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.

demise of the e-reader: implications

e-reader sales

A Christmas Eve Financial Times article indicates that while e-reader sales in 2012 will still be robust, the category may be on the brink of a rapid decline in popularity.  Its source is IHS iSuppli.   I’ve found the data in a graph from emarketer.com (note the convoluted chain of attribution–PSI cites emarketer, which in turn cites CNET citing IHS).

The reason for the falloff?   …the rise of light, powerful cheap multi-function tablets, which can serve as e-readers as well as do a lot of other stuff, for within a reasonable distance of the price of a dedicated e-reader alone.  This development wouldn’t be surprising, since the multi-function smartphone has replaced the dedicated music player for many users.

(The above is what I see as the consensus view. It’s not a unanimous one, though.   The Market Intelligence and Consulting Institute, which presumably has special insight into the Taiwanese companies that actually make the e-readers, predicts a bounceback in sales for 2013.  So we should at least keep in mind that the consensus may not be correct.)

Implications, if the FT is right?

In a world where the decision on what merchant to buy an e-book from hinges on what dedicated e-reader you own, the firm with the largest number of e-readers in circulation (Amazon) should be the dominant factor.  Other, non-compatible e-reader makers, like Barnes and Noble, should have small relative market shares.  Other would-be booksellers are footnotes, at best.

The game changes substantially, I think, if the key decision becomes what app the potential buyer has on his tablet.  That’s because any customer can download a new book app with a couple of taps.  Unlike the case with music, where users may want to construct playlists, it probably doesn’t matter much whether one’s entire library is on one app or several.  So the key factor in the purchase decision probably comes down to price.

It’s possible that AMZN can develop a tablet that’s the full equivalent of a Samsung or Google offering.  The performance of the Kindle Fire suggests that’s not likely.  But, if it can, perhaps AMZN can preserve its “ecosystem” with avid readers for a while longer.  And in doing so it would be able to bar the download of other booksellers’ apps onto its machines.

Personally, I doubt Barnes and Noble will be able to create a viable tablet.  Yes, it does have its alliance with MSFT.  But that only seems to me to guarantee that BKS can have the Zune of tablets.

AAPL is in an unusual position.  Its strategy has been to generate superior profits by selling up-market devices at premium prices.  Does it want to compete in the (eventual) $100 tablet market?  My off-the-cuff guess is that it doesn’t.  By default, this makes AAPL less of a player in the e-book market.

On the one hand, this would make the big publishers’ alliance with AAPL of a few years ago look extremely short-sighted.  On the other, it creates the opportunity for them to have a common app that bypasses both BKS and AMZN.

the stocks?

Any restructuring book distribution by cutting out dedicated e-readers is obviously not a reason for the companies that control the e-reader market to celebrate.  The biggest single loser, I think, is potentially BKS, since AMZN has 3x the market share in e-books that BKS has.  It isn’t that AMZN escapes the change unscathed.  But it already has lower prices than BKS; its large relative size gives it another big advantage in the price-drive. environment I think will develop.  Also, it’s not clear that AAPL will abandon the up-market strategy that snatched it out of the jaws of bankruptcy to become a serious competitor in the mass tablet market.

All in all, I score the situation as a net plus for AMZN.

The wildcard is potential new competitors who might be able do offer superior app performance.

Google’s proposed new class of common stock

the C class announcement

Yesterday, in conjunction with its release of 1Q12 earnings, GOOG published a letter to shareholders on its website.  In it, Larry Page and Sergei Brin outline their plans to create a new class of stock–C shares.

On shareholders’ approval, the new C shares will be distributed as a stock dividend, on a one-for-one basis, to all holders of A and B shares.  C shares will be publicly traded on NASDAQ, using a different ticker symbol from the “GOOG” the A shares use.  As will continue to trade, though.

no voting power

The sole difference among the share classes will be in voting power.  Each A share has one vote; each B share, held by corporate insiders, has 10.   C shares will have no votes.

Since holders of B shares–principally Mssrs. Page, Brin and Eric Schmidt–wield over 70% of Google’s voting power, shareholder approval is a mere formality.

Google intends to file full details of the issue with the SEC next week.

why do this?

…to keep voting control of Google in the hands of the current B shareholders.

How could control be lost?

…through a combination of sales by B holders, issuance of new A shares through stock options or acquisitions for stock.

current shares outstanding

According to the company’s 2011 10-K filing, 67.2 million class B shares, representing 672 million votes, were outstanding on December 31st.  258 million As, representing another 258 million votes, were also out.  Employee stock options on just under 10 million new A shares had been granted and remained to be exercised.  (Notably, I think, the stock option count is growing very slowly.  Google only granted options on 718,000 new shares last year.)

Therefore, assuming all stock options grants are exercised, A shares represent 28.5% of the total vote.  Bs represent 71.5%.

implications of the Cs

control structure frozen

The most obvious is that the new class will provide a way for the company to issue potentially large amounts of new shares without altering the current control structure of the company.  Google has already said future employee stock option grants will be for Cs.  Bs continue to rule.

price of the Cs vs. Bs

It’s not clear that the Cs will trade at the same price as the Bs.  Arguably, voting power should be worth something.  But in this case, as the company is currently constituted, the Bs’ votes basically have no value.  So you’d think the two prices should at least be pretty close.

stock options

Stock options don’t seem to me to be a big deal–or any deal at all.  Here’s what I mean:

If we assume all outstanding stock options are exercised, the company currently has a total of 940 million votes.  Bs have 672 million, with 268 million more for the As.

For the moment, let’s ignore the possibility that insiders sell a significant number of Bs to get walking-around money.  Yes, company rules require that Bs be converted into As before being sold, so no outsiders can end up with the super-vote shares.  Bs, therefore, can–and in the past have–disappeared.  And, yes, Mssrs. Page and Brin are halfway through a modest (for them) sell program that goes into 2015.  But put these thoughts to the side.

As things stand now, A shares can only achieve a voting majority if over 672 million are outstanding.  That’s an extra 404 million shares.  At the 2011 stock option issuance rate, the As take over in the year 2575, or 563 years from now.  At the 2010 issuance rate of 1.7 million, the As grab the reins in a mere 238 years, in 2250.

Suppose B holders sell 10% of their stock–because they need a loose $4.4 billion.  That would imply that the Bs outstanding shrink to roughly 6 million and As expand to 275 million.  In this case, the As still need 325 million more shares to take over.  That would happen, at the earliest, toward the end of the next century.

Even for long-term thinkers like Google, dealing with stock options worries can’t be a pressing issue.

stock-based acquisitions

This is the only reason I can see for the C share move.

True, Google has $44 billion+ in cash; operations generated $14 billion+ last year.  But a seller may well prefer stock to cash.  And, of course, a potential acquisition could be very large.  It could also be very large and very sick, needing a big infusion of cash after the purchase.

Yes, the founders’ letter says  “we don’t have an unusually big acquisition planned, in case you were wondering.”  I’m sure that’s true.  But I’d emphasize the word “planned.”  It seems to me that Google may well have decided it needs to make an acquisition of a certain type over the next couple of years and have developed a list of possible candidates. The next step is figuring out how to pay for it–which is what I think Google is doing now.

Who know what such an acquisition might be?  I wouldn’t care to bet on anything.  But I do have a guess, however   …somebody like Sony.  But that company has been such a train wreck for such a long time that I don’t see any percentage in speculating that Google would rescue them.  There are also severe legal obstacles that Tokyo has erected to deter foreign takeovers of its domestic firms.  On the other hand, Sony is a post-WWII upstart, not part of the establishment.  And the company does have TV technology, cellphones, tablets/PCs and the Playstation in tens of millions of homes around the world.

 

 

 

 

Google’s takeover of Motorola Mobility: implications

the deal

Yesterday morning before the start of trading in New York, Google and Motorola Mobility jointly announced an agreement for GOOG to acquire MMI for $40 a share in cash, or about $12.5 billion.  The takeover price represents a 63% premium over MMI’s closing quote last Friday.  The parties have also agreed to a breakup fee of $2.5 billion, or 20% of the deal price (an unusually large amount)–and that MMI will operate as a separate division of GOOG.  The deal is expected to close late this year or early next.

MMI ended Monday trading at $38.12 a share, a price that I think signals two Wall Street’s beliefs:   that the acquisition is highly likely to occur, and that a rival bidder is probably not going to emerge.  That’s my take as well.

MMI has three main assets:  by far the largest is its massive collection of cellphone-related patents; it also has a set-top box business; and it makes handsets.

why the acquisition?

Look no farther than the competitive situation in the global smartphone market.

In the early stage of any market, the field is wide open.  Entrants focus on building their own market share and ignore everything else.  With smartphones, we’re long past this stage.

As the market matures, the competitive field separates into frontrunners, and also-rans.  Typically, the stronger entrants turn on the smaller, weaker competitors–who fall by the wayside, one by one.  Think NOK and RIMM as being on the losing end.

A further sign of maturity is when the top dogs–in this case, AAPL and GOOG–turn on one another as the only additional sources to fuel further growth.  This phase comes last because the market leaders are typically the most difficult and expensive to wrest customers from.

That last stage is where we are now.

According to ComScore, the Android operating system extended its market share lead in the US during the three months ending June 2011 by 5.4 percentage points from 34.7% to 40.1%.  During the same period, the iPhone added 1.1 percentage point of share, from 25.5% to 26.6%.  The overall situation:  APPL is losing ground to Android, picking up a decreasing share of the customers being shed by RIMM and MSFT (NOK has almost none left to take).

AAPL is fighting with patents

Several reasons for this:

–smartphones are by far AAPL’s largest business, so growth here is important,

–APPL doesn’t want to introduce lower-priced handsets to compete with GOOG’s mid-market offerings, and

–its lack of patents is a potentially severe point of weakness for GOOG.

last week’s EU tablet decision is a case in point

The details can be found in the blog Foss Patents, but the bottom line is that Samsung’s 10.1″ Galaxy Tab has been banned for now from sale in the EU, ex the Netherlands.  What’s interesting is that the design drawings on which the ruling are apparently based are very generic  (look at pp.3-4).  They look kind of like Etch-a-Sketch screens and boxes without the knobs.  In fact, a ZD Net article suggests that the iPad itself isn’t an original idea–it looks amazingly like the prop tablets actors used on Star Trek.

In any event, last week’s ruling suggests that patent litigation can be unpredictable.  It can also have potentially disastrous consequences for the loser.

better safe than sorry

$12.5 billion is about what GOOG generates in cash flow during one year.  It’s also a bit less than a third of the cash the company has on the balance sheet.  The fact that this money is earning very close to zero is a key reason why the acquisition of MMI will likely be “mildly accretive” to earnings from day one.

So the cash is not a real issue, particularly since control of the mobile user is so key to GOOG’s–and APPL’s–future.

I’m suddenly a tablet advocate: here’s why

my take on tablets

I like gadgets.

I’ve had my eye on a tablet since I first saw one in a university bookstore (a MSFT product) almost a decade ago.  But that one was very clunky and didn’t let you do much more than highlight Word documents.  I looked at a Lenovo combination laptop/tablet a few years later, but it was very underpowered.  And there was still no infrastructure of applications to justify the tablet part.

Now there’s the iPad.  It’s the usual well-designed AAPL consumer device.  But to me it has seemed little more than another device to lug around that’s not much more than an expensive e-reader and an extremely costly way to play Angry Birds.

my newspaper problems

Then the Financial Times newspaper stopped coming to the house.

Yes, I still read the physical newspaper.

I read:

–the FT (comprehensive global business news; a UK perspective on US/world economic and political developments),

–the NY Times (reasonable, US-oriented business news, good–though weakening–sports coverage) and

–the Wall Street Journal (good sports, lots of gossip in the NY section, almost no useful business coverage–meaning I won’t renew).

why the physical paper

I’m not a fan of wood products per se.  But I’ve thought the physical paper has several advantages over the web version:

–the amount of news in the physical paper is greater than on the front page of the newspaper website.  So the editors’ selection of what’s most important is a greater influence on what you see online than in the physical paper.  As a result, the chances of finding information whose significance is not adequately understood is greater in the physical paper.

–I think the web presentation is organized to highlight stories that will maximize visits.  In contrast, the physical paper is organized to deliver information.

–I thought (not any longer) that it’s easier to reconstruct with the physical paper a timeline of information flow by reading back editions you might not have gotten on the day of publication than it is to go back a day or two in time on the website.

my call to the FT

When I called the FT last Saturday to get replacement copies of the papers that didn’t come, the representative I talked to mentioned the e-paper that’s available through ftnewspaper.com.

The site is run with software from Olive Software, a private company in Aurora, Colorado.  ftnewspaper.com has daily back editions.  You can turn the pages of each edition, just like an online catalog.  You can pop out to larger size and different formats the articles you want to read in depth.  I also discovered that, through FT email alerts, I had already read most of “today’s” paper online yesterday!

ftnewspaper.com has been around for a couple of years.  I just didn’t know about it.

my calculation

Anyway, I can cancel my physical paper subscription and save a couple of hundred dollars a year.  No more worries about cancelling delivery when we may be travelling.  No more toting around piles of unread orange newsprint.  Less recycling to do.

All of that just means that I can rationalize paying for a tablet with the money I’ll save by stopping a newsprint subscription.  But I’ve also found a sophisticated and valuable application, other than email, that’s completely suited to what a tablet can do and that I use every day.  This means that I have a positive reason to buy one.

I’d like to see the new Google tablets, as well as iPad 3, before I take the plunge.  I have only one concern.

one concern

In my career on Wall Street, I’ve observed the long struggle for control of brokerage houses between researchers and traders that has been decisively won by the latter.  I’ve thought of this as somewhat like the age-old high school contest between jocks/cool people and the nerds.

It seems to me that the same battle is going on in newspaper firms between traditional reporters and online search engine optimizers–the latter being more interested in eyeballs than in information.  As I study successful financial websites with an eye to improving this blog, I can see the same dynamic in play in this arena–well-crafted and very popular websites with lots of advertising, but almost no useful investment information.

By shifting my financial support from the reportorial nerds to the online jocks, I’m most likely speeding the day when even the FT will suffer from a content deficiency.    But that’s a problem for another day.

 

“Chromebooks,” Chrome-based notebooks finally arrive!! –and they look good

the Chromebook

Remember the Chrome OS from Google?  …announced in mid-2009, with the promise of Chrome-based netbooks in mid-2010 (see my post from way back then)?

What happened?

The Chrome operating system took longer to perfect than Google thought, and netbooks sales began to nosedive.  Whether this was due to the debut of the iPad or more competitive pricing from low-end notebooks (the latter is my guess) doesn’t matter.  Netbooks using Chrome would have been a non-starter.

What Google has just announced instead is the Chromebook, or Chrome notebook, which will be available for purchase in the US and western Europe on June 15th.

features

–made by Samsung (12.1″ screen, 3.26 lbs, 8.5 hr battery life) or Acer (11.6″ screen, 2.95 lbs, 6 hr battery life)

–Intel Atom processor

–8 second boot up

–small (unspecified size) SSD, cloud storage

–Chrome OS, Google apps–for now, Chrome notebooks will not be able to use traditional PC software; Google is working on a free service that will allow you to access Windows- or Mac-based PCs from a Chromebook, so you can use software installed on them, too

–printing either through Google Cloud Print, or through a link to a traditional PC.

pricing–

purchase:  $350-$500, depending on screen size and whether you elect 3G service or just stick with wi-fi.

rental:  Schools and students will be able to rent Chromebooks directly from Google for $20 a month; for businesses, it’s $28.  The price includes free replacement of lost/stolen/damaged units + centralized IT support for business users.

my thoughts

Score one for Intel.  Chrome is designed for either Intel or Arm chips, but Google is standardizing on the much more powerful Atom chip.

Google has picked two PC manufacturers with almost no presence in the US, and who therefore have no existing business to cannibalize.  They doubtless see Chromebooks as a huge opportunity to pick up market share and will do everything in their power to make Chromebooks work.

The replacement guarantee for renters should make Chromebooks especially attractive to schools.  If so, Google will gradually grow a generation of users with limited experience of traditional PCs.

Small businesses may find the savings of turning a lot of their IT administration over to Google to be big enough to justify a $28 a month price, since adminstration is a much bigger cost than the PCs themselves.  Large companies are a lost cause, though.  It’s not simply that they have so much legacy software; I imagine large corporate IT departments will fight this potential loss of their power with every office-political trick they have.

If Intel is potentially the biggest winner, other than Google, from the success of Chromebooks, Microsoft stands to be the biggest loser, in my opinion. Maybe buying Skype to dress up the appeal of Windows to consumers (and small businesses) isn’t so crazy after all.



net neutrality: one more time

Last week the FCC issued its latest pronouncement on net neutrality, the question of who regulates the internet–and therefore, implicitly, who owns it.  You can find the FCC releases and member commentary here.

background

Two pieces of background information are necessary to understand the meaning of the FCC statement.

1.  A while ago Comcast deliberately slowed down its service to BitTorrent, a file-sharing service.  Comcast said a small number of BitTorrent users were gobbling up huge amounts of bandwidth and slowing down service on its network for everyone else.  The FCC ordered Comcast to stop doing so.

Comcast successfully sued, arguing in court that the FCC didn’t have this kind of jurisdiction over it.  The case hinged on the FCC’s classification of the internet, not as a communications service, but as an “information” service.

Reading between the lines of subsequent statements by the parties and press coverage, the FCC decided to respond by saying it now realizes the internet is indeed a communications services, like plain old telephone service.  That would remove the internal contradictions in the FCC’s behavior.  But it would also potentially open the door to taxing internet access in the same way that phone service is.

Talk about driving a stake through the heart.  However, after hearing personally from over half of the members of the House of Representatives and a third of the Senate, the FCC changed its mind.

2.  In August, in the midst of the post-Comcast court victory discussion, Google and Verizon issued an internet manifesto (see my post).

what the FCC said

Last week’s FCC statement addresses the GOOG/VZN manifesto point by point.  The highlights:

–wired internet has one set of rules.  An ISP can’t block any content or services.  It also can’t deliberately slow down, or speed up, any particular content or services.  It can, however, offer different speeds of internet access to customers at different prices.

–wireless has another.  Basically, anything is ok, because the greater number of mobile internet service providers means consumers can switch ISPs if they don’t like what their current one is doing.

So far, this is more or less what GOOG/VZN suggested.  But…

–possible new services.  As I mentioned in my August GOOG/VZN post, I think GOOG wants to use its own money to build an internet service that’s more like the information superhighway that the rest of the developed world has, rather than the rutted country lane that ISPs have created in the US.  But before it invests billions doing so, it wants assurance that its service won’t be regulated as a public utility–that is, as if the network had been created with public money.  What GGOG/VZN got in this statement was just the opposite.

As I read it, the FCC says that a GOOG service would be subject to punitive regulation if it posed any threat to existing wired internet services.  But if a new service can’t be any better than today’s services, what’s the point?

jurisdiction?

The FCC asserts in its statement that it’s in charge–a reprise of Al Haig’s famous declaration, perhaps?  But the courts have been saying something else.  Congress seems to have the agency on a very short leash, as well.  And the new Congress may well have something more definitive to say.

Stay tuned.