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.






Apple (AAPL) today

the stock vs. the company

the company

As a company, Apple has in most respects followed the typical pattern for businesses of high-flying growth stocks.

The company stabilized itself as a computer maker, after a brief flirtation with bankruptcy, with the return of Steve Jobs as CEO.  It took a chance on making the iPod, which a geeky DJ apparently brought to it.  That produced a series of big profit increases that lasted several years and doubled this size of the company.  Just as the iPod wave was cresting, Apple reinvented itself again, as the iPhone company.  Another huge profit surge followed, which crested as the global market for expensive smartphones matured.

Yes, Apple has reinvented itself again as the iPad company, but each blockbuster must be progressively larger to move the profit needle for a firm whose income has grown exponentially over the past decade.  The iPad doesn’t have enough oomph to do so.  Heartless as it may seem, Apple has gone ex-growth.

Look at IBM, or Oracle, or Cisco, or Wal-Mart  …or, on a smaller scale, the Cheesecake Factory or Chicos or PF Chang.  Same pattern.

the stock

What has been strange about Apple has been the behavior of its stock.  Typically, as a company’s earnings begin to accelerate, the price-earnings multiple begins to expand as well.  So the positive effect of the earnings growth is magnified.  When (or just before) earnings growth beings to disappoint, as it sooner or later will the PE begins to contract.–and the stock plunges.  Timing this shift is the key issue for growth investors.

Not so much with AAPL.  Its PE peaked in 2008, four years prior to the peak in earnings (which were, by the way, almost 8x the 2008 level).  The multiple contraction has been pretty continuous, moving from 30x ( and 1.8x the market multiple) in 2008 to 12.3x (and a .7x relative multiple) for 2013.

an investment thesis

Growth investors, who are searching for the next AAPL, have abandoned ship andgone elsewhere, leaving the field to their value counterparts.

For value investors, I think the key question revolves around the PE.  When growth stocks fall from grace, the multiple typically contracts severely–and over a long period of time.  The decline ends in an overreaction on the downside.

Looking at AAPL,nine months of stock price pain (late 2012 – mid-2013) would be unusually short period of time.  But, then, the AAPL multiple has already been contracting for five years.

Although I’m not a value investor (read: although I’m no good at making these judgments), my sense is that the AAPL PE is too low.  I don’t feel an overpowering urge to buy the stock.  But 10% earnings growth + one point of multiple expansion this year doesn’t sound so bad, either.




Moffett Research, Vodafone’s financials, Wall Street’s security analysts

The “Heard on the Street” column of today’s Wall Street Journal talks about the purchase commitment Verizon Wireless had to make to Apple in order to be able to offer the iPhone on its network.

a footnote in the Vodafone financial statements

The information comes from newly-formed Moffett Research LLC, a venture headed by Craig Moffett, the truly excellent (former) telecoms analyst at Bernstein.  Mr. Moffett points to a footnote in the financial statements of  Vodafone plc, a Verizon Wireless co-owner, that implies Verizon Wireless has committed to buy a minimum of $44.7 billion worth of iPhones during 2011-2013.  The company spent only $18.5 billion on iPhones through the end of last year, however, and still had $2 billion worth (Mr. Moffett’s number) in inventory.

That leaves $26.2 billion worth of iPhones to be bought this year (my arithmetic–HotS says the shortfall is $23.5 billion).

I find three aspects of this story interesting:

1.  Neither Verizon Wireless nor Verizon disclose this information.  It took a sharp-eyed telecom specialist combing through the back pages of a UK company’s financials to spot the figures and realize their significance.

This example illustrates what security analysts do for a living, as well as the depth of information that traditionally has been at the fingertips of any professional investor who does business with the major brokerage firms who employ these analysts and furnish their research to customers.  In other words, no matter how dull-witted the pro and how smart we as individual investors are, the pro has a huge information advantage starting out.

2.  Mr. Moffett started up his new firm two months ago.  It may be that he’s decided he can make more money as an independent than as an employee of Bernstein.  More likely, if past Wall Street form follows true, is that Bernstein has started to dismantle its high-powered equity research effort.  Why do so?  Wall Street believes that research is a money losing business.

3.  What happens if/when Verizon Wireless falls short of its $44.7 billion purchase commitment?

HotS doesn’t say.

Using (very) round numbers, the shortfall will likely be $10 billion or so.  In contracts of this type that I’m familiar with, Verizon Wireless would have to pay that amount to Apple shortly after the end of the year.  Verizon Wireless would, however, get a credit against future purchases of a gradually declining percentage of the shortfall payment.

Given the popularity of the competing Samsung Galaxy phone line, I imagine the shortfall payment will be a prominent element in negotiations over supply arrangements in 2014.

On another note,  I wonder how Apple and Verizon have been accounting for the minimum purchase contract.   HotS says the minimums for 2011-13 are:  $13.7 billion, $14 billion, $17 billion, respectively.  The actual purchases have been $8.4 billion and $10.2 billion in 2011 and 2012.

Both firms are most likely using the actuals, not the contracted minimum amounts.  Might be a little awkward for Apple, though, if it isn’t.

thinking about Apple (AAPL)

setting the stage

(I should say at the outset that, although at one time I owned AAPL for years, I don’t hold it now and haven’t for a long while (except for a couple of days in January).

Q:  What does AAPL do for a living?

A:  It makes smartphones and other mobile computing/consumer electronics devices targeted at affluent consumers willing to pay a premium price for the perceived superior aesthetics and more user-friendly software.

A mouthful.

in other words, a niche player…

If my definition is correct, AAPL has decided to carve out a niche for itself in the high end of the mobile device market.  It’s a very desirable and lucrative niche, one it dominates.  But AAPL is a niche player, nonetheless.  It’s a little like TIF or WYNN.

Like any market strategy, this one has its pluses and minuses.  Anyone listening to the AAPL earnings calls over the past few years can’t help having heard the persistent questioning from Bernstein about what the company would do once everyone who can afford a $600 smartphone already has one.

Move downmarket?  Unlikely.  TIF is the only company I’m aware of who has taken this path and not completely destroyed its brand image–thereby losing its original customers.  Better to lose low-margin sales in the mass market than to kill the goose.

Absent new blockbuster products, however, the price of maintaining the upmarket strategy for AAPL is that sales slow as volume-oriented manufacturers ride down the cost curve and churn out smartphones that retail for $100-$300.

That’s where we are now.

Tons of publicly-available-for-free data has been available for years showing where the smartphone marke, and AAPL, have been heading.  So this outcome can’t have been a surprise.

…with an “ecosystem”

Another characteristic of AAPL devices is the “ecosystem,”  which has tended to make customers more sticky.  All AAPL devices work well together.  All reside in a “walled garden” created by AAPL software–reminiscent of the way AOL worked back in the infancy of the internet.

on this description…

…the current PE of 10.8x–8.0x, after adjusting for cash on the balance sheet–seems crazy low.  It’s less than INTC’s, for instance.

is there more to the story?

There’s an obvious risk in securities analysis of taking the current stock price as the truth and trying to come up with reasons why  it is what it is, rather than taking out a clean sheet of paper and trying to imagine what the future will be like.  The Efficient Markets hypothesis taught in business schools despite overwhelming evidence that emotional storms of greed and fear that routinely roil financial markets, encourages this thinking.

Admittedly possibly being influenced by the recent swoon in the AAPL share price, I’ve been asking myself recently whether the conventional wisdom about AAPL, which is my description above, is correct.

I have two questions.  No answers, but questions anyway.

my questions

1.  Is the high-end niche defensible?

In most luxury retail it is.  In consumer electronics, it clearly isn’t.  Think: Sony.  Based on the (small) number of entrants in the mobile appliance market and the (small) number of products sold, AAPL may be closer to Sony than to Hermès.

2.  Is the “walled garden” a mixed blessing?

It certainly worked for AOL for a long while. But then the Wild West of the early internet was gradually tamed and customers discovered there was a much more interesting world outside the garden.

I don’t think AAPL aficionados have any intention of tunneling out–at least not yet.  But the inaccessibility of AAPL customers to GOOG has prompted the latter to introduce the “hero phone” later in the year through its Motorola Mobility subsidiary.  The idea seems to be to create an attractive, user-friendly, high-end smartphone, load it with GOOG software and sell it at cost.

The “Made in USA” label and the management description of the “hero” seem to me to indicate it’s targeted directly at the large concentration of AAPL customers here in the US.  It’s an open question whether GOOG/Motorola can create a smartphone that’s attractive to iPhone users, or whether they’ll consider switching.  But a technologically inferior PC sure did undermine the Mac with consumers in the 1980s almost solely because it was a lot cheaper (btw, the Mac lost out to IBM with corporate customers because it had no clue how to sell to them).  And the wireless carriers will certainly welcome the “hero,” assuming it works well.

what do gold and AAPL have in common?

common factors

–they’re both large positive bets (large holdings) of hedge funds–and of many retail investors

–both have delivered weak performance over the past year, after extended periods of substantial gains.  And the losses have occurred during a time of generally stable conditions for the world economy, with ample liquidity and strong inflows of money into financial products

–recent trading in both seems to me to be giving signs of forced or distressed selling

are these factors connected?  

It’s hard to know, since global hedge fund disclosure is incomplete–and there’s ample evidence that what disclosure there is can’t be relied on.  However, I think it’s reasonable to assume they are.

if so, what does this imply?

In my experience, a professional investor goes through a three-step process as he realizes he’s made a mistake–or that his previously good idea is no longer working.  He:

–stops adding to the position when new money comes in, effectively shrinking its relative size,

–begins to sell, to further lessen the negative effect of the position on performance, and

–accelerates the selling when the position is small enough the extra visibility and extra downward pressure on price make little difference.

A professional investor can go through these states in the blink of an eye, or it can take a long period of time. A lot depends on style, self-awareness and how ugly the underperformance is.  Anyone who operates on margin may also get additional feedback from his lenders.

Many retail investors, in my experience, just panic–very close to the bottom.

Recent price action in gold and in AAPL strike me as Stage-Three end-game activity–some combination of panic, response to margin calls and/or dumping of the remainders of positions being sold over long periods.

is this an opportunity to buy?


For me, the answer here is easy.  It’s “No.”  The key supply-demand issue is whether central banks in emerging markets will continue to buy gold in the aggressive way they have done over the past several years.  I have no idea.  So I’m clearly the “dumb money” in this arena–the strongest reason there is to stay away.


We’ll have more information tomorrow, after AAPL reports its latest quarterly earnings.

The stock is now trading at less than 9x historic earnings and yielding 2.7%.  The shares have underperformed the S&P 500 by more than 50 percentage points since last September.

The company has no debt and its cash holdings are approaching almost half the market cap.

If there’s anything “wrong” with the stock, it’s that its fall from grace has been so extreme.  That prompts the question, “What must sellers know that I don’t?”

How do you overcome aversion, based on an extended decline, to a stock that looks like a $100 bill lying on the street?  The first step, I think, is to look for signs that the waves of selling that have pummeled AAPL are over.   This means having AAPL announce bad news and have the stock go up, rather than sell of further.  That’s why tomorrow’s earnings report may be important.


David Einhorn’s preferred stock proposal for Apple (AAPL)

Yesterday hedge fund manager David Einhorn made public an open letter to AAPL shareholders, publicizing his suggestion that the company issue perpetual preferred stock to shareholders.

mechanics of the issue

AAPL has no debt and $137 billion of cash on its balance sheet.  It is generating cash flow at the rate of about $40 billion a year.

Einhorn proposes that AAPL issue a new security for free to shareholders that would pay a total yearly dividend of $2 billion.

The new security would:

–be perpetual, meaning it would go on forever (or until AAPL goes out of business).  This also means the preferred would have no redemption value, that is, it could/would never be returned to AAPL in exchange for a cash payment

–be cumulative, meaning any unpaid dividends would continue to be obligations of AAPL, rather than simply lost, as is the case with dividends on common stock

–have a dividend preference over the common, meaning the preferred dividend–and any accumulated unpaid ones–would have to be paid before a common could be.


In round numbers, AAPL has a billion shares outstanding.  One way of implementing the Einhorn proposal would be to distribute one share of preferred for each common share held.  If so, the preferred would pay an annual dividend of $2.

How much would you pay for a potentially infinite stream of $2 annual payments?  Einhorn tried to frame the issue psychologically by saying this is “$50 billion” worth of stock, or $50 a share if the issue were constructed as I describe.  This would also be a 4% yield.

Especially for the first issue of this type, $50 could be low.  Yes, it represents 25 years of undiscounted dividend payments.  But AAPL is a pristine credit.  The yield is a huge premium to the 30-year Treasury.  There are tons of AAPL fans who might like a “cheap” way of owning an AAPL security–AAPL has (foolishly, in my view) chosen so far not to tap this base of support by splitting its common.  And the preferred issue would have novelty value.

an investor’s view

–The proposed preferred has no claim on AAPL’s assets and represents only a tiny fraction of the company’s cash flow.  It wouldn’t have voting rights under normal circumstances.  So it isn’t equity in any practical sense.  Arguably, therefore, its issuance might have no effect on the price of AAPL common.  In all likelihood, any negative effect would be tiny.  There’s even a (lottery ticketholder’s) chance that the effect would be positive.  

So the Einhorn proposal is like creating free money, as I wrote yesterday.

–Einhorn’s hedge fund clients hold about $500 million worth of AAPL.  Einhorn himself gets some percentage, say, 20%, of the profits they make on his investment choices.  An AAPL preferred issuance could represent a $10 million payday for him.

-The preferred is not a one-and-done story.  There’s no reason why this magic trick can’t be repeated at least several more times, each one giving a $50 billion boost to aggregate shareholder wealth.

–What’s not being said is that the pledge of future cash flows puts handcuffs on management, for good or for ill.  Each $2 billion in cash flow dedicated to preferred dividends means less that management is free to use for capital expenditure, acquisitions or other uses. The preferred can be regarded as a prudent safety measure.  Look at Hewlett-Packard–a once-great company that has squandered an enormous amount of its shareholders’ money through a decade of lunatic, management- and board-approved acquisitions.


–Q:  Who are these guys to tell us what to do?  They don’t work here.

A: They’re the owners.  You work for them.

Reply:  That can’t be right.

–About 3/4 of AAPL’s cash is held outside the US, so it’s only available to pay preferred dividends if it’s repatriated.  That would mean paying income tax at 35% on anything that’s brought back.

–If we assume AAPL generates its global cash flow in the same proportions as its cash holdings, then only $40 billion annually is available to pay dividends of any type.  $10 billion+ already goes to pay the common dividend.

If shareholders say they think Einhorn has a good idea (which he does), then management has potentially got to focus a lot more on earning money in the US.

my 2¢

There’s a tipping point out there somewhere, after which the Einhorn trick will no longer work.  Not a current worry, though.

There’s also a legitimate concern that at some point the diversion of cash flow away from reinvestment in the firm will hamstring management and hamper growth.  With $137 billion in the bank, not a concern, either.

weird stuff from the AAPL high command

In the old days, Steve Jobs would have thrown Einhorn out of his office and that would have been case closed.

IN contrast, current management is seeking to change the company’s charter to outlaw preferreds like Einhorn’s.  Not only that, it’s taking a page from Congress’s book, wrapping the change inside a bunch of others that are supposed to be voted on as a group.  So the owners don’t get a say so on the Einhorn idea alone.

These action has, predictably, had the opposite of the intended effect.  It’s publicized the Einhorn proposal like nothing else ever has.  It makes management look weak.  And it makes AAPL look like it has something to hide.  (My candidates:  the small amount of cash flow generated in the US; the dilutive effect of management stock options, which are obscured by stock buybacks out of US-held cash.)

what would I do?

I’m not a current holder–to my regret, although I did buy AAPL for my clients (including me) in 2004.  But if I were, I’d back Einhorn.

David Einhorn and Apple (AAPL)

It’s been a long day and I’ve gotten off to a late start.

the proposal

Hedge fund manager David Einhorn, who owns on behalf of his clients (so the internet tells me) over a million AAPL shares, has proposed to the company that it issue a perpetual (meaning it never comes due, and is therefore never redeemed) preferred stock with a total face value of $50 billion, paying a dividend of $2 per year.  The stock would be distributed for free to existing AAPL shareholders.

He’s apparently been discussing this idea with AAPL management since last May.

The proposal is a clever, novel twist on a finance truism   …namely, that if a security is a composite of disparate elements, like growth businesses and value ones, separating the two will increase the valuation of each.

The idea is that if a firm is composed of, say, mobile semiconductor design and cement mixing, growth investors will love the first and hate the second.  The opposite with value investors.  So either group will demand payment, in the form of a lower price earnings multiple, for being forced to take the part they don’t like or want.  Therefore, if you split the two parts up, the multiple on both will rise.

In the AAPL case, the potential split is between a security with earnings growth potential and one solely dependent on income/cash flow generation.

AAPL’s reaction to Einhorn

AAPL’s reaction has been to ask shareholders to vote at the next general meeting to change the company charter to explicitly ban the kind of preferred Einhorn wants.


Einhorn’s reaction to that has been to sue, to seek publicity and to take his own case to shareholders.

my take

The story is nowhere as simple as this.  There’s lots of stuff going on behind the scenes.  Details tomorrow.