3Q16 earnings for Intel (INTC): implications

Last night after the close, INTC reported 3Q16 earnings results.

The number were good.  INTC’s growth businesses grew; its legacy arms showed unusual pep.  The latter development had been flagged by INTC during the quarter when the company announced wholesale customers were increasing their chip inventories. Nevertheless, earnings per share of $.80 exceeded the average of 29 Wall Street analysts by $.07–and surpassed even the highest street estimate by a penny.

Despite this, the stock fell by about 3% as soon as the earnings release was made public.  Traders clipped another 2% off the share price on the earnings conference call.  During trading today, the stock initially fell almost another 2%, before rallying a bit to close just below its worst aftermarket level.

There was some bad news in the report.  It will cost INTC more than anticipated to rid itself of McAfee.  It also looks like chip customers are no longer so eager to build inventory.  Instead, thus far in the fourth quarter they seem to be subtracting some of the extra they added during 3Q.   The result of this is that INTC thinks 4Q–usually the strongest period of the year seasonally–will only be flat with the robust performance of 3Q16.

 

I find the selling to be unusually harsh (be aware:  I own INTC shares).  After all, if INTC had earned the $.73/share the market had expected, a forecast of $.76 wouldn’t look all that bad.  That outcome, which appears to be the company’s current guidance, would also be better than the analyst consensus had been predicting for 4Q last week.

I’m not trying to argue that the stock should have gone up on this report.  I just don’t see enough bad–or, better said, enough unforeseeably bad–news to warrant a selloff of this magnitude in a gently rising market.

I attribute the aftermarket selloff to some combination of computer trading and thin volumes.  What surprises me is that there were no significant buyers once regular trading–overseen, presumably, by senior human investors–began.

Because of this, I think that trading in INTC over the next days is well worth watching to see if/when buyers reenter the market.  We may be able to draw conclusions that reach wider than INTC itself.

Warren Buffett and Dow Chemical (DOW)

Today’s Wall Street Journal contains a front page article that will be widely viewed on Wall Street, I think, as a bit of comic relief.

In times of financial stress, cash-short companies have tended to go to Berkshire Hathaway for financial assistance.  If successful, they receive both money and the implicit endorsement of Warren Buffet.

In 2009, it was DOW’s turn.  It wanted to acquire Rohm and Haas, another chemical company.   The best deal it could find for a needed $3 billion was in Omaha, where Berkshire took a private placement of $3 billion in DOW preferred stock, with an annual dividend yield of 8.5%.  The preferred has been convertible for some time now into DOW common (yielding 3.4%), at DOW’s option, provided DOW has traded above $53.72 for a period of at least 20 trading days out of 30.

DOW shares were trading below $20 each when the deal was struck seven years ago.

On July 26th, the shares breached the $53.72 barrier and traded above it for five consecutive days–the final two on extremely heavy volume–before falling back.  At the same time, according to the WSJ, short interest in the stock has risen sharply.  In other words, someone has been a heavy seller, using stock borrowed from others.

Who could that be?

Although nothing is stated outright, the strong implication of the article is that the shortseller is Berkshire, which stands to lose $150 million+ a year in dividend income on conversion.

Part of the Wall Street humor in the situation is that the playing field isn’t level.  It’s perfectly legal for Berkshire to sell DOW short, although it does seem to cut against the homespun image Mr. Buffett has been at pains to cultivate for years.  On the other hand, however, DOW would run the risk of being accused of trying to pump up its stock price (and the value of management stock options) if it went out of its way to absorb any unusual selling.

 

Disney (DIS) from 30,000 feet

I’d only followed DIS from afar until the company acquired Marvel Entertainment, which I held in my portfolio, for a combination of stock and cash in late 2009.  I kept the shares I acquired and also bought more while DIS was depressed by critics doubting the wisdom of its move. I’m tempted to write about how wrong that view was, but that’s for another day (not soon).

As I studied DIS’s financials, I found that ESPN accounted for about 75% of the firm’s overall operating profit.  The movie studio, run by a former monorail driver at the theme parks, was a mess.  Income from the parks was depressed by recession.  The Disney brand was also almost completely dependent on female characters, making Disney attractions less appealing to half the adolescent population.  ESPN, on the other hand, was/is the dominant sports cable franchise in the US and was going from strength to strength.  For a moment–until I realized the marketing advantages of having the Disney name in the public eye–I wondered why the company didn’t just rename itself ESPN.

In addition, the simple percentage of earnings seemed to me to understate the importance of ESPN to DIS.  The movie business is typically a hit-or-miss affair and therefore doesn’t merit a premium multiple.  Same with the hotels/theme parks, because they have a lot of operating leverage and are highly sensitive to the business cycle.  So I concluded the key to the DIS story was the progression of its secular powerhouse–and its one high-multiple business–ESPN.  Nothing else mattered that much.  (Of course, I didn’t understand the full power of Marvel, or the turnaround in the Disney studio, or the subsequent acquisition of the Star Wars franchise, but that’s a separate issue.)

In 2012, ESPN began an effort to expand its business in a major way into the EU by bidding large amounts for broadcast rights to major soccer games in the UK.  Incumbent broadcasters, however, realized (correctly) that no matter what the cost it would be cheaper to keep ESPN out of their market than to deal with it once it had a foothold.  So they bid crazy-high prices for the rights. ESPN withdrew.

ESPN’s failure was disappointing in two ways.  A new avenue of growth was closed off.  At the same time, the attempt itself signaled that ESPN believed its existing Americas business was nearing, or entering, maturity.  That’s when I began easing toward the door.

The issues for ESPN–cord-cutting and the high fees ESPN charges–are very clear today.  What I find most surprising is that it took the market three years, and an announcement of subscriber losses by DIS, for the stock market to focus on them.  So much for Wall Street’s ability to anticipate/discount future events, even for a major company.

I don’t think ESPN is helping its long-term future by seeking to boost ratings by having personalities shout at each other in faux debates.  Nor does covering WWE as if it were a real sport.  I think they’re further signs of decay.  My sports-fan sensibilities aside, the real issue is about price.

Suppose every cable subscriber pays $4 a month to get ESPN, but only 15% actually watch sports–or would pay for ESPN if it weren’t part of the basic package.  If so, the real cost per user is closer to $30 a month, most of which is being unwittingly subsidized by non-users.  There’s only one way to find out if current users would be willing to pay $30 for ESPN, which is by removing the service from the bundle everyone must buy, reducing the basic cable charge by $4 a month, and offering ESPN separately.  That’s what the cable companies want–and what ESPN is looking to avoid.

We’re nowhere near the end of this story.  I don’t think the final chapter will be pretty for ESPN.

On the other hand, as I see it, just after the UK rebuffed ESPN, DIS began to direct its ESPN cash flows away from cable and toward building up its film and theme park businesses.  For me, this was the sensible thing to do.  And it confirmed my analysis of the situation with ESPN.

My bottom line:  for four years ESPN has been the cash cow that’s funding DIS’s expansion elsewhere.  Wall Street only realized this twelve months ago.   But DIS’s reinvention of itself is still a work in progress.  Until the market begins to view DIS as an entertainment company that happens to own ESPN rather than ESPN-with-bells-and-whistles the stock will continue to struggle.

 

 

March quarter earnings (3Q16) for Microsoft(MSFT)

MSFT reported earnings for its fiscal third (=March) quarter after the close yesterday.

My takeaways:

–the company had a good quarter for its future-oriented cloud and mobility businesses during a period where the legacy PC business was unusually weak.  In the latter arena, MSFT did substantially better than the market.

–the strength of the dollar continues to be a drag

–income tax.  Geographically, the US has been stronger than expected, emerging markets weaker.  One result of this development is that MSFT has adjusted its estimate for the corporate tax rate for the full year from 19% to 21%.  The full revision for the first nine months was made in the 3Q income statement, boosting the March quarter tax rate to 24% (this is normal accounting procedure).  That clipped $.04 from what eps would otherwise have been.

–company guidance for upcoming quarters is being revised down somewhat, in a justifiably cautious way.  The dollar is one issue.  But the bigger headache seems to me to be weakness in Latin America, the Middle East and Africa, where lots of transactional (as opposed to long-term contract) business takes place and where tax rates are lower.

–today’s selloff appears overdone to me.  That’s partly the way markets move nowadays, reacting violently to headline news.  It’s also partly because MSFT had been up by 35% over the past year in a market that has been basically flat over the same time span.

–I’m not tempted to transact.  I see no reason to sell the shares I own.  If anything, I’d be a buyer below $50.  But I see no reason to rush.

 

Intel’s restructuring announcement yesterday

Yesterday, Intel (INTC) announced 1Q16 earnings that were up year on year and more or less in line with the Wall Street consensus.  It did, however, lower full-year 2016 guidance a bit, based on a weaker than anticipated PC market.

More important, the company also disclosed a major restructuring aimed at orienting INTC away from its legacy personal computer business and toward the cloud.  The restructuring will eliminate about 12,000 jobs, or 11% of INTC’s workforce.  It will result in a $1.2 billion charge against 2Q16 earnings and is intended to be saving $1.4 billion annually a year from now.

The plan appears to be at least in part the brainchild of Venkata Renduchintala, recently hired away from Qualcomm to be INTC’s president–with the intention of having him make the kind of changes just announced.

Reading between the lines, this is a good news – bad news story.  The good news is that INTC, seeing the Ghost of Christmas Future in Hewlett Packard, is making significant changes to reorient its business.

The bad news is that it sounds to me like there may be a significant anti-change bureaucracy entrenched at INTC.  This is what I read the Oregonian as saying when it cites “a lack of product/customer focus in execution” as Mr. Renduchintala’s conclusion from his review of INTC’s manufacturing operations.  That’s also the reason, I think, for changes in senior management.  Maybe a fat-cat attitude is not so odd for big corporations in general,  but it’s of disappointing for a firm whose former chairman and manufacturing chief wrote a management book twenty years ago titled Only the Paranoid Survive, stressing market awareness as key to success.

In practical terms, I think what this means is that INTC is still a bit more GM-ish than I had thought possible. In consequence, the transformation INTC has been talking about for years and which current top management clearly wants won’t take place overnight. Still, I think that the moves INTC is making are needed and are an overall plus.

Pre-market reaction has been mildly negative.  I guess that’s about what one should expect.  Personally, I’m encouraged and remain content to collect the dividend and wait.  I’d be tempted to buy more on a selloff.

the Bain luxury goods worldwide study, winter 2015

I haven’t owned Tiffany (TIF) for a long time, but the ticker is still on my screen.  Watching the stock slide on a weak earnings report yesterday prompted me to look for the latest Bain study of the luxury goods industry, which was published about a month ago.

Although structural change is not the main focus of the report, that’s what really jumps out to me from it.

exiting the twentieth century…

Fifteen years ago, the personal luxury goods market was perhaps 40% European purchasers, 35% American and 25% Asian, most of that being Japan.  Each purchased primarily in his own region.

Although the report doesn’t mention this, the pricing structure for identical items was/is 100 in Europe, 120 in the US and 140 in Asia.  This difference is partly a function of import tariffs outside Europe, partly a judgment about what the market would bear.  Asian sales were unusually lucrative because, in addition to the much higher selling prices, wholesale margins were significantly higher and most profits recognized in Hong Kong, where the corporate tax rate for international concerns is zero.

Virtually all sales were at full price.  European luxury goods makers had few retail stores;  their distribution was primarily wholesale.

…and now

 

Chinese consumers, who represented 1% of the market in 2000, accounted for about a third of all purchases in 2015.  Japanese consumers, who were about a quarter of the market at the turn of the century, now make up about 10%.

Today, sales in Europe and the US each make up about a third of the personal luxury goods market, with Japan and China dividing the rest about equally.  However, more than half the European sales are by extra-regional tourists.  About a third of US sales and 25% of Japanese are also by tourists.  Tourist sales in China are negligible.  I’m not sure why; high prices and counterfeiting are my guesses.

Looked an nationalities a different way, European customers buy 90% of their luxury goods in Europe in 2015.  Americans bought almost exclusively in the US, with a tiny fraction in Europe.  Japanese consumers made 40% of their purchases outside Japan, primarily in non-China Asia, with the US and Europe taking smaller slices.  Chinese consumers bought only 20% of their luxury goods domestically last year.   They made about 30% of their purchases in Europe, another 25% elsewhere in Asia and the rest in the US and Japan.

One of the factors driving the large tourist market is, of course, the much higher domestic prices for Asians.  A second is the significant currency depreciation of the yen and the euro, which have made not only foreign stays but also foreign luxury goods purchases much less expensive.

10% of the global market is now in off-price stores.  That’s double the percentage of three years ago.  Markdown sales, including off-price stores, accounted for about a third of the market last year.

7% of sales are online, most of that in the US.

an inflection point

Bain thinks–correctly, in my view–that much greater awareness of regional price differentials, significant recent currency fluctuations, the rise of markdown sales at a time of steady price increases by luxury goods manufacturers have all conspired to undermine the belief that branded luxury goods have enduring value.

I suspect there’s more at work as well–generational change and the rise of new high-end local brands with greater appeal to younger customers.

TIF

Back to TIF for a moment, the company’s announcement that it expects a 10% fall in earnings for fiscal 2015 and “minimal” earnings growth in 2016 limits its near-term appeal.  At some point, though, it could become attractive again, despite ructions in the overall luxury goods market.  …$50 a share?

 

4Q15 for Intel (INTC)

After the close last Thursday, INTC reported results for 4Q15 and the full year.  For the final three months of last year, INTC posted revenue of $14.9 billion, operating income of $4.3 billion, net of $3.6 billion and eps of $.74–all better than the Wall Street analyst consensus. The company also announced an 8% increase in the dividend, to a yearly total of $1.04.

Nevertheless, in Friday trading the stock was down by 9.1%.

What’s going on?

There are lots of moving parts, but in a nutshell INTC appears to be forecasting another flattish eps year for 2016–vs. market (and my) expectations of a return to earnings growth.

The main reason is softness in demand that INTC is already experiencing in its important Asian markets, particularly in China.  My back of the envelope calculation is that pre-tax income for INTC will still be up by about 15% this year, despite a China slowdown.  But I think the shift of business growth from Asia to the US + the EU is the main reason the company is projecting a rise in its income tax rate from 19.6% in 2015 to around 25% this year.  That’s enough to wipe out virtually all the pre-tax improvement in the business.  So the bottom line remains basically unchanged.

Another worry:  during 4Q15 revenue from INTC’s important server business decelerated from a 10%+ growth rate to just over 5%.   Operating income fell by about 4% yoy, as high margin cloud sales cooled while low margin networking sales boomed.  INTC points out that 4Q14 was a record quarter, so simple yoy comparisons may be misleading.  It also says that the fourth quarter has become important enough for online sales that cloud customers don’t want to fool with their websites by installing new equipment.  So for its most important class of customers, 4Q is no longer the seasonal peak for orders, as it has been in prior years.

Two oddities:

–for reporting to shareholders (financial accounting)  INTC is changing the way it expenses the chip manufacturing equipment it uses.  It previously wrote their cost off in equal installments over four years.  It’s now going to use five.

Nothing changes in the way the business is being run or in the way the equipment is written off for income tax purposes.  But annual depreciation cost on the income statement will be about $1.5 billion less than under the old method.  In broad terms, this is enough to offset the rise in the tax rate for 2016.  It’s also the largest factor involved in my thinking pre-tax income will rise significantly in 2016.

It’s hard to know whether Wall Street will regard this accounting change as a good thing of a sign of weakness.  I presume algorithmic traders won’t care.

–for the past couple of years, INTC has tried to buy its way into the tablet business by essentially paying customers to use its chips (the company calls this support contra revenue).  The company appears to have pared back the subsidies significantly during 4Q15.  Tablet units decreased from 12 million in 4Q14 to 9 million in 4Q15, as a result.  But overall tablet revenues increased.–and operating losses in the segment appear to have shrunk.

My bottom line:

For the moment, I’m content to hold the stock.  There’s enough evidence from other hardware companies to suggest that the Asian slowdown is an industry phenomenon, not an INTC specific one.

We’ll also know in a quarter or so whether the cloud business bounces back or not.  Given the significant shift in retail from bricks and mortar to online this holiday season, I’d expect to see strength in cloud orders during 1Q16.

Finally, I’m a bit troubled about the change in depreciation policy.  The effect is to make earnings look better than they would otherwise be.  Is that the purpose, though?  Was INTC forced to do so by its auditors, or is this simply optics (which would be a very bad thing, in my view)?  I’m not sure.