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.

 

3Q15 for Tesla (TSLA); do an extra 4,000 cars make a difference?

Yesterday, TSLA shares were up by 11% after reporting an in-line quarter the night before.  This was in a market that was down slightly.

The reason?

The company modified its full-year guidance for production from 50,000 – 55,000 units to 50,000 – 52,000 units.  With 4Q15 almost half over, investors took this new guidance as relatively reliable.  But the key factor is that the guidance, while down, was not the 45,000 – 50,000 that Wall Street had been fearing.

Wild gyrations are a fact of life for highly speculative stocks like TSLA (I own a small position).  That’s not the interesting part.  After all, what sustains the sky-high valuation of the stock is not the current results is the dream that one day the company will be selling millions of units and earning billions.

What is an important investment lesson is the reason that a production difference of around 5,000 cars in a quarter, which sounds like a small amount, should make such a difference to investors.

It’s all about cash burn, or the question of how long a company that ‘s using more cash than it’s taking in can sustain itself without turning cash flow positive.  This also happens to be one of the few things in a “dream” stock that’s important and that we can know for sure.

 

In the TSLA case, the firm realized–at the start of 2015, in my view–that the multi-billion dollar bond offering it made in 2014 wouldn’t be enough to sustain it until it began to generate more cash than it used.  Contact with investment bankers resulted in a spate of glowing reports being issued by brokerage house analysts–and then a $750 million stock offering.  What investors has been panicking about a few weeks ago (and may begin to worry about again;  who knows?) is that this extra three-quarters of a billion dollars might not be enough.

If we figure that a fully loaded Tesla retails for $100,000 ( figure I just plucked out of the air), a shortfall of 4,000 cars translates into a cash shortfall of $400 million.  So, “Poof!,” half the cash cushion created by the recent equity offering is gone.  (I’m assuming that everything else for TSLA remains the same, which is probably too pessimistic.  But the exact dollar amount isn’t the point.)

Arguably, TSLA could simply issue more stock or bonds to raise extra cash.  However, if TSLA were actually seen to be needing a loan, the terms it could expect to get would probably not be as favorable as before.  Another offering so soon after the last equity raising would also risk shattering the investor “dream” of the inevitability of TSLA’s success.

TSLA now expects to turn cash flow positive during 1Q16.  This does not imply that it will be cash flow positive for the entire quarter, or for the quarter as a whole.  Instead, it means that it will begin taking in more money than it spends by March 31st at the latest.  We’ll know more when Tesla reports 4Q15.

falling sales, rising profits…

…are usually a recipe for disaster on Wall Street.  Yet, in the current earnings reporting season, a raft of companies are reporting this presumably deadly combination   …and being celebrated for it, not having their stocks go down in flames.

What’s happening?

the usual situation

First, why falling sales and rising profits don’t usually generate a positive investor response.

To start, let’s assume that a company reporting this way is maintaining a stable mix of businesses, that it’s not like Amazon.  There, investor interest is focused almost solely on its Web Services business, which is small but fast growing, and with very high margins.  AWS is so valuable that what happens in the rest of the company almost doesn’t matter.

Instead, let’s assume that what we see is what we get, that falling sales, rising profits are signs of a mature company slowly running out of economic steam.

So, where does the earnings growth come from?

Case 1–a one-time event.  Maybe the firm sold its corporate art collection and that added $.50 a share to earnings.  Maybe it sold property, or got an insurance settlement or won a tax case with the IRS.

All of these are one-and-done things. How much should an investor pay for the “extra” $.50 in earnings?  At most, $.50.  There’s no reason to make any upward adjustment in the price-earnings multiple, because the earnings boost isn’t going to recur.

Similarly,

Case 2–a multi-year cost-cutting campaign.  AIG, for example, has just announced that it is laying off 20% of its senior staff.  Let’s say this happens over three years, and that the eliminations will have no negative effect on sales, but will raise profits by $1 a year for the next three years.

How much should we pay for these “extra” $3 in earnings?  Again, the answer is that the earnings boost is transitory and should have no positive effect on the PE multiple.  So the move is worth, at most, $3 on the stock price.

Actually, my experience is that in either of these cases, the PE can easily contract on the earnings announcement.  Investors focus in on the falling sales.  They figure that falling earnings are just around the corner, and that on, say, a stock selling for $60 a share, the non-recurring $.50 or $1 in earnings is the equivalent of a random fluctuation in the daily stock price.  So they dismiss the gain completely.

why is today different?

I don’t know.  Although early in my career I believed that earnings are earnings and the source doesn’t matter, I’m now deeply in the only-pay-for-recurring-gains camp.

I can think of two possibilities, though:

–Suppose Wall Street is coming to believe (rightly or wrongly) that we’re mired in a slow growth environment that will last for a long time.  If so, maybe we can’t be as dismissive as we were in the past of the “wrong kind” of earnings growth.  Maybe company managements that are able to deliver earnings gains of any sort are more valuable than in past days.  Maybe they’re on the cutting edge of where growth is going to be coming from in the future–and therefore deserve a high multiple.

–I’m a firm believer that most mature companies formed in the years immediately following WWII are wildly overstaffed.  I also think that even if a CEO were willing to modernize in a thoroughgoing way–and I think most would prefer not to try–it’s immensely difficult to change the status quo.  Employees will simply refuse to do what the CEO wants.  As a result, this makes companies showing falling sales prime targets for Warren Buffett’s money and G-3 Capital’s cost-cutting expertise.  In other words, such companies become takeover targets, and that’s why their stock prices are firm.

transfer pricing

transfer pricing

Consider the case of a Japanese company that makes cars in Brazil, which it then sells in the US.  Its internal control books will allocate a portion of the revenues and costs of a given car to operations in Japan for use of the brand name and the firm’s intellectual property, another portion to the manufacturing operations in Brazil and a third to the sales operations in the US.

This allocation process is called transfer pricing.  This in itself is a benign process.  After all, the firm has to understand whether Brazil is a profitable place to make cars and whether the Brazilian output should be allocated to the US or to other, potentially more profitable, markets.

What makes transfer pricing controversial, however, is that the firm also has tax books.  And the logic that dictates the management control profit decisions may not be the same as the one that minimizes taxes.

An example:

When I began working as a global portfolio manager in the mid-1980s, Tokyo was a very important stock market.  Multinational brokers all had lavish offices in swanky downtown districts and very large staffs–all of which seemed to be growing by the day.  Yet, I kept reading, at my then glacial, now non-existent, kanji speed–in the Nihon Keizai Shimbun that these same brokers were losing tens of millions of dollars a year.  This state of affairs had been going on for years, with no relief in sight.

I began asking around.  What I learned , after a long time of digging, was that all of the Japanese securities trades that customers placed with these brokers were funneled through their Hong Kong offices.  In an operational sense, this was crazy.  I knew most of the Hong Kong operations of these firms.  They knew nothing about Japan, in my opinion.  And, of course, this was an extra, possible mistake-inducing, step.  Why?

The answer is simple.  Japan had, along with the US, the highest corporate tax rates in the world.  In Hong Kong, the tax on foreign corporations’ profits was zero.  So every foreigner in any line of business established a Hong Kong office and recognized on its tax books as much international profit there as it thought it could get away with.

What’s in this for Hong Kong ?  Again, simple.  The move created employment, commerce and taxable salary income that the now-SAR would not have had otherwise.  The price was only forgoing tax income it would never have had anyway.

The general transfer pricing tax strategy:  recognize as much profit as possible in low-tax jurisdictions, the minimum amount in high-tax locations.

turning to the EU today…

Margrethe Vestager, the new EU competition commissioner, is starting a crackdown on what the union considers abusive tax practices.  Her first targets are Starbucks and Fiat.

In the Starbucks case, Vestager has two gripes.  Both relate to a low-tax corporate subsidiary set up by Starbucks in the Netherlands, using an aggressive tax strategy endorsed as legal by that government thorough an informal tax letter.   (The situation is outlined best, I think, in a New York Times article).  The subsidiary allegedly:

–bought coffee beans for Starbucks worldwide from Switzerland and marked them up by 20% before selling them to other parts of the company, thus shifting profits away from higher-tax jurisdictions around the globe, and

–levied charges for the use in the EU of the Starbucks name and its secret coffee roasting recipe (which the EU competition commission claims was basically a temperature setting).  In the case of the large UK subsidiary of Starbucks these fees for intellectual property apparently amounted to most of its pre-tax income.

 

Vestager is not saying that Starbucks, Fiat and others did anything wrong.  She’s saying the Netherlands, and other countries that offered sweetheart tax deals did.  And she wants those countries to collect back taxes.

It will be interesting to see what develops, since presumably every multinational doing business in the EU is employing similar devices.

 

 

 

thinking about 2016: commodities

commodities

In the broadest sense, commodities are undifferentiated products or services.  Producers are price takers–that is, they are forced to accept whatever price the market offers.

Commodity products are often marked by boom and bust cycles, that is, periods where supply exceeds demand, in which case prices can plummet, followed by ones where supplies fall short and prices soar.

 

For agricultural commodities, the cycle can be very short.  For crops, the move from boom to bust and back may be as little at one planting season, or three-six months.  For farm animals, like pigs, chickens or cows, it may be two years.

 

For minerals, which right now is probably the most important commodity category for stock market investors, cycles can be much longer.  Base and precious metals have recently entered a period of overcapacity.  The previous one lasted around 15 years.  One might argue that prices for many metals have already bottomed.  I’m not sure.  But I think it’s highly unlikely that they will rise significantly for an extended period of time.

 

Oil is a special case among mined commodities.  Lots of reasons

–the market is huge, dwarfing all the metals other than iron/steel.

–there’s a significant mismatch between countries where oil is produced and where it’s consumed.

–there’s one gigantic user, the US.

–for many years, there was an effective cartel, OPEC, that regulated prices.

To my mind, the most important characteristic of oil for investors at present is the wide disparity in out-of-pocket production costs between Saudi crude ($2 a barrel) on the one hand, and Canadian tar sands ($70? a barrel) on the other.  US fracked oil ($40? a barrel) is somewhere in the middle.  The lower-cost producers have gigantic capacity, and the potential to ramp output up if they choose.  This wide variation in costs makes it very difficult to figure out at what price enough capacity is forced off the market that the price will stabilize.  For example, Goldman, which has an extensive commodities expertise, has argued that under certain conditions crude might have to fall to $20 a barrel before it bottoms.

 

The oil and metals situation is important for any assessment of 2016, because:

–about 25% of the earnings of the S&P come from commerce with emerging markets, many of which depend heavily on exports of metals and/or oil for their GDP growth

–the earnings for about 10% of the S&P 500–the Energy, Materials and Industrials sectors–are positively correlated withe the price of metals and oil.

–a low oil price is a significant economic stimulus for most developed countries, meaning margins expand for companies that use oil as an input  and consumers spending less on oil will have more money left to spend elsewhere.

As a result, one of the biggest variables in figuring out earnings fo the S&P next year will be one’s assumptions about mining commodities prices, especially oil.

 

More tomorrow.

 

 

results from Disney (DIS): a lesson in how the market works nowadays

DIS and ESPN

A relative in the movie business called my attention to Marvel Entertainment a few years ago.  When it was acquired by DIS in late 2009, I held onto the stock I got and added more in the mid-$20 range Marvel, of course, has been pure gold for DIS, even though DIS initially went down on fears that DIS had overpaid.  Naturally I sold the stock way too early, in the mid-$60s–acting more like a value investor than a growth stock fan.

My first thought on reading the DIS 10-K, as I acquainted myself with the company,was that the company really should have been named ESPN, since at that time the cable sports network accounted for 2/3 of DIS’s overall operating profit and virtually all of its earnings growth.

red flags about ESPN

Over the past several years, a number of key warning signs have popped up about ESPN, however:

–ESPN decided to expand into the UK, signalling to me that it considered its US franchise on the cusp of maturity

–but ESPN was outbid for soccer rights by locals and effectively terminated its international expansion ideas–not good, either

–DIS began to shift cash flow away from ESPN and toward the movie and theme park business, which I took to be a sign of corporate worries about ESPN’s growth potential, rather than simply diversification for diversification’s sake

–serious discussion has begun over the past year about the demise of cable system bundled pricing, which likely benefits ESPN substantially (I suspect we’ll find out how substantially sooner rather than later)

–since ESPN.com’s recent format change, I find myself almost exclusively using Time Warner’s Bleacher Report for sports information

–personally, although this isn’t the most crucial part of my analysis, I think the progressive dumbing-down of ESPN coverage, in imitation of sports talk radio, to gain a wider audience will backfire.

To sum up,, there has been an increasing collection of evidence that ESPN probably won’t be the same growth engine for DIS that it has been in the past.

Yet…

…DIS shares were down by about 10% in Wednesday trading (in an up market) on the first signs in the earnings report of the factors I’ve just listed.

discounting?

Where was the market’s discounting mechanism, which in the past has been continuously evaluating corporate strategy and factoring worries like the long list I’ve mentioned above into the stock price?

…only on the earnings report, not before

To my mind, DIS trading yesterday is another indicator that information isn’t flowing on Wall Street as fast as it once did.  That’s neither good nor bad;  it’s just the way the game is being played in today’s world.  What we as investors have got to figure out is how to adjust our own behavior to fit altered circumstances.

My initial thought is that it may be riskier than it has been to dabble in down-and-out industries like mining or oil until the final bad news has hit income statements.

 

big day for Amazon (AMZN)–why?

AMZN reported 2Q15 results after the close last night.  They were very good.

Sales were up 20% year-on-year; expenses rose by 17%, three percentage points less.  As a result, the company reported an operating profit of $464 million vs. a loss in the second period of 2014.

More than that, AMZN’s cloud services division, AWS, had revenue growth of 81% yoy and a quintupling of segment profits (basically operating profits less stock option expense) to $391 million.  AWS, broken out as a separate segment for the first time after 1Q15, remained a bit more than a third of the AMZN total.

 

AMZN posted an overall profit of $.19 a share for the quarter, vs. analysts’ expectations of a loss of $.13 a share and a deficit of $.27 per share in the year-ago quarter.

On the announcement, the stock immediately rose by 15% in aftermarket trading.

AMZN opened up by 20% this morning, before drifting down steadily during the day to close +9.8% in a market that was down just more than 1%.

 

Why the strong advance?

I have no good explanation, although I do have some ideas.

1. The obvious factor that changed overnight was the earnings announcement.

It contained a significant positive earnings surprise, one that makes it more likely that the company will earn, say, $1- a share in the current year. It makes the analyst consensus of $2.78 a share for 2016 more believable.   On the other hand, the stock was trading at $482 before the earnings report, or 173x the 2016 consensus.  Looking at the stock price another way, let’s say that at maturity for its businesses (whenever that may be), AMZN shares will be trading at 20x earnings.  To sustain the pre-earnings report price, that would imply a burst of rapid growth that shoots earnings up to around $24 a share.  That would be something like a doubling of earnings each year for the next five or six.

That’s already baked in the cake.  A buyer of the stock at this level must believe that $24 a share in eventual earnings is way too low.

I find it hard to believe that a $.32  per share earnings surprise during one quarter–when expectations were already sky-high=-would be enough to add 20%, or even 10%, to AMZN’s perceived market value.

2.  A second hypothesis…

What if investors are beginning to separate AMZN into two parts, AWS and everything else, and are doing a sum-of-the-parts evaluation.  To me, this sounds a little more plausible.  What would the numbers look like?

Let’s say that in 2016 AWS will comprise half of AMZN’s earnings and AMZN Retail the remainder.  To make the figures easier, let’s say each half earns $1.50 a share next year.

Let’s assume AMZN retail can grow in earnings at 20% a year for a long time, and that we’d be willing to pay 50x current results–a big number for a retail stock–for that future profit stream.  If so, AMZN Retail is worth $75.  To reach a sum-of-the-parts value of $482, AWS must therefore be worth about $400, or close to 270x its 2016 eps.  Ok, while I personally wouldn’t be willing to pay that much for AWS, I can see how someone else might.  However, I still don’t understand why confirmation that a holder at 270x earnings isn’t insane would cause the multiple to expand.  (Also, before I’d be comfortable valuing AWS as a separate company, I’d want to know more about how AMZN apportions revenues and costs among segments to ensure the published numbers don’t flatter AWS.  I’d also think long and hard about the possible effect of stock options.)

3.  The explanation for AMZN’s rocket ship ride that I’m leaning toward, however, is more technical.  Two factors may be involved.  At what Google Finance reports as 21+ million shares, today’s trading volume in AMZN was 7x normal.  The sharp opening spike suggests to me that algorithmic trading computers were at work reacting to the earnings report, not humans.  Humans, I think (?!?), would have a better sense of valuation.  I also suspect that the report and immediate upward move triggered a lot of short covering.

I’m partial to #3 because I think the whole reaction is a little  crazy.

Why is any of this important?  AMZN is a high-profile, large-cap stock with almost two decades of operating history.  There’s got to be a way to make money from the possibility that something like AMZN’s big move will occur with other similar names.