Warren hopes there are seeds in the Apple

6a00d83473f9dc69e20148c6ac7b95970cAfter decades of cautious suspicion towards technology-related stocks (with the notable exception of IBM), Warren Buffett has crossed the Rubicon and is now an Apple shareholder. The news clearly took the financial community by surprise: Apple’s stock jumped by 2% in pre-market trading after the announcement (indicated by a green arrow in the chart below) and is now up 4% compared with last week.

Sans titre

Mr. Buffett cannot be described as a 'geek'. Credits: CNN.
Mr. Buffett cannot be described as a ‘geek’. Credits: CNN.

Not only does the move surprise given Mr. Buffett’s historical ‘tech-adverse’ inclination  but this move also contradicts a statement he made no earlier than 4 years ago, saying that he would “not be able to value [Apple’s] stocks“. Last but not least, Berkshire is investing at a time when another famous investor, Carl Icahn, has taken the opposite direction by offloading his $4bn stake last month.

Why has Warren turned round? We cannot accuse Berkshire of trying to benefit from the recent air pocket Apple went through which we discussed on this blog three weeks ago, since the stake was built throughout the first quarter. Nor can we assume that Mr. Buffett will be able to impose his views on Apple’s management: his stake is important in nominal terms ($1bn), but only represents 0.2% of the total shareholder structure.

Credits: www.apple.com

In my view, the reason lies in another factor we have underlined. According to our EV/EBITDA benchmarks (reproduced below) the market is primarily viewing Apple as a hardware company at present, which is understandable given the share of revenues generated by devices such as the iPhone and, to a lesser extent, the iPad and the iPod.

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

And yet, Apple is trying hard to get out of the generally slow-growing, low-margin hardware trap where it can be considered as an alien – but for how long? – by investing part of its massive war chest into promising ventures, both internally – iTunes and, more recently, iCloud – and externally – the $1bn stake taken in Chinese ride-hailing app Didi Chuxing is the most significant to date.

Warren-Buffett-laughingIf Apple manages to grow the seeds it has been planting over the last few years and to convince Wall Street that it has now become a credible player in the ‘virtual’ space alongside other tech behemoths such as Google, Amazon or Microsoft, it will be able to command a higher valuation multiple which will ultimately lift its stock price. And the ‘Oracle of Omaha’ will have won his bet (once more).

Rotten Apple? On innovation and deflation

Credits: www.thesun.co.uk

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
Credits: www.apple.com

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
Credits: www.dailystar.co.uk

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.

Twitter or swansong?

Twitter released last week its results for the financial year 2015. The event offered mixed news, the significant increase in revenues (from $1.4bn in FY14 to $2.2bn in FY2015) being offset by the stagnation of the monthly active user base to 320m over the last 2 quarters of the year.

By judging at the share price evolution over the next trading day, stock markets were clearly not expecting such an outcome. Share price dropped by as much as 14% before recovering and closing the day with a limited loss of 1.9% – although no new data had been released in the meantime.

Black or white swan?

This behaviour illustrates the difficulty analysts and investors have to value many of the ‘2.0’ companies. LinkedIn learnt it the hard way, giving up half of its market capitalisation in one day after announcing its 2015 results a couple of weeks ago. Other companies such as Google, Facebook or Amazon also had their own fights against the stock market but now offer relative steadiness in an industry known for dramatic and disruptive change.

SP evolution
Indexed share price evolution of Twitter, LinkedIn, Facebook and Google compared with the S&P500 (index 100 as of January 2014). Source: CapitalIQ.

Twitter is even more of a ‘tough beast’ since, contrary to the three other companies listed above, it keeps bleeding cash. Lots of cash. As much as $580m in 2015. The situation is not hopeless though. In one hand, the company’s operating cash flow (i.e. the cash generated by ‘day-to-day’ activities) increased significantly, from $82m in 2014 to $383m in 2015. On the other hand, over the last couple of years, the company spent an average of $1bn per year in investing activities. Investors are now trying to assess whether Twitter’s survival goes through colossal investment needs and, if so, whether Twitter will be able to generate sufficient operating cash flows to offset these costs.

Part of the answer lies in the purpose and the business model of Twitter. Both of which are not very clear and distinctive. We use Facebook primarily to interact with friends, LinkedIn is our professional ‘shop window’, Google provides services making our life easier (including email). Conversely, the ‘raison d’etre’ of Twitter’s 140-sign messages is far from obvious – and the way to monetise them is even less so. By judging at the relative variance in analysts’ target share prices, this questioning seems widely shared.

Rebased distribution of analysts' target share prices as of 16/02 for Twitter, LinkedIn, Facebook and Google (100 = share price as of 15/02). Source: Author research.
Rebased distribution of analysts’ target share prices as of 16/02 for Twitter, LinkedIn, Facebook and Google (100 = share price as of 15/02).
Source: Author research.

Last but not least, the Twitter case also embodies the shortcomings of EBITDA as a meaningful financial aggregate. Despite the Enterprise Value / EBITDA ratio being widely used by investors, the EBITDA aggregate is in this case meaningless and even more when it is ‘adjusted’ as per Twitter accounts. Losing $580m of cash is indeed not incompatible with the fact of reporting a highly positive adjusted EBITDA – $558m to be precise. The main reason is that the large investments Twitter agrees to today are by definition capitalised and amortised and therefore accounted for in the ‘Depreciation & Amortisation’ line of the P&L (that is to say, below EBITDA). As written earlier, disregarding these investment needs when valuing the company would be careless.