Rotten Apple? On innovation and deflation


Apple reported on Tuesday a decrease in quarterly sales for the first time since 2003. The trend in itself was less surprising than its magnitude – revenues dropped by 13% on a YoY basis and, more importantly, fell short of analysts’ estimates. CEO Tim Cook used a bunch of arguments to justify the unexpected underperformance – blaming in turn a strong dollar, difficult economic conditions especially in APAC and difficult “comparisons for iPhone sales” – but could not prevent Apple’s share price from dropping by 8% right after the announcement and is now trading 7% below its pre-announcement level. All equity analysts have revised their target share price downwards and most of them believe that $120 a share is now a realistic long-term value, which only gives a 24% upside to existing shareholders. The Financial Times has even dared to state that “Apple [was now] living in the shadow of its own past success”. After more than a decade of impressive performance, is the love story between the firm and Wall Street coming to an end?

$48bn of shareholder value vanished overnight. Source: Yahoo Finance
$48bn of shareholder value vanished overnight. Source: Yahoo Finance

What is irrefutable is that the market is increasingly realising that Apple will likely remain a one-product shop in the foreseeable future. Growth in ancillary products and services can be perceived as impressive – 30% and 20% YoY respectively – but the iPhone still generates almost two thirds of Apple’s revenues. And when this core engine starts coughing earlier than expected, as it did over the last quarter – 50.4m iPhones shipped over the quarter vs. 51.2m forecast by analysts, down 16% YoY, with an average sales price (ASP) of $641 vs. $658 anticipated – the full firm wobbles.

Split of Apple's Q2 revenues by product. Sources: 8-K report, author analysis
Split of Apple’s Q2 revenues by product. Sources: 8-K report, author analysis

This slowdown could nonetheless have been anticipated. Since 2012, Apple has launched at least a new iPhone model every year in September in an attempt to boost not only its sales volume, but also its ASP as older models became increasingly cheap. This helped the firm create maintain a decent ASP until the next model was launched – a usual pattern in tech: innovation is the best way to fight deflation. Depending on the price point chosen for the new model, the mix between volume and ASP uplift varies – for instance, as the chart below shows, the iPhone 5 was a ‘volume’ hit whereas the iPhone 6 and 6+ primarily lifted the ASP. The issue is that the iPhone 6S and 6S+, launched in September last year, did not manage to achieve any of those two objectives. Analysts blame the extending renewal cycle as a root cause. This is possible. What is certain though is that the ‘boost’ last year was much shorter-lived and the landing is more severe than it was over the previous years. Q3 (ending in June) is expected to bring no improvement, especially on the ASP front, given that Apple just launched the iPhone SE, priced at $400 in order to further penetrate emerging markets.

Quarter-on-quarter evolution of iPhone volume sold and ASP. Sources: Apple 8-K reports, author analysis

Using EV/LTM EBITDA and EV/FWD EBITDA valuation multiple benchmarks to adjust for differences in capital structure, Apple now sits in the same ballpark as many high-tech hardware manufacturers such as IBM, Intel or HP, trailing true ‘software developers’ such as Facebook and Google – a gap that kept widening since Facebook announced brilliant results for the same period. This means two things. First, as previously written, Apple is still largely perceived as a hardware company and it will take time for the markets to believe in the services as a real growth pillar. Second, the market believes that, with an installed base of 500 million iPhones and more than 1 billion Apple device users worldwide, Apple’s golden growth era is now behind and that we should not expect similar the future to be a replica of the past. In the manner of the world’s largest banks which have become ‘too big to fail’, high-tech behemoths are now ‘too big to soar’.

EV/EBITDA benchmarks as of 28 April 2016. Sources: CapitalIQ, author analysis

Apple also made a couple of surprising announcement with regards to its financing structure that left analysts even more circumspect. The firm indeed decided to expand its share buyback program from $140bn to $175bn and to increase its quarterly dividend will be increased by 10%. The company is still sitting on more than $230bn of cash and equivalents and this redistribution program should not impede its acquisition firepower if need be. Nonetheless, Apple has been returning increasing amounts of cash to shareholders since 2012 and this cannot be interpreted as a good signal if you remember one of my earlier posts. The firm uses buybacks and dividends to support its share price by implicitly believing that any incremental project it could invest in would not generate any better return than the one shareholders would get elsewhere on the market. With the S&P 500 down 1% over the last 365 days and interest rates at an all-time low, Apple states loud and clear that there are not many growth levers available on the market at a decent price right now.

So, is there any hope? Yes. First, Apple still benefits from a strong brand image and high customer loyalty, which enables it to command a price premium while limiting the risk of massive and sudden ‘customer exodus’. The launch of the iPhone 7 later this year will be a real make-or-break since analysts, as well as the general public, have been waiting for the ‘next big thing’ for too long. apple-icloud-logo1Second, Apple made its entry in the services arena early enough to establish a significant position, primarily through iTunes and, to a lesser extent, iCloud. If it manages to keep a competitive advantage against Amazon, Google and al., Apple will not only be able to maintain a strong financial performance but also get closer in terms of market perception to the real ‘software disrupters’. In the meantime, Wall Street is granting the company the ‘benefit of the doubt’: hard for them to change sides and burn the idol that they used to venerate.

Whatever happens in the future, this is a perfect illustration of the race between innovation and deflation that has been shaking high-tech companies for decades; you need to keep running to stand still. If you stop innovating significantly enough so that your products are not perceived as clearly ahead of the technology curve, you face a huge risk of ‘commoditisation’ and dilution into a very competitive and agile market. Microsoft and Nokia will not disagree.

P.S.: The full Earnings Call presentation and podcast are available on Apple’s website.

Brexit: How tight is it, really?

brexit-ballot-boxWith the official referendum expected in less than two months, the latest polls on Brexit show a narrower than ever gap between both camps. The Financial Times’ Brexit poll tracker shows that the June referendum could go either way. However, as mentioned in an earlier post, bookmakers such as Betfair have barely adjusted their odds over the last few weeks and still predict a victory for the ‘Bremain’ side with a 65% probability – and even closer to 75% following Barack Obama’s visit to the UK last week. How can we reconcile those two facts?

Evolution of implied ‘Bremain’ success odds according to Betfair.

First, to reiterate an argument already developed on that blog, bettors and bookmakers believe that, unconsciously or not, individuals positioning themselves in favour of Brexit do not reveal their real vote intention to pollsters. A similar bias can be observed in voters’ behaviour towards the most extreme parties prior to an election. A share of the self-declared ‘extremist’ electorate will actually revise their intentions just before putting the ballot in the box.

Result of the first round of the 2002 French Presidential Elections

That being said, the reverse trend used to be true in some countries such as France – i.e. individuals planning to vote for the Front National were fearful of revealing their real intentions and hid it to pollsters – and partly explained the 2002 French Presidential Election upset where Front National’s Jean-Marie Le Pen unexpectedly ousted Parti Socialiste’s Lionel Jospin from the second round. Being able to identify and quantitatively assess behavioural biases has become part of survey institutes’ core job, especially in tight contests such as the one we are witnessing today.

Unconscious behaviours nonetheless do not fully explain the discrepancy between polls and bookmakers. Statistics also come into play. In the context of the Brexit referendum, the Bremain camp has indeed managed to maintain a small, although very narrow, lead in most of the polls. As a consequence, the odds of the Bremain camp winning are actually greater than the gap could lead us to believe. To illustrate this fact, let us assume that the distribution of vote shares in favour of ‘Bremain’ follows a normal distribution – the infamous ‘bell curve’.

This distribution is centred around an average of 52% – i.e. on average Bremain wins by a 52-48 margin. Let us also assume that we are almost certain (with a 95% certainty to be perfectly exact) that the Bremain camp will score between 44% and 60% on D-day. The resulting bell curve is drawn below, with the shaded area representing the area sitting above the 50% threshold – i.e. the area where the Bremain camp wins. Although we built the bell curve around a 52% average, the shaded area represents 69% of the total area under the curve, which means that the Bremain camp has a 69% chance of winning. The parameters for this example have not been chosen randomly: 69% is indeed very close to Betfair’s latest estimates.

Bell curve with average of 52% and std deviation of 4%. Shaded area corresponds to p>50%.

This exercise would theoretically give us a lot of confidence on the referendum outcome. In practice, the exercise is unfortunately made much more complicated by the high share of ‘undecided’ voters, standing at roughly 30% of the voting population as of today. Given its size, this group will clearly decide on the referendum’s outcome and can overturn any statistical projection. Being able to predict the behaviour of such a heterogeneous group has therefore become the focus – and the nightmare – of all pollsters – notwithstanding the bookies.

Stamping the housing market


Last week the Financial Times used the latest Office for National Statistics (ONS) housing price figures to assess the impact of the stamp duty raise on the housing market. Since the beginning of the month, purchasers of buy to let property and second homes indeed face a 3% stamp duty surcharge. Some experts believed that prospective second home buyers would rush to complete their transaction before the deadline and would thus generate an artificial and temporary price increase.

The FT article took the opposite view and concluded that “UK house price growth weakened slightly in the year to February, to 7.6 per cent […] meaning that a boost reported by mortgage lenders and estate agents ahead of stamp duty changes for buy-to-let investors is yet to show up in official data”. This statement surprised me and I decided to dig further into the data. My take is the following: although the statement may be true at a global level, by performing the analysis for each Government Office Region separately, one could conclude that the impact of the stamp duty reform was actually much more significant.

k12985080To perform this exercise, I used two publicly available sources of data:

  • ‘Number of residents with a second address in a region, who are usually resident outside of that region’ and ‘Number of usual residents in a region with a second address outside of that region’ as per the 2011 census;
  • ‘Mix-adjusted average house prices by region’ published monthly by the ONS.

First, we need to understand that all UK regions are not equal. The more second houses a given area hosts, the more impact the stamp duty reform should have had. The most recent information on the topic comes from the 2011 Census which gives us the number of residents elsewhere with a second address in a given region – e.g. in 2011 184,616 people had a second address in the South East.

Number of usual residents elsewhere with a second address in the area (2011). Source: 2011 Census

Separately, the ONS data gives us the year-on-year house price evolution in each area from July 2015 to February 2016.

Year-on-year housing price evolution by region. Source: ONS
Year-on-year housing price evolution by region. Source: ONS

Nonetheless we are not interested in the price growth rate but by the increase of the growth rate as the stamp duty implementation deadline approaches. I have therefore compared the average housing price increase (in percentage points) in January and February 2016 with the one witnessed in July and August 2015 in each region – I have taken a two-month average to smooth out any shock. The analysis shows wide discrepancies between regions – for instance the growth rate increased by 5.0 percentage points in London over the period but actually decreased by 2.7 pts in Yorks & Humber.

Increase in housing price growth rate by region, January-February 2016 vs. July-August 2015. Sources: ONS, author analysis

Finally, I look for a correlation between the number of second addresses and the increase in housing price growth rate.

Correlation between housing price growth rate increase and number of second addresses

The correlation between the two variables is clear and we could therefore conclude that the stamp duty change has ‘warmed up’ the housing market in the regions with a high number of second addresses. The stamp duty effect was indeed pushing buyers to complete the transaction as fast as possible, even if it meant paying a higher price (up to 3% more actually). The surge in gross mortgage lending witnessed in March by the Council of Mortgage Lenders supports this conclusion. On a side note, this is another piece of evidence illustrating the fact that the UK housing market remains a ‘seller’s market’ – in a ‘buyer’s market’ you would have conversely seen a drop in prices as sellers try to get rid of their property before having to pay the surcharge.

Stamp_Duty_Paid_mark_for_British_cheques_from_1956It would be interesting to keep an eye on the market prices in the future. Given that purchasers have by definition a limited purchasing power, was the bump just bringing forward future increases (in that case the market should cool off for at least a few months) or will future sellers be able to maintain enough competitive tension to use the ‘overheated’ prices as the new normal?

Watch the step – Paradigm shift ahead

Have you fastened your seat belt?
Have you fastened your seat belt?

Last week the IMF downgraded its global growth forecast for 2016 to 3.4%. Among the developed economies, only the US and the UK show encouraging signs, with forecast growth of around 2.4% for this year. Growth remains limited despite abnormally low interest rates and a debt stock only seen in a WW2 context which low inflation cannot clear. Such a sequence of bad news could trigger only one question: is the ‘crisis’ back?

Advanced economies' debt amount as share of GDP. Source: Le Figaro.
Advanced economies’ debt amount as share of GDP. Source: Le Figaro.

The commodity price drop witnessed at the beginning of the year has taken its toll on the lending and bond side. 46 corporate borrowers have already defaulted on a total of $50bn of debt so far this year. According to the Financial Times, more than 80% of investors expect the default rate on junk-rated companies to reach at least 5% by year-end. This has already caused the liquidity on the bond markets to dry up, practically barring the weakest companies from accessing fresh capital inflows. Private equity sponsors, which are well known for making highly-leveraged acquisitions, have seen the default rate for their leveraged loans go from 0.88% on 31 January to 1.46% as of 31 March. Again, this tightness happens at a time of very affordable debt, which can make us fear the time when Central Banks will sketch a move back towards positive interest rates territory. At a country level, lending from the World Bank has reached its highest level since the aftermath of the 2008 financial crisis. “It is our highest lending in a non-crisis period ever” added the World Bank’s president. If we are not in a crisis then where are we?

What is certain is that the root causes have been identified for months: “sluggish capital investment, falling industrial production and declining business confidence” which partly feed themselves from geopolitical uncertainties (Brexit currently topping the agenda) and a lack of politically supported structural reforms – on the latter, we cannot blame politicians for favouring electorate-friendly measures over high-risk initiatives one year before reelection time.

Three leaders that put their job back in play in 2016 and 2017
Three leaders who will have put their job back in play by 2017

To solve these issues, all only have one word to say: ‘GROWTH’. The IMF estimates that one additional point of growth would enable the advanced economies to bring their indebtedness ratio to pre-crisis levels. But experts strongly diverge on practical ways to get hold of this extra growth.

Although many lights are red-flashing on the world economy dashboard, I agree with IMF’s Jose Vinals and I do not believe we are heading towards a ‘sudden’ crisis of the type we faced in 2007-2008. I nonetheless think that we are entering a world where low growth and low inflation will become the new norm –

Olivier Blanchard
Olivier Blanchard

former IMF Chief Economist Olivier Blanchard writes about a ‘weak recovery‘ situation. Once decision makers and Central Banks will have realised that achieving 2% of inflation annually is not realistic in a world where innovation builds on limited capital accumulation, where disruption takes place through not only better features but also lower prices and therefore drag inflation down (take the example of Airbnb or Uber) and where 5 out of 10 America’s fastest growing jobs pay less than $25k a year, the money tap will stop running, there will undoubtedly be a few winners but many more clear losers. And the interest rise wall can be closer than we think: in the video below, US Federal Reserve Chair Janet Yellen justified the December 2015 rate increase by the fact that labour statistics were positive – still the case as the US is experiencing its longest-ever streak of private sector job growth ever – and that “the Federal Reserve was feeling reasonably confident in the fact that inflation would move up over the medium-term back to 2%” – i.e. there is no need for inflation to reach 2% for rates to go up again.

The big question is now if the paradigm shift happens, how will it do so, and which target will Central Banks will be asked to go for. A brand new uncharted territory for the economic theory to discover.

A plan B for point C

Hinkley Point C (artist view). Credits:

The debate about Hinkley Point C, although not new (the project has been on the table since 2008), has got passionate over the last few weeks, involving incessant decision adjournments, a CFO resignation, diverging positions from two engineering groups both operating within the same company as well as the usual high volume of well-intentioned statements from politicians sitting on both sides of the Channel. The current situation stakeholders are facing could appear surprising and complex; however, this tension could have been forecast from the beginning by simply paying attention to each one’s incentives.

For the UK government, for instance, the optimal behaviour is straightforward: they should keep championing the project, which features as a prominent part of their ‘cleaner’ energy strategy – the UK government intends to cut carbon emissions by 60% by 2030 – and acts as a strong relationship builder with China – which indirectly owns one third of the project. Furthermore, under the current contract terms, the UK government does not bear any financial risk linked with the construction of the plant – actually, the longer the delay, the higher the compensation penalties EDF will have to pay. The only itching point is the high purchase price promised to EDF for the electricity generated: £92.50/MWh, i.e. more than twice the current electricity wholesale price and the equivalent of $150 per oil barrel according to Deutsche Bank. That being said, the first bill will not come before 2025, which leaves room for 2 successive governments, including the current one, to put this point back on the table as (and if) the project moves forward.

EPR project in Flamanville (France)

For EDF Energy’s employees, the situation is as straightforward, but in the opposite direction. Combined together, the size of EDF Energy’s initial financial commitment (£18bn), the back-and-forth movements the Hinkley Project has been subject to as well as the unproven nature of the European Pressurized Reactor (EPR) technology and the delays that the other projects using the same technology are facing throughout the world appear as great ingredients for a disaster recipe which could wipe out a significant portion of EDF Energy’s equity value – Areva_Logo.svgvalue which already got weakened by EDF Energy’s acquisition of Areva’s distressed nuclear reactor business in January. That is in substance the point Thomas Piquemal, EDF Energy’s CFO earlier this year, defended to the extreme by summarily resigning last month – pouring additional oil on the fire.

Delays and overruns of EDF's other 2 EPR projects. Source: Financial Times
Delays and overruns of EDF’s other 2 EPR projects. Source: Financial Times

China General NuclearDespite its strong financial interest in the project through General Nuclear Power Corporation, the Chinese government has stayed mum. At first sight, this is surprising. With hindsight, it clearly appears that the Chinese stakeholders do not need to make any effort or take any decision. Financially speaking, they are in the same boat as EDF Energy, which also needs to fight to defend its wallet. Politically speaking, the Centrica withdrawal has reinforced their minority investor position. As a first-of-a-kind cooperation in the nuclear energy sector between China, France and the UK, one can expect that the last two will do anything to keep the relationship afloat.

Dr-Jekyll-y-Mr-HydeThis leaves us with one torn – and sometimes schizophrenic – entity, namely the French government. The ‘Dr. Jekyll and Mr. Hyde’-type behaviour of the French State as shareholder is not news and already got criticised by the Cour des Comptes in 2008As a 85% equity holder in EDF Energy, it should depress the brake pedal. The project’s current estimated return on investment (9.2%) is not exceptional and relies on (i) the perfect completion of the project from now on and (ii) unchanged energy purchase prices from the UK government, two factors whose strength is not unquestionable and which have already been flagged by the Cour des Comptes, France’s state audit body. The government seems to have already forecast trouble ahead by indicating that it could inject fresh capital into the company. As a champion of French industrial excellence, it should push the accelerator. Hinkley Point C is a massive project that could showcase the French capabilities in last-generation nuclear power plant building, an increasingly competitive arena, while strengthening our ties with the ’emerging world’, whose energy needs will undoubtedly be called to further grow over the next decades. Last but not least, the government pushing for the project will not be the one paying for damages at completion – in 2025, President Hollande will not be in office any more. Unfortunately, any driver will know that pushing the brake pedal and the accelerator at the same time makes a car spin


So where do we go from here? The usual three options are envisaged: Hold, Drop and Change. The first one is the official line, championed by governments as well as EDF Energy’s CEO, and consists in keeping the project going as it is, despite all the risks previously highlighted. Others call for a full withdrawal of the project which would open the door for renewable energy and alternative nuclear power plant builders, although this would entail significant adverse consequences on UK’s future energetic independence, on the ability of France to remain a nuclear know-how pioneer and on the appetite for Chinese investors to support and collaborate on large projects in cutting-edge industries. Finally, the most reasonable option could involve a further delay to enable engineers to design an alternative solution, made of a number (4 to 6) smaller and thus more highly mastered plants. This would enable France to save face while minimising the risk of failure. The latter option seems to gain momentum following the publication of an internal white paper written by senior EDF engineers late last month.

27976819-Un-match-de-bras-de-fer-de-bande-dessin-e-avec-l-homme-mince-vaincre-l-homme-muscl--Banque-d'imagesThe Hinkley Point C project is an interesting example of apparent conflict between politic imperatives and economic logic. The next few weeks should indicate us which side (if any) takes over.