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.

 

 

 

 

 

 

 

 

 

the Apple – IBM partnership

Jobs 1.0

Back in the early 1980s, AAPL made a better personal computer than IBM, at a time when the PC was beginning to displace the minicomputer in corporations and when individuals were starting to become a viable market for computing power.

Steve Jobs made two strategic errors, however, that ended up preventing AAPL from exploiting its advantage, which ultimately marginalized his company and put it on the verge of bankruptcy.

–AAPL priced its PC at 2x -3x the level of its MS-DOS alternatives, providing an overwhelming economic incentive to put up with the clunkiness of an IMB or a Compaq.

–Jobs marketed solely to company IT departments, which at that time had no power to make purchasing decisions.  He completely ignored the CEOs and COOs who did.  This may have enhanced his counterculture image, but it effectively closed the door to any corporate sales.

Jobs 2.0, Groundhog Day–except better so far

Arguably, Jobs 2.0 repeated the same game plan as 1.0:  make high-end, high-priced consumer devices and ignore the corporate world.  

In the post-Jobs era, and after a whole lot of waffling, AAPL management has decided to stick with Page One of the Steve playbook and is continuing to define itself as a maker of high-end consumer devices.  On the other hand, it lived (by the skin of its teeth) through Jobs 1.0 and knows how that story ended.

That’s why I think AAPL’s just-announced decision to partner with IBM to sell mobile products to corporations is potentially very significant.  It suggests AAPL is no longer willing to be straitjacketed by the Jobs mystique.  This is a good thing, because growth companies only continue to prosper if they periodically reinvent themselves.  

Also, given the continuing ineptitude of Ballmer-led Microsoft, the corporate market is much more wide open to AAPL smartphones and tablets than AAPL had any right to expect.  

I’m not rushing out to buy AAPL on the strength of a single new venture.  But it’s a start.  It suggests that Tim Cook is doing more than rearranging the deck chairs.  It argues that we should also be on the alert for further signals of favorable change in the company’s strategy.

 

 

 

 

 

“New World Order”: Foreign Affairs

The July/August 2104 issue of Foreign Affairs contains an interesting conceptual economics article titled “New World Order.”  It’s written by three professors–Erik Brynjolfsson (MIT) , Andrew McAfee (MIT) and Michael Spence (NYU)–and outlines what the authors believe are the major long-term trends influencing global employment and economic growth.  I’m not sure I agree 100%, but I think it’s a reasonable roadmap to start with.

Here’s what the article says:

the past

Globalization has allowed companies to exploit wide wage differentials between countries by moving production from high-cost labor markets close to consumers to low labor cost areas in the developing world.  Former manufacturing workers in high-cost areas enter the service sector to seek employment, depressing wages there.

This period is now ending, as relative wage differentials have narrowed.

now

Relative labor costs are at the point where manufacturing plant location is determined by other factors.  These include:  transportation cost, turnaround time for new orders and required finished goods inventory.  This implies that manufacturing can be located closer to the end uses it serves.  However, globally higher labor costs also imply that new factories will be much more highly mechanized than before.  Robots replace humans.

As a result, wage growth will remain unusually subdued.

the future 

Although returns to capital have avoided the erosion that has befallen labor over the past generation, this situation won’t last.  Long-lived physical capital is being replaced by software (note:  the majority of investment spending done by US companies is already on software).

Software doesn’t have either the total cost or the permanence of capital invested in physical things.  Software can be moved, it can be duplicated at virtually zero extra expense.  To the extent that software replaces physical capital as a competitive differentiator, it makes the latter obsolete.  It, in turn, can be made obsolete by the innovative activity of a small number of clever coders.

Therefore, the authors conclude, returns on invested capital (especially physical capital) are already beginning to enter secular decline.

Where will future high returns be found?

…in the innovative activity of talented, well-educated entrepreneurs.

education

This brings us to a major problem the US faces.  It’s the relative slippage of the domestic education system vs. the rest of the world, and an increased emphasis on rote learning (No Child Left Behind?).

The trio dodge this politically charged issue–they do observe that there’s a direction relationship between the quality of a community’s schools and the affluence of its citizens–by asserting that online learning will come to the rescue.  A child stuck in a weak school system will, they think, be able to in a sense “home-school” himself to acquire the skills he needs to succeed in the future they envision.

my take

What I find most interesting is the presumed speed at which the authors seem to think transition will occur.

–Is it possible that we’ve reached the point where there’s no available low-cost labor left in the world?  If so, this is a dood news/bad news story for low-skill workers.  On the one hand, downward wage pressure will stop.  On the other, robotization is going to take place at warp speed, making it harder to find a job.

Relocation of factories will also have implications for transportation companies, warehousing and even the amount of raw materials tied up in company inventories.

–Does software begin to undermine hardware so quickly?  Certainly this the case with online retailing and strip malls.  But how much wider is this model applicable?

–If the key to future growth is young entrepreneurs, then the sooner we as investors reject the Baby Boom and embrace Millennials the better.  This, I think, is the safest way to benefit in the stock market if the New World Order thesis proves correct.

 

 

rent vs. buy: financing and Solarcity (SCTY)

My California son, Brendan, got me interested in SCTY a while ago.  SCTY rents solar panels that generate electricity to individuals and to companies.

From an analytic point of view, it’s a complex and interesting firm.  It may also eventually turn out to be an important component of the nation’s power generation.  But it’s by at least a mile the riskiest stock I own (both Brendan and I hold small positions).  For instance, SCTY is a JOBS Act company , so the financials it has published to date aren’t ready for prime time.  Its business is heavily dependent on government subsidies of one type or another–and they’re shrinking.  It’s part of–but not at the heart of–the Elon Musk empire.  So holding it runs counter to the time-honored rule that you have your money as close as possible to where the entrepreneur has his–in this case, that would be Tesla, I think.

In this post, I want to use SCTY to  illustrate that in the rental model, a company can have an immense call for capital in advance of the business generating much revenue.  This can pose a significant risk.

Here goes:

First, note that I’m making the numbers simple (read:  pretty much making them up) and that there are many, many more moving parts to what SCTY does than I’m going to write about here.  But I think what I do say gets to the essence of the matter.

the business basics

1.  Look at a typical rooftop solar panel array that SCTY installs on a single family house.

–the panels cost $10,000 to build and install

–they have a 30-year life

–the homeowner signs a 20-year contract to pay $50 a month to rent them.

2.  In this industry, there’s some urgency to get panels installed on rooftops, at the very least because once someone has signed a 20-year contract, he’s not going to switch to another provider.  So the first mover has a key advantage.

financing new customers

Suppose SCTY installed panel arrays on 50,000 rooftops last year and wants to install another 100,000 this year.  What do the money flows look like?

Well, $30 million is coming in in rental income from last year’s installs.  But this year’s installation program will require $1 billion!! in capital to complete.  Where is this money going to come from?

In many senses, SCTY is a startup.  It doesn’t have deep pockets or an existing cash-generating business to use to fund the panels.  So raising $1 billion, and presumably more than that next year, is a formidable obstacle.

my point

That’s the point of this post–that the upfront capital committment in a rental business–especially involving physical stuff–can be very large.  From a financial point of view, some rental/service companies aren’t that much different from owning, say, an oil tanker, a steel blast furnace or a cement plant.  Not so glamorous if you look at them this way.

what SCTY does

The SCTY solution?  …the installed solar arrays are each sort of like a bond, that is, they pay a fixed amount of money each month for twenty years.  At the end of that period, the array still has ten years of useful life and therefore hopefully a substantial residual value.  If you package up a big bunch of them, the result doesn’t look that different from a collection of car loans or home mortgages.  In other words, the bundle is a security that you can sell to institutional investors who are looking for fixed income investments.  That’s a bare-bones version of what SCTY does.  Of course, it doesn’t hurt that SCTY is run by a financial entrepreneur.  Not every solar panel company is going to have the size or credibility to do this.

 

 

 

 

 

rent vs. buy: examples

Olympus Optical of Japan (yes, the huge-derivative-speculation-losses, put-out-a-hit-on-the-new-chairman Olympus) was the first company to open my eyes to the value of the rental model vs. selling an item.  The company makes endoscopes, the computer plus coated fiber optic cable devices used in colonoscopies and endoscopies.  Olympus initially used a razor/razor blade model to sell these devices around the world.  It sold the computer devices at slightly above cost.  The fiber optic cables were supposed to be the razor blades, being replaced at regular intervals with new ones, generating high profits.

Olympus didn’t make much money from endoscopes, however.  Physicians generally refused to buy replacement fiber optic cables, even when Olympus salesmen told them they risked having the cables break apart in patients’ bodies.

So Olympus tried an experiment in the US.  It switched to a rental model.

Let’s say an endoscope kit sold for $60,000 (a number I made up).  If so, the new idea was to rent the units, throwing replacement cables to avoid safety problems, for $1,000 a month.  Because $1,000 a month was easier for a doctor to stomach than $60,000 upfront, more doctors signed up for the machines.  In addition, because Olympus was collecting rent for each machine over something like a ten-year useful life, reported profits skyrocketed.  Yes, this is partly a question of accounting technique (more about this tomorrow), but the amount of money Olympus ultimately collected for each machine was double what it had before.

Anixter, the wire and cable company.  This was one of the first companies I covered in my career as an analyst.  Back then, Anixter’s main business was industrial wires and cables.  It ran a national system of warehouses.

The Anixter salesman would call on a customer, ask how much wire and cable inventory a company had–usually a lot more than anyone realized– and offer to buy it all on the spot.  Anixter would guarantee to meet all the company’s wire and cable needs from Anixter warehouses.  Outsourcing to Anixter would mean the customer could repurpose its warehouse space, lay off or reassign the three guys who dealt with the inventory, and free up, say, $10 million the firm had lying around in wire and cable stock.

The manager who shifted the company from owning its own inventory to working with Anixter would be a hero in the eyes of top management.  People couldn’t sign on the dotted line fast enough.

At the same time, although apparently not many clients realized this initially, there’s no going back from a decision like this.  If you’ve taken a victory lap for creating $10 million in cash out of thin air, as well as saving $300,000 in annual expense, you can’t subsequently return to the board to say you need money to build a new warehouse, hire new employees–and, by the way, you need another $10 million (or more) to fund inventory.

As well, in the case of Adobe, there’s no place to go back to.  As the company put it, ADBE has burned the boats.  It no longer sells its media products.  It only rents them.

Electronic Arts  In the early days of MMOGs, I was at an analyst meeting for ERTS.  Someone asked how many users the company had for its MMOG.  The then-CFO, long since retired, said he didn’t know.  All he knew was that the company collected $10 a month from 180,000 credit cards.

I took this to mean that the company had a significant number of people who were renting the game but never using it.  This isn’t necessarily a good situation.  You’d prefer that people love your service so much that they’re heavily engaged every day.  On the other hand, the no-show users are pure profit.

Tomorrow:  the Achilles heal of rental, the upfront capital needed to get going.