Qualcomm (QCOM) and/vs. Apple (AAPL)

QCOM and its IP

QCOM is a company that has its roots in early Defense Department mobile communication and encription technology.  As a public company, it manufactures mobile chips itself and licenses its proprietary technology to others in return for royalty payments.  The latter, which has always been the prime focus of investor interest, comprises the bulk of its profits.  QCOM’s operating income for fiscal 2016 (ended September 25th) amounted to $6.5 billion, net $5.7 billion.  On a non-GAAP basis, each figure would be about $1 billion higher.

royalty dispute with AAPL

Last week, QCOM announced that AAPL, whose phone designs (like almost everyone else’s) incorporate QCOM intellectual property and who had been complaining that royalty rates were too high, has decided to cease making any payments to QCOM while the dispute wends its way through the courts.

As I understand the situation–and I’d bet this is a simplification of a set of very complex deals–AAPL doesn’t pay QCOM directly.  It designs phones that use QCOM’s IP.  The phones are made by contract manufacturers, who purchase the IP from QCOM.  AAPL reimburses them.

with China, too

This isn’t QCOM’s first quarrel with a customer.  In 2015, pressured by the Chinese government, QCOM agreed to pay a $975 million fine and lower its royalty rate on older technology in phones made for sale in China by a third.

implications for AAPL and QCOM

My question:  why is AAPL bothering?   Yes, it’s a lot of money.  And maybe it’s just that it wants to have the same reduction on the IP affected by the China deal.  But I can’t believe that it doesn’t have that already.

Look at the magnitudes involved:

QCOM says its next quarter revenues (and operating income) will be $500 million lower than expected because of AAPL’s action.  Annualized, that amounts to $2 billion, or about a third of QCOM’s operating income in fiscal 2016.

For AAPL, in contrastfiscal 2016 operating income was $60 billion.  Analysts are estimating 8% growth for the current fiscal year and a 15% advance the following one.

So cutting the QCOM royalty payments in half would only raise operating income by 1/60th, or 1.7%.

my take

One way of looking at this dispute is that AAPL believes it is running out of ways to make revenues grow and has to concentrate, for the moment at least, on cost control.  That’s the typical pattern.  It would also be more evidence that today’s model isn’t the Steve Jobs AAPL any more.

 

 

 

why Apple (AAPL) is a growth stock anomoly

Although AAPL is one of the most important growth stocks of the past decade, its price action doesn’t fit my description of “typical” growth stock behavior.

Although AAPL’s earnings per share rose by 500% between 2009 and 2012, the price earnings ratio of AAPL, which experience says should have expanded a lot during this period, actually contracted.  More than that, it shrank during a period when the PE of the overall S&P 500 was expanding.  So, relatively speaking, its PE behavior was considerably worse than appears at first glance.

In addition, by 2013-14, there was, in my view, ample evidence that the best days for the iPhone would soon begin to be visible only in the rear view mirror.  Yet, after a slump in 2013, the shares recovered their upward momentum in 2014 and carried on their strong performance through most of 2015.  In other words, there wasn’t, as I read the stock price, the usual performance falloff in anticipation of the end to super-normal growth.

How did these things occur?

no PE expansion

On the first point, I don’t have a great answer.  As I wrote while this was happening (or, actually, not happening), I’d never seen this behavior elsewhere in 20+ years of buying growth stocks in the US and around the rest of the world (I was a value investor early in my career).

The only thing I can come up with is that AAPL changed from a very conservative method of accounting for its iPhone profits to a more aggressive one in late 2009.  The change added between 50% and 100% to near-term reported profits.

Professionals typically applaud companies whose accounting is conservative, and disapprove of those who sail closer to the wind.  In AAPL’s case the more flattering figures had been routinely included in notes to the financial statements, where anyone who cared could look at them. So although the move may have been calculated by AAPL management to give the stock a boost, the change didn’t provide any new positive information.  It only created the impression that AAPL was more concerned with flashy optics than operations.

(The issue was how to account for sales of iPhones by AT&T on two-year contracts where AAPL shared in the revenues AT&T collected over the contract life.  AAPL’s initial stance was to recognize the revenue over the two years.  The change was to credit everything up front, at the time of sale.)

no anticipation, no PE contraction

This is a lot easier.  The main factors:

The PE never went up in the way the multiple of growth stocks typically does.

As is the case with many successful growth stocks, AAPL started out with a retail investment base.  Then came hedge funds.  Traditional long only professionals bet against AAPL early on, in my view, and came to the party only after suffering considerable underperformance, either from not owning the name at all or from owning a less-than-market-weight position.  AAPL’s earnings growth was so powerful and so long-lasting that the safest position for skeptics became to establish, kicking and screaming, a market-weight position.  That allowed them to forget about AAPL and look for outperformance elsewhere.  In a sense, the stock’s upward momentum fed on itself.  But it also meant steady accumulation of the name.

In 2013 Carl Icahn convinced AAPL to begin using financial engineering–borrowing to fund large scale stock buybacks and dividend increases–to boost the stock price.  Maybe he didn’t put it quite that way, but between the end of the company’s fiscal 2012 and its fiscal 2015, AAPL shrank the number of its outstanding shares by 15%, despite issuance of new stock to employees.  That’s enough to change the psychology of buyers, as well as to relieve potential selling pressure and give a mild boost to eps.

Mr. Icahn has recently announced the sale of his AAPL holding.  Given that and recent negative earnings news, the stock has declined and the PE has contracted a bit.  However, the shares are now trading at about 2/3 the multiple of the typical US stock–mostly because the market PE has expanded while AAPL’s hasn’t.  All the damage has been in the relative PE, not the absolute.  At such a low relative PE today, I find it hard to argue that damage to the absolute PE multiple is in the cards.

Apple (AAPL) as a growth stock

Apple is among the most successful growth companies of the past ten years.  However, AAPL has had a most peculiar trajectory as a growth stock.  To my mind, it has barely followed any part of the typical growth stock pattern I outlined yesterday.

How so?

For one thing, the peak price earnings multiple and the peak stock price didn’t coincide from AAPL.  Yes, the company did switch to a much less conservative method of accounting for iPhone profits early in that product’s life, but I don’t mean that.  Even after the switch, the PE didn’t expand while the company was piling up quarter after quarter of spectacular, continually surprisingly strong, earnings performance .  The multiple contracted slightly instead.

For another, it was clear by, let’s say 2012, that the smartphone market was becoming saturated.  AAPL was also facing increasing competition from the Android operating system and from Samsung as a manufacturer of mobile devices.  So we had to think that pretty soon the iPhone profit dynamo would begin to lose momentum.

What about another reinvention?  The issue here has always been:

–Reinvention #1, the iPod, doubled the size of a small company.  Reinvention #2, the iPhone, more than doubled the size of a now-large company.  To repeat the same quantum leap, Reinvention #3 would have to be twice the size of the smartphone.  What would that product be?  Would such a product be possible?  (my answer: probably not)  Is such a product likely?  (not likely at all)

(AAPL has had two subsequent innovations, the iPad and the iWatch.  Neither has created anything like the response needed to be Reinvention #3)

In a nutshell, the elevator speech was starting to give a sell sign–based both on earnings momentum for the company as currently constituted and another possible reinvention.

 

Yet, the stock continued to go up, and to outperform the S&P, until about a year ago.

Why?

More on Monday.

 

growth stock investing and Apple (AAPL)

Apple

The company Apple is one of the great growth stories of the early 21st century, as well as a tale of redemption and return from the ashes.  In a number of respects, however, AAPL is an atypical growth stock.

Ultimately, that’s what I want to talk about.  But I’ve decided to take the long way around and start by writing in general about growth stock investing.

growth stocks

Growth stock investing is all about finding extraordinary companies or industries.

two characteristics

The growth stock investor looks for two things:

–a firm that will expand its earnings per share at a faster rate than the consensus expects, and

–that will do this for longer than the consensus expects.

key judgments

The growth investor has to make two key judgments:

–that a company has the potential for superior growth, and

–that this potential is not yet recognized by the market (meaning is not yet factored into today’s price).

analyzing a growth stock

The analysis of company fundamentals also has two parts:

qualitative, a description of what makes the company unique and what will defend it from competition as it expands.  Most often, in my experience, this can be condensed into an “elevator speech,”  like “AAPL is the leading maker of high-end smartphones, a huge, rapidly expanding global market.” or “Amazon is the dominant force in Cloud services and in online retail, two fast-growing barely penetrated markets.”

quantitative, meaning spreadsheets projecting one’s best guess about how the financial statements–income statement, cash flow statement and balance sheet–will play out over the next several years.

open-ended is good

Often, although the spreadsheets have numbers in all the appropriate fields, the quantitative analysis has an open-ended aspect to it.  I may end up concluding that I’m confident eps will be up at least by 25% in the coming year   …but it could easily be 50% or more.  Uncertainty, yes, but of the best possible kind.

why the elevator speech

The elevator speech has two important purposes:

–it forces the analyst to step back from the numbers and pay attention to what the company’s competitive advantage is

–as a growth idea gets long in the tooth, it’s most often the story that breaks down, not the numbers.  So the qualitative analysis ends up being an early warning sign that one should reduce exposure or exit the stock entirely.

 

More tomorrow.

 

 

 

 

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.