trying to move downmarket is tough–Apple vs.Tiffany and Superscope (who?!?)

going downmarket:  the Superscope example

When I got my first job as a securities analyst, rookies were assigned coverage of companies no one else wanted.  So I got a bunch of firms with bad managements, poor operating procedures and/or failing strategic concepts.  I was happy to be employed, but otherwise I was less than thrilled.  But a comment by J.L. Austin turned out to be true.  I did learn a lot more about how business works by observing things going wrong than I ever would have by watching uniformly smooth sailing.

One of my first companies was called Superscope.  The company’s claim to fame was that it discovered Sony “operating out of a quonset hut” in Japan in the late 1950s.  It obtained from the then fledgling electronics giant an exclusive license to distribute Sony’s innovative line of tape recorders in the US.  The license made Superscope a fortune.

In the mid-1960s, Superscope bought Marantz which was then an ultra high-end maker of stereo systems.

In the 1970s, preparing for the reversion of the tape recorder license to Sony, Superscope decided it would replace the lost income by launching a line of inexpensive, mass-market consumer electronics devices.   It thought it would increase the odds of the line’s success by branding its offerings as “Superscope by Marantz,” thus grafting onto its boomboxes the Marantz brand qualities of exclusivity, high quality and dependability.

As the successor company website comments, “Naturally enough, the two brands became intertwined in consumers’ minds.”

Translating this marketing-speak into ordinary language, the move completely destroyed the Marantz brand.

The appearance of low-fidelity $150 stereo systems under the Marantz name shattered the image of high quality and exclusivity that had motivated audiophiles to pay many thousands of dollars for the original Marantz systems.   As I recall, it didn’t help either that the  boomboxes were very far from best-of-their-breed.

the Apple smartphone dilemma

Why this trip down memory lane?

It’s because Apple faces a somewhat similar problem with its smartphone business, which produces half the company’s profits.

As some Wall Street analysts have been point out for over a year, the market for $600+ smartphones in wealthy countries is approaching saturation.  The as yet untapped markets are in emerging nations like China or India, where older “feature” or “flip” phones still predominate.  But if your annual family income is, say, $5000, how many $600+ smartphones can you afford.  Answer:  zero.

That’s why many phone makers are collaborating with local wireless companies to develop and market smartphones that cost $100 or less.

How can Apple compete?  Should Apple try to compete in this market segment?  The risk is that it repeats the experience of Superscope.

going upmarket is easier

Oddly, experience says it’s much easier to go up-market, although often a company will create a new, upscale brand name.  That’s what the Japanese auto companies did, for example.  Nokia, too, with its Vertu brand–which consists of making ordinary phones into jewelry with precious metals and gems.

Tiffany magic

How does Tiffany come into the conversation?  It’s the only company I know that is able to be successful both at the high end of its market (jewelry at $10,000+) and the low end (key chains and trinkets for $100-).  I don’t know how the firm accomplishes it.  I offer the example only to say that the move downmarket can be done.

Verizon (VZ) outperforming Apple (AAPL)? …what’s going on?


Yes, it’s true.  Over the past three months, VZ is up 10.7% while AAPL is flat and the S&P 500 is down 4.2%.  We should toss in another 50bp to VZ’s outperformance because it has a high dividend.

Maybe there’s nothing to this.  After all, the stock market is, even at its best, a two-steps-forward, one-step-back affair.  So VZ could be having one of its forward steps while AAPL is temporarily in reverse.  The period in question is very short.  The overall market is also down over the past quarter, the kind of environment that favors more defensive stocks.  And, of course, VZ and AAPL were neck and neck through the first half of last year before AAPL rocketed ahead and left VZ in the dust.

Still, there may be something a little more substantial going on.  I don;t mean to argue that AAPL will be an underperformer.  The surprise may be that VZ continues to be an outperformer.  I may be biased here, too.  I haven’t finished my research yet, but I have recently bought some VZ.

the argument for VZ

the US cellphone market is maturing

According to Nielson, 69% of current cellphone purchasers in the US are buying smartphones.  If we break that out by age, close to 80% of new phone purchases by Americans under 55 years of age are smartphones.  About half of those 55 or older are choosing smartphones, too.

Given that there will be some–mostly 65+–users who will never adopt new technology, can it get much better than this?  I don’t think so.

strategy shift in maturing markets

In a recurring subscription business, the winning tactic in any new market is usually to stake out as much territory for yourself as possible, without much regard for profitability.   You don’t care what anyone else is doing.  You just want to get as many clients in the door as you can.

As the market matures, however, two changes occur:

–growth comes from taking customers away from competitors, not from finding people who have never used the service before.  This is typically harder work and more expensive, so firms with scale end to have an advantage.

–profitability becomes more important.  Firms try to raise prices and to cut operating costs.

I think this is where we are in the US cellphone market.

sources of profit growth for VZ

1.  lowering phone subsidies.  To use round numbers, let’s say VZ pays AAPL $600 for an iPhone 4s.  It resells the phone, linked to a two-year contract, to a customer for $200.  VZ loses $400 on the transaction.

If the company can persuade that customer to choose an Android phone that it pays, say, $450 for, it loses $250 instead.  So it’s $150 better off.  That’s all incremental profit.

Better (for VZ) still, if the customer chooses a Nokia Lumia phone, the loss may be only  $200.

In Europe, phone companies are experimenting with using INTC reference designs to make house-branded phones.  Why bother?  INTC is only interested in selling chips, so it is ceding the entire wholesale markup to the carrier.  So it may cost the carrier $350 for a phone it can resell for $200–meaning a loss of $150.

Make this sort of marketing shift for enough customers and the savings become significant, even for a company of VZ’s large isze.

2.  raising prices.  In a sign that VZ thinks its market is maturing, it is fundamentally reworking its pricing.  Starting late this month, customers will get voice for free but begin to pay for data.  No more all-the-data-you-can-use plans, either.  Interestingly, VZ is going to eliminate a $20 per month charge for the ability to make your phone a mobile “hot spot” for internet access.  So you can tether your laptop or tablet to your phone for free, just by asking VZ politely.  Why?  Videos look a lot better on a tablet.  And they’re very data intensive.

all good things end, someday

At some point, possible profit-enhancing measures will run their course.  But that’s probably several years down the road.  In the meantime, VZ’s profit performance vs.Wall Street expectations may be surprisingly good.

In a perfect world (for the holder of VZ shares), the company would be able to spin off or otherwise shed its fixed line and FIOS money pits.  For stockholders, that would be like hitting the lottery.  It’s very highly unlikely to happen, in my opinion.  But, on the other hand, there’s nothing in the stock price for the possibility.

will INTC make tablet/smartphone chips for AAPL: the AAPL point of view

Yesterday I wrote about this topic from the INTC point of view.  My main thought:  INTC is an attractive stock to own whether the answer to this question is yes or no, so you don’t need to figure this out to be a holder of the stock.  Having AAPL as a foundry customer would be a useful vote of confidence in INTC process technology, but it’s not necessary.

For AAPL, the answer isn’t so easy.

If we turn back the clock to the beginning of the year, AAPL was buying the processors for all of its Macs from INTC and having the ARMH-based chips it designs itself made by Samsung.  Why the split?

the semiconductor “arms race”

In simple terms (which is the best I can ever do), ten years or more ago the high cost of owning a fab forced the semiconductor makers to morph from integrated design/manufacturing firms to the current situation, where a large number of companies design chips and another, smaller and very capital-intensive, set makes them.  The design firms generally customize templates created by ARMH.

ARMH-based chips tend to be highly flexible and to consume little electricity.  But they lack raw processing power.   INTC, one of the few companies big enough to follow the older integrated model, makes chips that have immense processing power but aren’t very customizable and use a lot of electricity.  Mobile devices use ARMH chips.  PCs and servers use INTC chips.

ARMH is trying as hard as it can to boost the processing power of its offerings, so they can displace INTC chips in PCs.  The light bulb finally went on at INTC a few years ago that much of its market had changed and th customers no longer were lining up to buy the latest chip INTC engineers chose to fabricate.   INTC is now racing to make chips that customers wnat–that is, ones that are more flexible and use less power.

APPL’s situation

Mac:  Until 2005, IBM made the logic chips AAPL used in its Macs.  But this was, for IBM, a low-profit business that the company wanted to deemphasize.  As a result, IBM was unable/unwilling to produce the volumes AAPL needed.  INTC chips were better, and were readily available.  AAPL switched.

iPad/iPhone:  Several years ago, AAPL started an in-house effort to design ARMH-based chips to use in its smartphones and tablets.  It selected Samsung, another integrated firm and a competitor in the phone/tablet market, as its foundry.

Samsung trouble

But AAPL is now suing Samsung for copying its smartphone and tablet designs.  And, according to the EETimes, APPL is also beginning to shift its foundry business away from its Asian rival–presumably because of this.

Where should AAPL go?

One possibility is a foundry like TSMC, UMC or Globalfoundries (the combination of AMD’s former manufacturing + Chartered Semiconductor).  Another is INTC.

why INTC?

With either “pure” foundries or with INTC, APPL’s intellectual property will be equally safe.

The foundries would presumably be lower cost.  Also, they all have, to different degrees, databases of intellectual property that APPL could use.

On the other hand, INTC has a one-two year lead in process technology.  This means a chip design it produces for AAPL today on its machines would be smaller, faster and use less electricity than the same design made by a foundry.

TSMC is the safe choice

The safe choice for AAPL would be to go with TSMC.  It’s also the option that opens AAPL to the least second-guessing.  The main distinguishing features of the iPhone or iPad using TSMC chips would be the aesthetics of the device’s appearance, the app store and the status value of the Apple brand.

Also, if INTC is the permanent invalid that the stock price suggests, by selecting TSMC AAPL may dodge any future trouble that a weakened INTC may generate (what that might be, I have no idea–the worry would be that something would adversely affect the quality of foundry output).

the risk

On the other hand, it’s possible that some other tablet/smartphone maker–Asus, Acer, even Nokia–might link up with INTC instead.  If the INTC process technology works as claimed, then non-Apple devices would start to appear that process data faster and have longer battery lives than AAPL’s.  The “cool” factor might then start to pack up and leave Cupertino for Finland or Taiwan.

It will be interesting to see which choice AAPL makes.




will INTC make tablet/smartphone chips for AAPL?: the INTC view

recent analysts’ reports

A few days ago,Forbes published an article highlighting a report by Glen Yeung, an analyst from Citigroup, saying that AAPL will use INTC as the manufacturer for the advanced tablet and smartphone chips that it’s designing in-house.  Thsee chips will use ARMH designs, but INTC’s fabrication know-how.  Later on, speculates Yeung, AAPL could shut down its own design effort (more likely sell it to INTC, in my opinion) and rely 100% on INTC for both design and fabrication.

Similar reports have been circulating for at least a month.  In  typical Wall Street fashion, they follow a spate of other analysts’ output claiming exactly the opposite!!  –that AAPL, which uses INTC to power all its Macs, will ditch INTC entirely in the next year or two, in favor of its own ARMH-based chips.


I think this issue is interesting for three reasons:

–stuff like this is fun to talk about,

–what APPL decides now may be important to the market share it eventually stakes out in the tablet business, and

–contrary to what you may think, what AAPL decides makes no difference to the positive case for INTC stock.

I’m going to write about this last point today.

my take on INTC

1.  What catches most people’s eye about an advanced semiconductor plant, other than it requires highly specialized craft skills to run, is that it costs at least $3 billion to build.  That’s the wrong thing to focus on.  What’s more important is that to operate the plant effectively, you have to be able to sell the $7 billion+ of output it is capable of churning out annually.  If you figure the selling price of each unit at $100, that means 70+ million units a year.

If you don’t have a market that size, you’re not only pouring $3 billion down the drain by trying to make chips yourself, you’re ensuring a constant flow of red ink until you shut the plant down.

In other words, in today’s world it only makes sense for Intel, Samsung and third-party foundries like TSMC to build and  operate cutting-edge semiconductor plants.  ( In 2Q11, AAPL sold 3.8 million Macs and 4.7 million iPads;  that works out to about a 34 million units a year.)

2.  INTC is the best operator of advanced semiconductor plants in the world.  It has maybe a two-year lead over TSMC in process technology.

3.  The yin of mobile computing–the small size, low power market that INTC has missed up until now–has created a yang of demand for high power corporate servers and cloud computing that plays to INTC’s traditional strengths.

The fast growth of emerging economies over the past decade has created a large market of first-time computer buyers.  Unlike buyers in the US or the EU, who want tablets and smartphones, these customers want the high power laptops INTC has traditionally excelled at.

These businesses combined make up the majority of INTC’s profits today and are growing very rapidly.

4.  INTC’s stock has been such a poor performer recently that it’s now trading at about 9x earnings and yielding a tad below 4%.  If its consumer business in the developed economies were to completely vaporize today (including, of course, its Mac business with AAPL), I think the stock would still be trading at under 15x earnings and yielding more than Treasury bonds–but would be showing growth of 20%+.

5.  INTC had a management change a few years ago.  The new guys have been working very hard on delivering the small size, low power use chips that smartphones and tablets require.  So far, what they’ve done hasn’t been good enough.  But they’re making fast progress.  And who knows?

I think INTC now has a much better management than investors are giving the stock credit for.  But the real point is that at 9x and a 3.9% yield, the stock looks to me to have factored the worst possible outcome for the company’s business–and then some. So downside seems limited to me (remember, I own the stock), and hte upside oculd be large if INTC’s chips in 2012 onward perform as advertised.  Sure, having AAPL use INTC as a foundry would be a plus, but–yes or no–it doesn’t alter the fundamental positive case for the stock by much.


post-earthquake supply disruptions from Japan

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It has only been a little more than a week since the devastating earthquake/tsunamis in Japan.  However, a lot more information about possible supply disruptions is available now.  As an investor, the main conclusions I see, based on what we know to date, are:

1.  Many of the disaster-affected plants that are sole sources for key components supply the auto industry.  A number of auto manufacturers have already announced that they may soon have to shut down either individual production lines or entire factories for lack of parts.  Although I’ve owned auto stocks from time to time, this is not an industry I’m particularly interested in or familiar with.  But one of the main reasons I’m not a fan is that the industry is characterized by chronic (and huge) overcapacity.  So far it doesn’t appear that there’s any one component in potential shortage that’s used in virtually every car in the world.  So the effect of plant closings will be market share shifts, not a shortage of cars or trucks.

2.  It’s possible that electric power will have to be rationed, at least in the Sendai area, for many months.  The Japanese government tendency is always to prefer industry over the consumer.  Public outrage over currency speculators who bid up the yen in the aftermath of the earthquake–they’re being described as criminals who exploit human tragedy, the moral equivalent of gangs that loot stores during a fire in the city–suggests there won’t be any popular opposition to this.  The practical questions for factories where the problem is power (not that the earthquake destroyed the machinery) will be how quickly power lines can be repaired and what the limitations of the Japanese power grid are in delivering electricity from other areas of the country. (I’m assuming that, as the latest reports are suggesting, the Fukushima reactor crisis is finally coming under control.)

3.  With one notable exception, the Japanese technology-related firms that have announced earthquake-related shutdowns make commodity products, like DRAM or NAND flash, where alternate sources of supply are available.  Prices may go up a bit but devices will still get made.

The one exception: bismaleimide-triazine  resin (BT), a compound used to glue semiconductor chips to printed circuit boards.  BT is used in all smartphones and tablets.  90% comes from Japan.  The largest producer, Mitsubishi Gas Chemical, which accounts for about half of what the tech industry uses, has shut down production due to earthquake damage.

The other major Japanese source of BT is Hitachi Chemical.  It’s plants are still operating.  But, according to the Financial Times, the BT made by different chemical companies isn’t simply interchangeable.  Output differs enough that at the very least a period of testing is required before you can use BT from another supplier. The Wall Street Journal says this process could take a month for most kinds of circuit boards.  For cellphones, though, because of their small size and the specific amount of heat a given chip may throw off, the entire design may need to be changed in order to accommodate a different flavor of BT.

But the main issue is there’s no way for the rest of the industry to double production overnight–which is what would be needed to keep cellphone production rolling along at the current clip.

Mitsubishi Gas Chemical will likely make an announcement about the extent of damage to its Fukushima BT plant in the next few days.  All we really know now is that production has been halted.

In the meantime, MGC customers are doubtless talking to Taiwanese and Korean suppliers of chemicals that they wouldn’t have given the time of day to a month ago.   And they may be seeing what they can do to get increased allocations from Hitachi Chemical (good luck with that).

The BT story bears close watching.  If MGC production isn’t restored soon, disruptions to the supply chains of phone makers whose products use the MGC output could be severe.  Pain will be felt not only by the phone manufacturers but by all their component suppliers, as well.