July 2, 2007 at 7:40pm
· Filed under Advice, For Fun
Hype is by definition a short-term phenomenon. And Apple’s iPhone has epitomized it.
Of course hype, short-term results, and pumped up demand for product often blind market participants to long-term business ramifications and actual shareholder value creation. But on the other hand, world-changing innovations which started as hypes and were derided as fads have gone on to make fortunes for owners. So what’s the deal on the heels of the iPhone’s much-awaited debut — is AAPL overbought or underestimated?
Well, first a few qualitative thoughts. As much as I may not be able to tell you with certainty where AAPL will be in ten years, I can say this: they are the reigning kings of what I’d call synergistic marketing and demand creation. In other words, whether or not they are actually innovative (that’s up for debate — iPod was not the first MP3 player, for instance), they are better than anyone at convincing customers that there product is the coolest, hippest, and best must-have invention on the face of the planet. And their success has bred only more success and greater cross-selling revenue (Paul Carton has a great discussion of Apple’s halo-effect here).
Think of it this way — that Apple has been so successful and hip with the iPod has made computer buyers more interested in their other, largely unrelated product, the Mac. This should come as no big surprise — simple psychology informs us that, well, people love winners. This is at the heart of what I believe is Apple’s true competitive advantage. Apple has been and should continue for the foreseeable future to be a winner.
From a quantitative perspective, the added revenue if the company meets sales prediction for the next twelve months should be around $5-7 billion (or about 20% of TTM revenue). That’s assuming sales of 10 million iPhones. My quick and dirty estimate might put incremental net income from iPhone sales at around $0.60/share. So it’s not an insubstantial short-term factor. But in the long-term things become more interesting. Who’s to say the iPhone won’t flop in a couple of years and that the shares that have been so heavily bid up will topple?
Certainly not me, which is just part of the reason I won’t take a position in any shares (I generally don’t short, and almost universally avoid stocks with such rich multiples as AAPL unless exponential growth is a no-brainer). But I can at least speculate on what I think the future of the iPhone or iPhone-like products will be. For what it’s worth (and that’s probably not much coming from me), I’ll attempt to prophesy the future. I’ll keep it brief, but bold:
1) 1-4 years. The iPhone sees significant demand, but competing products (likely from shops like Research in Motion) begin to cut into market share and drive down prices as quality and functionality also increases.
2) 5-10 years. Hand-held, all-in-one personal devices will ultimately become nearly as good, affordable and universal as personal computers. They’ll steal share from the desktop and laptop markets, but those devices will never entirely disappear, though they may change forms. We enter new tech era.
3) 11-15 years. Owners of said devices begin to realize that it is too risky to carry their whole life in tablet form, so devices come equipped with a body-encapsulating bubble and a life-insurance policy.
4) 16-17 years. Given the slight inconvenience of personal bubbles, the iPhone as physical device is replaced by implanted brain chip with telepathic email functionality, trance-inducing sedatives that allow you to watch YouTube videos in your mind.
5) 18-20 years. YouTube, Apple, and Google merge to form You-Google-Appletube, with combined market cap (adjusted for inflation) of $17 trillion and a PE of 245.
6) 21-24 years. All human interaction is replaced by electronic communication.
7) 25-26 years. World peace.
Note: I do not have a position in any company mentioned in this article. I also don’t think we’ll ever see world peace.
March 6, 2007 at 7:49pm
· Filed under Advice, For Fun
Here’s a great piece from a friend and #1 Businessweek Entrepreneur Under 25, Brad Galiette. I believe it’s an important read looking forward, and I encourage you to take to heart the facts. Brad has first-hand industry experience and knowledge, and below he shares a number of insights with far-reaching implications for entrepreneurs and investors.
“Some of you may have doubted the financial viability of Web 2.0-oriented websites; indeed, this is something that, to an extent, even I don’t like to believe. But that fact of the matter is that the YouTube’s, Facebook’s, and even MySpace’s out there suffer from low-quality Internet traffic (i.e., non-US and under 18) that results in even lower quality monetization. Still doubting? For the first time in the history of the Web 2.0 paradigm, we now have publicly-released numbers from one of these properties (YouTube) thanks to the fact that its parent, Google (GOOG), released its 10K report within the past few days.
Although there is no explicit indication of YouTube’s revenues or income, Google has provisioned a helpful table of what these figures would have been for the company at large had they factored in the performance of YouTube assuming that it started including YouTube’s financials on January 1, 2005 (in one column) and on January 1, 2006 (in another column). Therefore, we can derive exactly what YouTube grossed and netted via subtraction.
According to the 10K, Google actually grossed $10,604,917,000 for FY 2006 and $6,138,560,000 for FY 2005; it recorded net income in the two periods of $3,077,446,000 ($9.94 diluted EPS) and $1,465,397,000 ($5.02 diluted EPS), respectively (page 36). Had YouTube’s financials been included since 2005, however, Google’s revenue would have been $6,138,575,000; therefore, in 2005, YouTube had revenues of:
$6,138,575,000
- $6,138,560,000
==============
$15,000 (yes, that’s dollars … not thousands of dollars)
The picture isn’t much better in 2006, where Google’s revenues, including YouTube financials, were $10,617,810,000, meaning YouTube had 2006 revenues of:
$10,617,810,000
- $10,604,917,000
==============
$12,893,000
Looking at net income, the picture is worse still. Had YouTube’s financials been included in Google’s FY 2005 and 2006 numbers, its income would have been $1,194,814,000 and $2,801,942,000, both noticably less than what they would have been without YouTube. Therefore, YouTube recorded 2005 and 2006 losses as follows:
$1,194,814,000
- $1,465,397,000
==============
($270,583,000) [2005]
$2,801,942,000
- $3,077,446,000
==============
($275,504,000) [2006]
(The YouTube-inclusive figures from which I’m deriving these calculations are all on page 84 of the 10K)
So, how exactly does Google’s board rationalize a price tag of $1.7 billion for YouTube? It’s clearly not the capital asset pricing model (because YouTube didn’t [and still doesn’t] own anything, has no earnings and little prospect thereof, and aside from VC inflows to keep it alive, had no cash to speak of). If you want to see some creative accounting, take a look at the top of page 84 where the purchase price is broken down as follows:
Goodwill: $1,134,687,000
Patents: $24,000,000
Tradename & Other $153,000,000 (this is nearly twice the $82.8 million value Google places on its own trademark, if you consider their 2005 intangible assets)
Liabilities & Deferred
Taxes: ($117,267,000)
That’s an enormous chunk of goodwill, mostly because YouTube owns virtually nothing (before their acquisition, in fact, they rented office space atop a pizza parlor):
And even today, YouTube is facing mounting lawsuits and lawsuit threats over the fact that they don’t own much of the most popular content that appears on YouTube. And the greatest irony, they still record a loss for doing this (bandwidth expenses for streaming video are exorbitant and cannot easily be absored by even high-quality advertising).
What’s historic about this 10K is that it is the first time that a Web 2.0 property has gone public with its financials. Even prior to the acquisition, Google didn’t make any details about the deal pricing public, nor did it reveal YouTube’s financials. The same was true in their November 2006 10-Q where the company said little more than that acquisitions (such as YouTube) may result in “writeoffs of goodwill” down the road. At least in the recently published 10K, the problems YouTube face are stated more clearly:
“…the anticipated benefit of many of our acquisitions may not materialize. For example, we have yet to realize significant revenue benefits from our acquisitions of dMarc Broadcasting (Audio Ads) and YouTube. “
Within the past week at a Morgan Stanley industry conference, CEO Eric Schmidt even went as far as to say that while he saw potential in YouTube, he noted that “it will take some time for the industry to figure out the right business model [for monetizing video].” (see it here)
But YouTube’s problems aren’t just limited to its exorbitant bandwidth costs — its traffic is unproductive (because it doesn’t represent an ideal demographic). A few months ago, I did a test run by buying some space on YouTube and seeing how it performed with some of the campaigns I manage in conjunction with my own business. In retrospect, that decision ranks among the worst decisions I ever made as an entrepreneur; I nearly lost a client because the quality was that bad.
Until YouTube figures out a way to get somewhat older, US-only visitors (said differently, until it figures out how to stop being YouTube), it will tax Google’s statements heavily until it’s spun off. Fortunately, the rest of the company does so well in its search unit that these problems won’t weigh too heavily on its long-term performance. The question, though, is how long shareholders will tolerate YouTube’s financial underperformance.
In fact, stuff is already hitting the proverbial fan:
“Google CEO hits back on YouTube purchase” (posted today at 2:12 PM)
Seeing my penchant for micro-cap stocks, a few readers have challenged me to share my “smallest” idea. I often find that good things come in small packages, and this may be the winner, at least in the “small package” department. It’s an itsy-bisty, teeny-weeny, little stock — barely visible under a microscope and about as illiquid as a rock.
Market cap, you ask? A whopping $580,000.
Transtech engages in the “supervision and performance of landfill monitoring, closure, and post-closure procedures. It provides environmental services for landfill and remediation sites. The company also engages in the management of methane gas recovery operations, and the generation and sale of electricity using methane gas.”
Here’s the (very simple) thesis and my take on its corresponding risks: Selling at $0.20 a share, the company has more than $1.20/share in tangible book value. Most of the book value is in cash, Treasuries, and restricted escrow accounts on the asset side while most of the liabilities are in “post-closure costs,” which are incurred by the company largely for a landfill it ceased operating in 1987.
This may seem like a huge margin of safety, but there are some clear and significant risk factors (aside from the obvious illiquidity problems). First, the bulky post-closure liability of around $8.5 million is, at its core, an estimate by the company and some third-party researchers. Using a standard discounted cash flow estimate, the company uses a 2.5% inflation rate and a risk-free 4.5% discount to reach its number. Estimates are also made in terms of how long post-closure activities will continue. Standard post-closures stretch thirty years, leaving another 10 for this particular landfill (1987 - 2007 represents the first twenty years). This is a model quite sensitive to inputs, which might be a concern for some investors (but since it works both ways, this could also understate the true post-closure cost).
Second, and no less important, the company runs perennial losses after adjusting for one time insurance claim gains in the past few years. It’s revenues are not nearly up to par with their very steep SGA expenses (including executive salaries approaching the market cap of the entire company).
Third, the company is also party to a number of lawsuits and governmental/municipality actions which could materially damage their results and their balance sheet.
It’s certainly not a stock for the faint of heart — its unclear liabilities, losses, and, of course, itsy-bitsy size are definite risks. But others may find its current margin of safety too nice to pass up.
It’s no mystery that a company with an established and trusted brand name maintains a hefty competitive advantage over current and would-be competition. A strong brand gives the company “market share of mind,” as I call it, while simultaneously giving the added benefit of pricing power. Brands may also reinforce switching costs, making it unlikely that regular customers will leave quickly. Just ask a Marlboro smoker to switch to Camels. Or a Coke drinker to start up on Pepsi.
As a quick exercise, here are what I consider some of the top brand names, which benefit from pricing power, switching costs, customer trust, and/or wide recognizability.
First, a disclaimer: I’m probably a terrible source on that will be “hot” in any short, arbitrary period of time (like 2007, for instance), and I will never make the claim that any company or industry I mention will beat the market in that same arbitrary period of time. In fact, there’s a great chance that everything that follows will indeed underperform in 2007. But that wouldn’t necessarily be a bad thing. Actually, it will make both more attractive purchases. Nonetheless, I wanted to highlight to two industries and one company in particular that I think investors may want to consider. I’ll weigh some of the risks and rewards for the long term (if not 2007).
ORGANIC FOODS – WHOLE FOODS, WHOLE PORTFOLIO?
Spotlight on:
Whole Foods Market (WFMI)
It was the S&P500’s worst stock for 2006. Wall Street beat up its share price last year as expectations met the reality. Believe it or not, same-store sales can’t grow to the sky.
Whole Foods’ CEO John Mackey has also taken a beating, going from hailed industry titan and organic food guru to one of BusinessWeek’s “Worst Leaders of 2006” and the subject of ridicule for the size of his paycheck (though he’s now paid just a $1 token salary).
But Wall St.’s fickleness is sometimes cause for investor celebration as great companies get hammered, providing bargain purchases for the contrarians. So that brings me to the point of this Whole Thing: is Whole Foods a bargain?
I’ll approach the risks and rewards in list format as best I can before delving into the valuation. Here goes:
PROMISE
- Great business with strong management, lots of room to grow, enjoying an expanding market for its industry.
- Perfect example of “People, People, People” article (management pay improved, one of the most respected leaders in the business in John Mackey, strong attention paid to the customer and shareholder, ranked as one of greatest places to work, most of the executive team has been with the company for over 10-15 years)
- Stores profitable from day one, 88+ stores in the works (with leases signed). Only ~180 now, operating in just 34 states, D.C., the U.K., and Canada. Lots of room to grow.
- Is increasing its brand awareness very successfully. The company is the largest and most well-known of its kind, and customers are willing to pay a little extra for service and experience.
- As they expand in size and brand loyalty, they can benefit from both economies of scale and pricing power, taking advantage of covering costs through higher volume of fresh foods while leveraging their brand and incessant focus on the customer’s experience to charge a premium. This is a competition killing two-punch combo, leading to both higher returns with wider margins over time.
- Their management has been very good at building a competitive moat – with an obsessive focus on the customer, the employees, and the shareholders, along with strong and increasingly growing brand awareness, the company is investing successfully in marketshare of mind, creating a culture that many will benefit from and many will be loyal to. Oh, and did I mention cost savings from economies of scale?
- As Charlie Munger has said, taking a competitive advantage to the extreme often benefits the company and insulates it from competitive pressures. Just as Costco took cost-savings to the extreme, Whole Foods takes its culture and people-friendliness to the extreme. That is their advantage.
- Many compare it to Starbucks in that company’s early days (check out Yaser Anwar’s article).
RISKS
- The question we have to ask is whether the company can really beat the burgeoning competitive landscape – Walmart, Wild Oats Markets, etc — and remain at the top of the industry to actually enjoy those competitive advantages for an extended period of time. Currently, Whole Foods is more successful than any competitor, and given the culture and lifestyle it is forming, I can foresee this being the case for a long time into the future.
- Another related, yet altogether different, question is whether the industry will continue growing given that there is some, though probably small, chance that it’s all a fad.
- Speaking of fads, America’s blitzkrieg on trans-fats, the obesity epidemic, and mounting health issues continue to open new market potential as customers become more educated and grow in number. It is difficult to tell whether this is a lasting societal change or an extended trend that will either be temporarily lived or overcome by another. If the former, the chances are high that growth will continue at a rapid pace over the next ten to fifteen years plus for this outstanding company.
- Though I’m not confident enough to place much money on it (at least not yet), I believe that the industry and the company are in good shape and will stick around in full force for the foreseeable future.
- Despite the big pullback from the $80 per share days, the company still trades at a high PE around 32. We’ll talk about this further in the valuation section.
OTHER PROS/CONS (aka THINGS I LIKE, AND THINGS I DON’T LIKE)
- Stock option plans
PRO – With its generous payouts, employees are digging it and staying happy, which trickles down to the customer
CON – Dilution. The size of the stock option plans mean current investors won’t have as big a claim on future income as otherwise possible.
[Optional Note on Options: Though the grants are expensed on the income statement, I always question the wisdom of valuing them based on the Black-Scholes model. Though this is clearly not the company’s doing, but rather SFAS guidelines, I think the Black-Scholes model is great for pricing short-term options, but poor for pricing LEAPS. Whenever you have a company that is expected to do well and whose share price will increase over the long-term, assumptions like volatility and interest rates that enter into the Black-Scholes model can lead to wide errors in what those options are truly worth (usually understating the value and hence understating the expense while partially hiding the dilutive effect). The company mentions that it intends to avoid dilution greater than 10% in any one year. But even so, that’s still a lot, and with an increase in shares outstanding of around 5% annually over the last few years, it’s something for investors to keep in mind.]
- Returns
The company’s average returns on capital over 5 years are high relative to the grocery industry (around 12% versus the industry’s 9.6%). They do this with basically no debt, save for some small line items. Capital has historically been internally generated cash flow that is reinvested in the business along with equity from the issuance of shares to “team members.” These returns are not objectively very high, but for grocers it is.
VALUATION
I’ll try to keep this as simple and short as possible. Let’s assume that the company’s free cash flow of $215 million in last FY (Net inc of $204 + Depreciation of $156 – Maintenance Capex of $145) will continue to grow at 15% over the next ten years. After that, the company will grow FCF at 5% per year. Assuming a WACC of around 10% (probably high), we get a value for the company of $9.8 billion (its current market cap is around $6.6 billion). That would represent a 33% discount from intrinsic value.
But is this realistic? Well, again, that depends how you weigh the risks and likelihood that the company continues its growth trajectory as we know it.
The company is ambitious in opening new stores and is aiming for sales of $12 billion by 2010. With a (simplistic) calculation that this would mean earnings of around $420 million (based on the company’s consistent net profit margin around 3.5% and not accounting for the possibility that this margin could improve based on economies of scale and pricing power, as mentioned above), which would, in turn, mean that the 15% growth rate may be low.
But, on the other hand, if the competition, big and little, starts eroding market share and pressing margins and operating results, a value near $10 billion might well be as good as from thin air.
While this may seem anticlimactic, this brings me to an important point. DCF, multiples analysis, or any other valuation method is pointless unless we first size up the business’s true long-term potential. Whole Foods is a promising enterprise, with great management, a solid business model, and strong financials. It seems reasonable (though not necessarily a no-brainer), that the company can justify its high PE and, in fact, still be a bargain.
Because it doesn’t strike me (yet) as a no-brainer, I personally have no money in it.
That said, I will be watching Whole Foods very closely in 2007, and if prices begin to leave investors with a wider margin of safety, you can rest assured I’ll be on it.
[Another Optional Note: if investors wish to get really fancy and want to bet on Whole Foods dominance vis-à-vis competitors, as distinct from Whole Foods being undervalued per se, they may wish to take a look at the fact that competitors like Wild Oats (OATS) and Hain Celestial (HAIN) trade at PEs close to WFMI. By shorting competitors and buying WF (or buying calls on WFMI and puts on competitors), investors could, in theory, still make money if WFMI underperforms, so long as OATS and HAIN underperform even more. This is pretty risky and I wouldn’t do it, but for someone looking for a nifty trade, it’s a thought…]
THE HOMEBUILDERS – BUYING WHEN NO ONE WILL
Let’s cut to the chase: Everyone hates the homebuilders now, and the short-term outlook isn’t good. Many pundits predict the market has yet to bottom, and given their already hugely out-of-favor standing and un-promising future, their stock prices have suffered big-time in the last year. You know what that means for me: take a look for bargains.
Since I just chewed your ears off with Whole Foods, I’m going to keep this discussion short, and instead provide a link to someone who describes the opportunity better than I could. Though the link is from August, much of it is still relevant to today. Also, although the Absolutely No DooDahs links are no longer active, the post is informative and I highly recommend it.. Suffice it to say that I agree with him, as I seem to on many things.
Scroll down to the “On Homebuilders” article and read:
Just back from that long day of last minute Christmas shopping. For fun, I kept copious notes (okay, maybe not so copious, but you get the point) on the busiest and the not so busy storefronts on this quite hectic mall day. Basing this purely on my eye-witness observations and anecdotal evidence, I’ve ranked the top four on a rough density measure - that is, how full the stores seemed per square foot.
First, the best:
4. Yankee Candle Company (YCC) — If someone told me earlier that a candle store was jam-packed with husbands and sons picking up doo-dads and scented wax for their wives and mothers, I would probably have laughed in their face. But it is, indeed, true. Lots of teens and husbands without a clue packed in the tiny store to collect a potpourri of scents for the women in their life. Green apple, red cinnamon, pumpkin pie, buttercream, anything you can think of. The company recently announced that it will be acquired for $1.7 billion by an affiliate of Madison Dearborn Partners, LLC. Looks like they must have done their scuttlebuttin’ homework.
3. Build-a-Bear Workshop (BBW) — Everyone’s favorite do-it-yourself plush toy store (okay fine, the ONLY do-it-yourself plush toy store) was a hopping hit today. Bustling with folks building their own special bears, the store is not-so-quietly proving that their concept is working and sustainable. The stock has hovered since its IPO a few years ago, but the company’s margins, growth rate, uniqueness, and popularity may be reason to put it on the radar. Mama Bear, Papa Bear, and Baby Bear approve.
2. Abercrombie & Fitch (ANF) — Sex really does sell. Alot. I walked by both Abercrombie and Hollister (owned by ANF) to see scantily clad “salespeople” luring customers in to check out the(ir) goods. Not surprisingly, it worked. The store was loaded with teens and 20-something year olds spending their [parents’] hard earned money on ripped jeans, faded t-shirts, and oh-so-soft fleeces (one “saleswoman” flirtatiously insisted that I feel just how soft they were. So I know.) On another note, I had the opportunity to meet ANF’s colorful CFO, Mike Kramer, back in October. He spoke at length about the company’s mission to build a lifestyle rather than just a clothing company. They believe that this lifestyle, however scandalous, is critical to creating and maintaining a competitive edge. If today was any indication, they’ve done this quite well. Good job, Mike.
1. Apple (AAPL). I have one word to describe the volume of shopping at Apple’s storefront. WOW. Apple destroys the competition when it comes to the population density at their storefront this holiday season. I could barely move when I tried to step in the door, and I was struck by just how popular the place was. Now, everyone knows that iPods are in the running for the season’s most popular gift item, but I still could not believe how many people flocked to the little corner store manned by those friendly little geeks (I can call them that because I’m a fellow geek) always looking to lend a helping hand or a thoughtful suggestion. Whoever told Steve Jobs his storefront concept was a bad idea was dead wrong. (Note: A friend of the site forwarded me Yaser Anwar’s blog, which more rigorously confirms the density measures. My senses aren’t so bad after all )
Okay, now the not so good. I’ll exclude the mom and pop shops and focus only on the publicly traded companies that we’ve all heard of. So, here are the three worst of my shopping day — the empty, desolate, and dreary storefronts with no one showin’ them any love. I won’t go into too much detail bashing them, since you get the point. And I feel bad…
3. The Gap (GPS). Looks like the Gap has fallen into itself. There were a few straggling customers, but overall, after passing the store four times over the course of the day, not once did I see any noticeable volume. And when salespeople are caught filing their nails on the job during the holiday season, it’s usually a bad sign.
2. RadioShack (RSH). I’ve looked into the company before when huge sell-offs dropped the stock price to basement levels, but despite some strong cash flows, the company continues to struggle against more powerful competitors (like Best Buy, etc.). I seemed to find much of the same today.
1. Hot Topic (HOTT). A “music/pop culture” clothing and accessories store, I saw no more people than the vaguely Gothic employees sitting idly waiting for the next customer. And waiting. And waiting.
Obviously, none of this constitutes rigorous research in any way, shape, or form, but I thought it would be fun to share. Portfolio food for thought, if you will.
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