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.

 

capital spending and the business cycle: BHP as an illustration

BHP’s fiscal 2012 earnings report

When BHP Billiton made its full (fiscal) year earnings announcement, it indicated that it is rethinking its planned $20 billion expansion of the Olympic Dam copper/uranium mining project.  It hopes to restructure the expansion in a way that costs less.  The company also recorded $3.5 billion in asset writedowns (“impairment charges”) for the year, the largest being a $2.8 billion reduction in the value of its US shale gas assets.

some perspective

To put these items in perspective, even after the writedowns BHP still made $15.4 billion for the twelve months and had operating cash flow of $24.4 billion.  So, for BHP the announcements aren’t a big deal.  But they do provide the occasion for making several important points about corporate behavior.

1.  Companies rarely outspend their cash flow, no matter what they may say to the contrary.  And if they do borrow to fund capital projects, it’s almost always just after the bottom of the economic cycle, when evidence is accumulating that business is past the lows and is accelerating.  Otherwise, if a firm sees that its projected cash flow over the coming year–sometimes longer–is going to be less than previously thought, it cuts the capital budget.  That’s what’s happening here.

Borrowing to fund capital expenditure adds an additional element of risk because the assets developed are long-term and illiquid, not stuff companies want to stock up on when the future is iffy.

2.  Cash flow isn’t always as available as it might seem.  Companies often have principal repayments on debt.  They can also have mandatory progress payments on capital projects already contracted for.  They pay dividends.  They may need to finance working capital–meaning they need money to buy raw materials, pay workers and offer trade credit to customers.  And (in BHP’s case a minor point, but not always) they may be “capitalizing” interest payments for ongoing projects (BHP capitalized $314 million of interest in fiscal 2012).  Capitalizing means the interest payments are parked on the balance sheet until the associated project is complete.  The money is paid to the creditors, but doesn’t appear as an expense on the income statement.

All this means a large chunk of cash flow is already spoken for each year.  Under normal circumstances, the easiest item to shrink is capital spending on new projects.

3.  Asset writedowns are a form of corporate housekeeping.  Many times–like this one, in my opinion–they occur when earnings aren’t so stellar anyway.  The idea is that more bad news doesn’t stand out so much.  That’s not the whole story, though.

Take the $2.8 billion writedown of shale gas assets.

Taken literally, the asset reduction means that BHP no longer believes the holdings are worth the amount it has invested in them.  They’re actually worth $2.8 billion less.  Conceptually, the firm is required to make the writedown once it becomes convinced this is the case.  Practically speaking, companies have a lot of wiggle room to use to avoid doing so.

Suppose it’s right that BHP has lost $2.8 billion through investing in shale gas.  It has two choices:

–it can either reduced the carrying value of the assets now, to the point where it can maybe make a slim profit in the future–and do so at a time when the business is slack and investors don’t really care, or

–it can keep the $2.8 billion loss on the balance sheet and show it little by little as gas is brought to the surface and sold.  Losses would continue for the life of the operations, until the entire $2.8 billion flows through the income statement.  Most of the red ink would presumably occur during better economic times, when investors are more eager to see earnings gains and would respond more negatively to the losses.

In other words, BHP is (prudently) wiping the slate clean while no one is looking.  In the non-commonsensical way that professional investors think, the writeoff is the mark of a good company.

cash flow per share and earnings per share as valuation metrics (ll): cash flow per share

investor preferences

A large number of investors in the US want to buy stocks where the underlying companies are growing profits rapidly.  The same is true in many other stock markets of the world.  For such investors, earnings per share growth is the main metric they look for when transacting.

This isn’t an immutable law of equity investing, however.  To a large degree, the search for growth is also a question of investor preferences.  In the US, the market I have the longest experience with, I’ve seen the mix of price and growth that investors prefer change dramatically several times.  This has been not so much because the macroeconomic environment has changed, but because the personal circumstances of investors (their age and wealth) did.

Also, I’ve seen other markets where preferences are quite different, where a “good” stock is one that pays a high dividend and where the company is mature enough that it has little need to spend capital on expansion.  These are markets where the search is for income, not for growth.  Taiwan in the 1980s is the first strong example I’ve encountered personally (technology stocks there couldn’t list unless they were willing to pay a 5% yield!).   But the US in the pre-WWII era seems to me to have been another.

the search for income

Not every company can grow at a rapid clip of a long time.  As well, some companies temporarily experience declining profits, either because the economy has turned against them cyclically, or because they’ve just lost their way.  In any of these cases, the large group of investors I’ve mentioned above lose interest in the stocks and more or less consign them to the equity junk pile.

There’s a whole set of other professional investors–in fact, in the US they are arguably in the majority–who evaluate stocks not on their earnings growth potential but on the companies’ ability to generate cash from operations.  There are many variations on this approach.  But all use cash flow per share as their main tool.  Such investors calculate an absolute worth for the company (usually a present value of cash flows over, say, ten years) and compare that with the share price.  They buy what they hope are the most undervalued stocks.

Around the globe, such value investors expect that at some point either the company’s fortunes will take a cyclical turn for the better, or that other investors will realize the undervaluation they see, or (in the US at least) that pressure will be brought to bear on the company to improve its operations.

[By the way, about two years ago, I wrote a series of posts on growth investing vs. value investing that you might want to read.  Take the test (which of two stocks would you buy) to see if you’ve got more growth or value tendencies.]

the stock as a quasi-bond

The key to this approach, viewing it through my growth investor eyes, is to regard the stock as a quasi-bond.

Let’s say the firm is now generating $1 a share in cash from profits and $2 a share in cash from depreciation and amortization.  That’s $3 a share in yearly cash flow.  Taking a ten-year investing horizon, the company will generate a total of $30, even with no growth at all–if the firm can get away without serious new capital investments.  If we were to assume that the company could achieve an inflation-matching rise in cash flow, then the present value of the stream of cash flow is $30.  (Yes, this is a vast oversimplification, but it is the thought process.  Remember, too, we’re also figuring there’s nothing left after ten years.)

What would a company like this sell for on Wall Street?  $20 a share?  …less?

We do have a yardstick, since if we reverse the profit and depreciation figures the description in the last paragraph is a rough approximation of INTC.  The value investor’s explanation for serious undervaluation is that people are so worried about the possibility that processors using designs from ARM Holdings will gradually eat in to INTC’s markets that they are overlooking the latter’s substantial cash generating power.

happy vs. unhappy shareholders

Another way of putting the difference between looking at earnings per share and cash flow per share–

–investors look at eps to gauge a firm’s value when they’re happy with the way the company is performing;

–they look at cash flow per share when they’re not, when they’re trying to figure out how much the company would be worth with different management, or in private hands, or after being acquired by a competitor.

The risk the first group takes is that all good things eventually come to an end.  The worry of the second group is that they’ve be unable to pry the company out of the hands of current management.