3Q15 earnings for Microsoft (MSFT)

the report

After the closing bell last Thursday, MSFT reported earnings for its third fiscal quarter (its fiscal year ends in June).  The company had revenue of $21.7 billion for the March period and earnings per share of $.62.  This compares with Wall Street consensus estimates of $.51/share.

Cloud-related businesses were very strong, Windows-related less weak than expected–although the coming launch of Windows 10 at mid-year is already keeping a lid on Windows performance, as potential buyers wait for the newer version.

 

MSFT shares opened Friday trading up by 5%+ from the Thursday close and tacked on another 5% or so be 4pm.

 

Yes, the quarter was good.  And management made it clear, even through its brand of jargon-laden corporate speak, that its move to the cloud can enable a radical expansion of its business, not simply a shifting of revenues from one pocket to another.

the Amazon influence

However, I think the unusually sharp rise in MSFT shares on Friday is more due to Amazon (AMZN) than to MSFT.

AMZN also reported after the close on Thursday.  For the first time, it broke out its Amazon Web Services as a separate business line.  Most Wall Street observers had apparently assumed that AWS, a cloud industry leader, made little or no profit for the company.  I’m not sure why they thought this.  The only thing I can come up with is that AMZN as a whole lost money for the first eight years of its existence as a public company–and analysts argued that AWS would be déjà vu all over again.

Turns out, though, that despite AMZN’s notoriously conservative accounting, the line of business breakout shows AWS making a ton of money.  AMZN shares opened Friday up by 12.5% from Thursday’s close, and drifted higher during the day.

It seems to me that MSFT rose mostly in sympathy with AMZN.

what to do about the stock

The move to the cloud has a bunch of pluses for MSFT:

–the company’s services can be used on many platforms–servers, PCs, smartphones, tablets

–it is launching new multimedia, multi-platform services

–it can provide truncated versions of sophisticated corporate services to small businesses and individuals

–the rental model for services will generate higher income than sales, and

–MSFT can reshape its image from being a PC-centric company of the past to being a cloud-based company of the future.

 

My sense is that Wall Street still views MSFT through PC glasses.  Change in perception represents substantial upside for the stock, in my view.  Still, the outsized upward move in the stock has got to tempt holders–myself included–to take some profits now, with the idea of replacing the stock being sold at lower prices.

merger talks off between Intel (INTC) and Altera (ALTR)

CNBC is reporting that INTC has broken off takeover talks with ALTR .  ALTR has supposedly rejected an offer of $50+ per share.

If ALTR’s value were not in its software engineers, that is, intellectual property that drives out of the parking lot every evening, we’d expect that the situation would develop along two parallel lines:

1.  figuring (correctly, in my view) that shareholders who are not part of ALTR’s top management would jump at the chance to sell their stock to INTC for $50, INTC might consider a hostile bid (that is, one not endorsed by ALTR’s CEO), and

2.  ALTR would decline on the news, but remain above its new-leak level as Wall Street would expect, at worst, another suitor to emerge sooner or later.

 

I don’t think the first will happen in this case.  INTC doesn’t want buildings, land and equipment.  It wants researchers–who might either decamp to work for competitors or even form their own independent software firm if they felt they were being forced against their wills to work for INTC.   Management likely wouldn’t stand in anyone’s way.  Therefore, making a hostile bid risks ending up with an empty shell.

On the other hand, I don’t expect another suitor.  It seems to me that INTC is uniquely able to use ALTR’s intellectual property to create new value  …and I found myself struggling to justify a bid price, even with INTC as the buyer, over $40 a share.

 

Still, ALTR may not simply drop back to the mid-$30 range.

If we assume that INTC knows what it’s doing, then it thinks that an INTC/ALTR partnership would have transformative value that would make ALTR worth something like double the pre-bid market price (otherwise, why bid $50+? …the other alternative, which I’ve ruled out in the first clause of this paragraph, is that INTC is either foolish or desperate).

INTC sought to capture most of the upside by buying ALTR.  That hasn’t worked.  Presumably, when emotions clear and heads cool, INTC will try to work out a different arrangement (joint venture?) in which ALTR will retain its independence and take a larger amount of any upside for itself.

If this is correct, a big selloff in ALTR over the coming weeks might offer an interesting opportunity to buy.

 

ARK Investment Management and its ETFs

ARK

I was listening to Bloomberg Radio (again!?!) earlier this month and heard an interview of Cathie Wood, the CEO/CIO of recently formed ARK Investment Management.  I don’t know Ms. Wood, although we both worked at Jennison Associates, a growth-oriented equity manager with a very strong record, during different time periods.  Just before ARK, she had been CIO of Global Thematic Strategies for twelve years at value investor AllianceBernstein.  (As a portfolio manager I was a big fan of Bernstein’s equity research but I’m not familiar with her Bernstein output.)  She’s been  endorsed by Arthur Laffer of Laffer Curve fame, who sits on her board.

ARK is all about finding and benefiting from “disruptive innovation that will change the world.”

Ms. Wood was promoting two actively managed ETFs that ARK launched at the beginning of the month, one focused on industrial innovation (ARKQ) and another the internet (ARKW).  Two more are in the works, one for genomics (ARKG) and the last (ARKK) an umbrella innovation portfolio which will apparently hold what it considers the best of the other three portfolios.

What really caught my ear in the interview was Ms. Wood’s discussion of the domestic automobile market (summary research available on the ARK website).  Most cars lie around doing nothing during the day.  What happens if either ride-sharing services like Uber or the Google self-driven car, which make more constant use of autos, catch on as substitutes?  According to Ms. Wood, until these innovations reach 2.5% of total miles driven (based on the idea that on a per mile basis ride-sharing costs half what owning a car does), there’s little effect.  But at 5% penetration, the bottom falls out of the new car market.  New car sales get cut in half!

Who knows whether this is correct or whether it will happen or not   …but I find this a very interesting idea.

about the ETFs

The top holdings of ARKW are:  athenahealth, Apple, Facebook, Salesforce.com and Twitter.  These comprise just under 25% of the portfolio.

For ARKQ, the top five are:  Google, Autodesk, Tesla, Monsanto and Fanuc.  They make up just over 24% of the portfolio.

Both will likely be high β portfolios.  Both have performed roughly in line with the NASDAQ Composite since their debut.

The perennial question about thematic investors (I consider myself one) is whether the high-level concepts are backed up by meticulous company by company financial research.  This is essential.  In addition, it’s important, to me anyway, that the holdings be arranged so that they’re not all dependent on a single theme–the continuing success of the Apple ecosystem, for instance.

I’m not familiar with Ms. Wood’s work, so I can’t say one way or another (Fanuc and ABB strike me as kind of weird holding for ARKQ, though).  But I think her research is worth reading and her ETFs worth at least monitoring.  For us as investors, the ultimate question will be whether Ms. Wood can outperform an appropriate index.  The NASDAQ Composite would be my initial choice.

 

 

 

 

 

earnings calls: Apple (AAPL) vs. Microsoft (MSFT)

Last night after the market close, AAPL reported earnings per share that beat the consensus of Wall Street analysts–and the stock went down in the after-market.  MSFT, in contrast, reported results that fell short of analysts’ estimates–and the stock went up!

What’s going on?

AAPL gave next-quarter guidance that fell below Wall Street’s projection–but it always does this, so that’s not the reason.  MSFT’s income statement looks better after factoring out the large operating loss generated by Nokia, but I don’t think that’s the reason for the market’s positive response, either.  After all, if you wanted to (I didn’t), you could have gotten a reasonable guess at how much Nokia would subtract from the MSFT total from Nokia’s recent results as a stand-alone company.

I think the market’s response is much more a a conceptual response.

Tim Cook has made it clear that AAPL is a manufacturer of high-end mobile consumer technology.  There’s no “next big thing” on the horizon, however, with only a periodic refresh of the company’s smartphone line due any time soon.  If reports from suppliers are accurate, new offerings will include a phone with a large, Samsung Galaxy-matching screen size, and a(n even larger) tablet/phone.  For Jobs-ites, this departure from Steve’s view that phones should be small enough to operate with one hand may be earth-shaking.  But for the rest of the world, this is only catching up to what Samsung already has on the market.  So a ho-hum Wall Street response is appropriate.

For MSFT, on the other hand, the news is relatively better.  The company seems to have a focus for the first time in a long while.  The fact that Nokia is putting up operating losses at a near-$3 billion annual rate seems to me to justify the downsizing MSFT has recently announced.  The only surprise is that this wasn’t started sooner.

Leaving the X-Box content creation business is probably more symbolic than anything else, but it removes a potential distraction–especially given the continual mess the company has typically made of its game software development efforts.

One, admittedly small, figure what caught my eye was that MSFT has added another 1,000,000 individual/small business users to its Office 365 rolls during the June quarter.  I think this just shows the power of the cloud–easier administration, much lower cost-of-goods expense, and hugely better protection against counterfeiting.

For MSFT, then, the earnings were nice, but the fact that the company’s board is allowing significant changes is nicer.  True, the message may turn out only to be that the company will try harder not to shoot itself in the foot again, but even that’s an uptick.  Hence the positive market response.  Absence of missteps won’t be good enough for long, but it’s ok for now.

a closer look at Intel’s 2Q14

2Q14 results

After the close of Tuesday, Intel (INTC) reported a strong 2Q14.   Revenue came in slightly higher than the company’s upwardly revised guidance from last month.  Earnings per share were $.55 vs. Wall Street analysts’ expectations of $.52 (expectations which were revised upward when INTC announced in mid-June that business was looking up).

INTC also revised up its full-year revenue guidance from basically flat year-on-year to +5% growth.  It said that its server business ($3.5 billion of the company’s $13.8 billion total during the quarter) continues to boom, with both unit volumes and unit prices rising.  That’s no surprise.  In addition, however, the PC business ($8.7 billion in 2Q14 sales) appears to have bottomed and to be bouncing back a bit.

The PC development has two aspects.  Corporate customers, who make up about 40% of the PC total, are buying again.  The simplest explanation for this is that their existing laptops and desktops have just gotten too old.  Buying may also be spurred by the fact the Microsoft is ending support for Windows XP, that corporations don’t regard tablets as a viable substitute for laptops, or simply that firms are flush with cash.  In any event, corporates are buying, and will easily continue to do so in increasing amounts into next year.

Consumers, 60% of the total PC market, may also be showing signs of life–although this is more OEM and distributor body language than actual orders.

Remember, too, that INTC’s sales are not to end users.  So it stands to benefit not only from increased final sales but also by manufacturer and distributors purchases to built up bare-bones inventories.

operating leverage

INTC has substantial operating leverage, both from the capital-intensive nature of its manufacturing and its very large R&D and SG&A budgets.  As a result, small changes in revenue can make a disproportionately large impact on the bottom line (in fact, they’re almost pure profit).  At the moment, the revenue changes in INTC’s two main businesses, PCs and servers, are both positive.

tax rate

INTC is saying it  expects its tax rate to remain at 28% for the rest of the year, implying that the growth it is seeing is mostly coming from the developed world, where tax levies are relatively high.

lines of business

As is always the case in securities analysis, the line of business table is where the real work is done.  For INTC, I’ve duplicated the relevant 2Q14 lines below:

PC Client Group :    revs = $8.667 billion, op income = $3.734 billion

Data Center Group :   revenues = $3.709 billion, op income = $1.807 billion

Mobile and Communications Group : revenues = $51 million, op income = ($1.154 billion).

No, that’s not a mistake.  INTC’s tablet and smartphone chip business had revenues of $51 million for the quarter …and an operating loss of $1.2 billion.

INTC is earning operating income of $22 billion – $25 billion a year from its traditional businesses and using a chunk of that to fund the massive losses it is incurring in trying to break into the mobile computing business.

The M&C Group figures need some interpretation.  The revenue figures are net of marketing or other incentives INTC gives to buyers of its mobile chips; the operating loss includes R&D and other expenditures that arguably have an enduring value.

Nevertheless, the line of business table does convey the essence of the INTC story for shareholders wiling to pay $30+ for a share of stock.  INTC is, in effect, two companies:

–one is a mature microprocessor maker earning $2.50 or so a share and growing at maybe +10% a year

–the other is a startup currently bleeding red ink at a $4 billion annual rate.

my take

The fact that INTC is incurring large near-term losses on its M&C Group says two things to me:

–it doesn’t yet have a set of products customers are willing to actually pay for, and

–INTC believes M&C is crucial to its long-term success.

I might be persuaded to pay 15x earnings for the traditional business, if I thought it would have stable-to-rising earnings.  That would mean a target price in the high $30 range.  However, INTC’s actions imply that top management doesn’t believe the business is viable without M&C.  So maybe the right price for the traditional business would be $30.

That leaves the question of the status of M&C still up in the air, though.

On the other hand, if INTC can create a profitable mobile business, that would mean–to pluck numbers out of the air–total INTC near-term earnings could be $3 a share, with a higher growth rate.  Worth $45 a share?  …probably so.

My bottom line:  news of a cyclical upturn in the PC and server businesses probably supports INTC shares for the time being.  Eventual downside to the high $20s (?) if/as it becomes clear the mobile chip business has no hope.  Upside to $40+ on signs that INTC is narrowing its M&C operating losses.

I find it hard to assign probabilities to either outcome.  For the time being I’m content to remain a holder of the stock.