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.

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.





net neutrality: Google, Verizon and the FCC’s “Third Way”

FCC call for comments

In mid-July, the FCC called for comments on its latest ideas on how it would oversee the internet and deal with net neutrality.  Formulated in May, the agency calls the proposal the “Third Way.”

What made the Third Way necessary was a Federal court decision in April, one I’ve commented on in an earlier post.  In 2008 Comcast had slowed the speed of customers’ access to BitTorrent, a peer-to-peer file-sharing service that Comcast said was hogging too much bandwidth.  The FCC ordered Comcast to stop doing this.  Comcast complied, but sued.  In the April decision, the court said that Congress had not given the FCC the power to issue the kind of order it did.

The first two “ways” the FCC thought it might proceed, but rejected, after the court ruling were:

–continue to issue orders to ISPs concerning their internet service, and run the risk it would lose in court again and again, or

–declare that it no longer considered ISPs to be “information services” but were actually public utility communication services like fixed-line telephone companies, thereby putting the commissions legal authority over ISPs on a firmer legal footing.

The first would be an exercise in futility.  Congress appears to have told the FCC in no uncertain terms that the second alternative was unacceptable.

Hence, the “third” way.

The Third Way

To my mind, the key clause in the wordy Way is:

” Protecting consumers and promoting healthy competition by, for example, providing greater transparency regarding the speeds, services, and prices consumers receive, and ensuring that consumers—individuals as well as small businesses—are treated honestly and fairly;”

In other words, the FCC’s job is to make sure the ISPs make it clear how much they are charging for what service, and that these rate and speed differences aren’t crazy.  This seems to me to be putting the best face possible on the court finding that the FCC doesn’t have the authority to regulate how ISPs control their traffic.  That’s because Congress hasn’t given it to them.  That situation could be changed in an instant,  but by Congess granting the FCC authority. But congress hasn’t done so.

rumored Google-Verizon deal

The story surfaced in the New York Times last week, and is amplified in a Wall Street Journal blog.  I think it’s likely to happen.  The purported agreement would have GOOG paying VZN a fee so that Android-based phones would have priority access to the VZN wireless system.

How is this consistent with net neutrality.  The explanation will turn in what, in my mind, is a semantic trick.  In the Comcast-BitTorrent instance, Comcast was implicitly offering two levels of service–regular and slow.  BitTorrent got the second, everyone else the first.  Although it’s understandable why Comcast would act the way it did, and the court said the company was within its legal rights to do so, advocates of net neutrality worry that this is the thin end of a wedge that would allow IPSs to slow down anyone’s access.  That would be a bad thing.

GOOG-VZN seem to want to define a third tier of service, call it “premium” or “extra-fast” or something like that, that’s faster than regular.  They will presumably argue that for GOOG to pay for this for Android phones is not a violation of net neutrality because no one in particular is being singled out for getting slower service.

The FCC Third Way manifesto suggests this argument will fly with it.  Newspaper reports suggest Congress will give a thumbs-up as well.

investment implications

First, let’s see if this actually happens.

It seems to me that a development like this is bad for AAPL’s iPhone, by giving the already attractive Android platform another positive attribute.  One might even imagine circumstances where GOOG would be willing to pay ATT for premium service on that network, forcing AAPL to either follow suit or maybe try to preempt with a larger payment.

In my earlier post on the court decision, I said that as a growth investor, my preferred way to try to benefit would be to buy makers of internet access devices.  If a GOOG-VZN deal emerges, an equally good (or maybe better) path will likely be through cash-rich content providers or through healthy ISPs.