version of the device on time in the US.  What was the problem?  Other than DRAM, components are easy to get on short notice at reasonable prices.  And there’s lots of AAPL-quality contract manufacturing capacity available.  But it takes a period of weeks to get everything lined up–and more time to get the finished goods into stores.

It sounds as if AAPL has already ramped expanded production up, so it looks like an unrestricted flow of iPads will be coming from the company for the June quarter.

AAPL responded to questions about possible cannibalization of other AAPL offerings by saying that it’s too soon to tell–which it is (and Macs and iPod Touches are the only areas where you might be able to notice)–but that there’s no evidence of it to date.

what I thought was interesting

the geographical breakdown of operating income (in $millions)

US          $1674       up 20% year on year

Europe     $1661         up 102%

Asia-Pacific   $892     up 320%

Japan      $441       up 80%

Only about a third of operating profits, not counting retailing income from the Apple stores, are coming from the US.

AAPL said on the conference call that first-half revenues from “greater China,” that is, the mainland + Taiwan + Hong Kong were up 9x year on year, at $1.3 billion.  This is presumably the introduction of the iPhone there.

the iPhone

If we figure that AAPL gets $600 for each iPhone it sells to a carrier, that amounts to $5.25 billion in sales for the quarter, or close to 40% of the company total.  That number understated the importance of the iPhone to AAPL, because it doesn’t include the share of revenue from carriers that AAPL also gets.

You may remember that AAPL recently changed the way it accounts for the carrier revenue.  It used to show this money more or less as it came in, over a two-year contract period.  Now it does a present value calculation and recognizes it all when the contract is signed.  (I think the new way is the better accounting method, but AAPL actually provided more information under the old method, when it also gave the new method results in footnotes.  Oh, the exciting life of an analyst!!!)

This time last year, AAPL was using the old method.  This year’s financials restate those results.  The restated number show a gross profit that’s $656 million higher than what was originally reported.  If we assume that’s all the present value of carrier contracts, and that present contracts have the same profitability, then the comparable number for carrier payments for the March 2010 quarter is a gross profit of $1.5 billion.  If AAPL takes the same manufacturing markup on iPhones as on other products, then the iPhone is producing 55% of AAPL’s gross income.  You can do more refining that would imply that the “real” percentage is actually higher, but the point would remain the same–AAPL has transformed itself in just a couple of years into a smartphone company that happens to do other stuff.  This is an almost unbelievable achievement.

the tax rate (a minor point, but an accounting thrill)

AAPL estimated three months ago that its full-year tax rate would be 29%, based on its forecast of the geographical composition of revenues.  Now it realizes it wildly underestimated foreign sales, presumably in the Pacific.   Its new estimate for the year is 27%.  To offset the first quarter tax rate being too high, AAPL had to make the second quarter rate low enough (at 24%) so that the first half as a whole was back on track.  This had the effect of shifting some profit recognition from the first quarter to the second.

the iPad

AAPL believes that the market potential for the iPad is huge. As a result, it says, it is pricing the iPad in an “extremely aggressive” manner.   Even so, it was caught by surprise by the high level of demand for the device in the US.

AAPL expects sales of the iPad to depress gross margins in the June quarter by 1.5%, or 25% of the gross margin drop from 41% to 35% that it is guiding analysts to expect for the next three months.

Question:  how many iPads do you have to sell, and at what sub-par markup to make such a big dent in gross margins for a firm as big as AAPL?

AAPL’s answer:  we’re not saying.

What I think:  if AAPL marks up the iPad by a third over its manufacturing cost–remember, there are a lot of marketing expenses for a new product–then it has to sell about 2 million in the June quarter to move the gross margin down that much.  Depending on the model chosen, that could end up being $1.5 billion in sales.  Wow!

other stuff (not on the conference call)

The iPad is banned in Israel, because it uses too much mobile bandwidth.  Tourists have to leave them at the border.

An AAPL employee left a test model of the yet-to-be-released iPhone 4.0 in a bar in Redwood City, California.  Whoever found it sold it to the blog Gizmodo, where you can see an analysis.  Interestingly, just like Mission Impossible, AAPL caused the phone operating system to self-destruct when it discovered it was lost.

AAPL doesn’t like netbooks.  No surprise here.  But the company said on the conference call it “couldn’t think of a single thing a netbook does well.”  I guess we have to wait for ASUS or Acer to release Chrome-compliant models.




Net Neutrality: this week’s appeals court decision

the Comcast lawsuit

Three years ago, the Associated Press responded to consumer complaints by running tests that showed that Comcast was slowing down access to peer-to-peer file-sharing services like BitTorrent, which allows users to swap large files, like movies.  Comcast first denied doing anything, but later said it acted because a small number of users were hogging bandwidth and slowing down access speeds for everyone else.

The Federal Communications Commission ordered Comcast to stop this, under “net neutrality” principles it had laid down in 2005.  Comcast sued.  Earlier this week, an appeals court ruled that the FCC had no legal authority to issue the order.  So, barring another appeal, Comcast has won.

What is Net Neutrality?

First of all, one should note that the name itself is a very clever, highly political choice, sort of like the Patriot Act or the Employee Free Choice Act.  Just as no one wants to be seen as opposing free choice or patriotism, it seems unreasonable to be against neutrality.  So opponents are already on the defensive, no matter what the actual concepts are that lurk behind the names.

FCC statements on net neutrality say consumers are entitled to:

–access all lawful content

–run any applications or services

–connect to the internet with any legal, non-harmful device

–competition among service, application and content providers

–disclosure of operating principles by ISPs

–no discrimination by ISPs against any legal content or applications.

two observations

1.  This is all jockeying for economic advantage.

On the one side, cable and telephone companies have spent billions building out internet networks, with at least vague imaginings of being able to operate the kind of “walled gardens” that Apple’s iPod and iPhone now run, and AOL did in the Nineties.  They don’t want to be reduced to being “dumb pipe” conduits earning a minimal return for transporting very profitable applications run by others.   But they suffer from the weakness of any capital-intensive industry (think:  container shipping or cement plants) that their capital is already sunk in the ground and can’t easily be retrieved.  So they are almost by definition price takers.

On the other, content and application providers are radically dependent on ISPs to deliver their products to consumers.  They wonder (fear?) what would happen if an ISP owned a service that competed with theirs–like Comcast when it takes control of NBC Universal.  Would, say, competing news services find their offerings delivered at slower speed than NBC’s?  Would content/application providers that didn’t link up with Hulu find themselves shunted onto the local track while more NBC-friendly competitors stayed on the express rails?

You might say that an ISP would be foolish to do this, but outside the most densely populated areas, what recourse do consumers have?  There’s no competing internet service to switch to.

At this point, this is mostly in the realm of “what if?”.  Other than the BitTorrent instance, there’s scant evidence that ISPs are acting on what may well be their secret fantasies.

2.  Almost everything that has been said about Net Neutrality is couched in negative terms–what ISPs are not allowed to do.  The other side of the coin has been pretty much ignored.  ISPs are allowed to sell different classes of service, with minimum quality of service guarantees.  And wealthy service providers (think:  Google) can maintain cutting-edge server networks of their own to support their products.  They can also pay ISPs to colocate their equipment with the ISPs to increase service speed.

So neither side is exactly the powerless “victim” of the other that its proponents would like to portray it as.

investment implications

1.  The Roberts family, which controls Comcast, are very shrewd businessmen.  Their attempt a few years ago to acquire Disney and its current agreement to buy an interest in NBC Universal illustrate what they think of the future of the IPSs (i.e., dumb pipe).  In the BitTorrent case, they had two options:  slow down service or add capacity.  The second would mean capital spending that wouldn’t generate any more revenue.  Whether you think Comcast did the right thing or not, it’s an indicator of the maturity of the business if option #2 makes no economic sense.

2.  The wired broadband networks have by and large been built with private money.  This suggests they shouldn’t be regulated as public utilities.  Even if that were possible, and net neutrality thereby assured, I don’t think anyone wants that.  The next step, I think, would be taxation along the lines of telephone services, raising the cost of internet service for everyone.

In theory, tax increases would get parceled out among consumers, ISPs and content providers according to their economic power.  But no one really wants to find out what that allocation would be.  And everyone except the government is worse off.

3.  Content providers want security but they don’t want regulation.  What do they do?

a.  They attack the “walled garden” that Apple has established by providing/supporting the creation of equivalent devices at lower prices.  The Google phone, the Chrome netbook or the $100 iPad-equivalent that Marvell recently displayed are examples.

b.  They promote the proliferation of alternative ways of internet access–WiMax, municipal free internet services.  The more alternatives a consumer has, the less able any one ISP is to take content-unfriendly action.  Also, an ISP would certainly hesitate to take action if that meant that a whole town or county or some other political entity were affected.  Doing so would invite adverse political consequences.

4.  How to invest?

I suspect a value investor would have a field day rooting through the cable companies and the traditional media companies, since many have already acted on their belief that these firms are the ultimate losers in the internet revolution.

That’s not what I do, however.  I continue to think that the designers of new devices, and of the key components that go into them, are the best bet.

Kindle economics (III): the Macmillan book dispute

The dispute

The Macmillan publishing house and Amazon had a recent, very public spat about Kindle book pricing.  Amazon had been paying Macmillan about $12.50 per e-book for a $25 list-price new release–the same as it would have paid for a physical book–and then selling it through Kindle for $10.  Macmillan wanted that stopped.

Instead, it wanted AMZN to raise the Kindle price to $13-$15 and use the iPad (and now Kindle, starting in June) agency model to pay it.  That model, also used by publishers in dealing with independent bookstores, calls for the sale revenue to be split 70% for the publisher and 30% to the retailer.  If AMZN didn’t agree, Macmillan apparently threatened to withhold its titles from e-book sale on Amazon for six months after publication, while Apple would be allowed to sell them on day one.

The arguing even went as far as having AMZN cease selling Macmillan books through its website for a short time.  AMZN then issued a surly letter to customers and acceded to Macmillan’s demands.

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