Category: companies

Apple math

Apple just issued a brutal warning for the quarter just ended Dec 31:

– revenues of $84 billion, -4.9% (vs. previous guidance of $91 billion, a 3.1% gain)

– gross margin of 38% (vs. 38.4%)

– operating margin of 27.6% (vs. 29.8%)

We’ve felt Apple bulls have been guilty of recency bias and extrapolation for some time, especially with regard to its fat profit margins.  Annual operating margin has slowly drifted lower over the past three years, from 30.3% to 26.0%.  Where does that settle out for a company heavily dependent on one product in a market that is saturated and losing market share to a slew of feisty competitors?  Our best guess is 15%.  Worse, what happens to sales, especially as we head into a global recession?  We think down 20% from the peak is a strong possibility.  That would take Apple’s revenues back to where they were just 3 1/2 years ago.

With these assumptions, Apple’s earnings per share drop to $5.50 ($5.00 if you assume they squander their remaining cash on pricey buybacks all the way down, a safe assumption considering CEO Tim Cook’s assurances).  According to Yahoo Finance, the 42 analysts who follow the company expect Apple to earn $13.29 this year and $14.64 next.

Assuming the analytical herd has it wrong, what would you be willing to pay for such a company?  10x earnings?  Perhaps 12x assuming a turnaround?  8x in a worse case?  At $5.00/share in earnings, that gives you a stock price of anywhere from $40 to $60, i.e. 58%-72% lower than the current $143.42.

The importance of Apple to the foundation of the everything bubble cannot be overstated.  257 U.S. ETFs own AAPL, the most of any stock.  At just 10.8 x illusory “forward earnings,” Apple’s inflated margins help support the narrative that “stocks are cheap at less than 15 x earnings.”  Lastly, how much has AAPL’s outperformance over the past 10 years helped foment a bubble in passive investing where $2.0 trillion flowed out of active funds and $2.5 trillion into passive funds?  Indexing leader Blackrock (BLK) is down less than 2% on a day when AAPL is -9%.  For now, investors are failing to connect the dots…


Caterpillar is no butterfly

If Caterpillar offers a window into the global economy, the view isn’t pretty.  Year-over-year revenue growth by geography/segment:

North America:

  • Construction -3.5%
  • Energy & transport -15.7%
  • Mining -7.4%

Latin America:

  • Construction -46.8%
  • Energy & transport -6.6%
  • Mining -5.6%


  • Construction -18.0%
  • Energy & transport -4.7%
  • Mining -20.1%


  • Construction -30.5%
  • Energy & transport -17.3%
  • Mining -12.2%


  • Mining revenues down over 60% from the peak.  Declines are coming from depressed levels.
  • North America E&T (shale boom) was a bright spot, now a negative.
  • North America Construction was a bright spot, now negative.
  • Construction around the world is plunging (-29.4% excl. North America).

CEO Doug Oberhelman was interviewed on CNBC yesterday and asked if he regretted buying back stock at $100/share (traded at 79.76 at previous day’s close).  His response:

When you do a buyback at an industrial company like us, we have a lot of cash on our balance sheet.  Our balance sheet is strong, our debt-to-cap ratio is as strong as it’s been in decades, and having cash just sit on the balance sheet doesn’t do anybody any good.

[…] Caterpillar’s a 90-year old company and I am convinced at some point, probably not in the too distant future, those $100 shares will look cheap.  They’ll certainly look cheap today and you look at this as a long-term basis.

Oberhelman apparently sees no need to batten down the hatches even though he’s in the mother of all storms (and we’re just getting started).  In fact, he just hiked the dividend 10% in June and now wants to ramp up buybacks!  Keep in mind, Oberhelman never saw this storm coming.  On November 15, 2010, just months from the top of the commodity bubble, he paid $8.6 billion for Bucyrus International, which he called “a strong statement about our belief in the bright future of the mining industry.”  The company’s press release announcing the deal read:

The acquisition is based on Caterpillar’s key strategic imperative to expand its leadership in the mining equipment industry, and positions Caterpillar to capitalize on the robust long-term outlook for commodities driven by the trend of rapid growth in emerging markets which are improving infrastructure, rapidly developing urban areas and industrializing their economies.

Caterpillar is the ultimate canary in the global economy coalmine.  As their 2nd quarter confirmed, the canary is stone cold dead.  Yet eerily, hardly anyone is talking about it.  Fittingly, CEO Oberhelman is still at the helm.

Generals charge ahead while soldiers in full retreat

Friday was a remarkable day for students of the market’s internal strength, aka “market breadth.”  The Nasdaq 100 (NDX), powered by a 16% surge in Google, was up 1.45% even though declining stocks outnumbered advancing stocks by 50.  This has never happened on a day the NDX gained over 1%, not even close.  According to Jason Goepfert of SentimenTrader, breadth was negative only three other times in history.  One of those days was March 23, 2000 – right at the top of the Nasdaq bubble!

Year-to-date, the Wilshire 5000 (a measure of market capitalization of 5000 companies) has added $751 billion in market cap, a 3.5% gain.  By our measure, 10 companies have accounted for $471 billion, or 63% of those gains.  The top 5 have a combined market cap of $1.489 trillion – 6.6% of the Wilshire 5000 – and accounted for 52% of the ytd gains.

  • Apple: $113 billion, +18.4% ytd
  • Google: $107 billion, +31.8%
  • $81 billion, +55.6%
  • Facebook: $48 billion, +21.7%
  • Gilead Sciences: $38 billion, +25.9%
  • Netflix: $29 billion, +135.2%
  • Celgene: $18 billion, +20.3%
  • Biogen: $15 billion, +19.2%
  • Regeneron Pharmaceuticals: $15 billion, +34.5%
  • Tesla Motors: $7 billion, +23.5%

Further, biotechnology stocks make up 3% of the S&P 500 by market cap yet account for 15% of the year’s gains.  Meanwhile, the Dow Jones Transportation and Utility Averages are 12.5% and 11.9% below their 52 week highs respectively, even though the Dow Jones Industrials Average is within 1.4% of an all-time high.

As legendary market watcher Bob Farrell warned, narrowing leadership is typical of the late stages of a bull market.  This phenomenon is even more pronounced during the blowoff stage of a financial bubble.  We call this the “casino effect.”  Gamblers, addicted to winning over a long period, refuse to leave the casino even though several tables are coming up snake eyes.  Instead they gravitate to the diminishing number of winning tables.  Regarding the stock market, this is a classic sign of denial.  The losing tables are in essence early warning signs, stocks succumbing to deteriorating economic fundamentals.  Yet speculators ignore the red lights and fail to connect the increasingly obvious dots.  At the end the investing crowd feels it is in control and their favorite stocks are immune to macro factors.

Apple is a good example.  In Q1, China revenue grew 71% and accounted for 29% of the total.  At what point do the troubles in China affect Apple, the beloved stock of retail investors and the biggest weighting in index funds?  We could get some clues this Tuesday after the close when they report Q2 earnings.


Paying a visit to Starbucks

My friend Tanya Seyfert, an early investor in Starbucks, passed along this update on a great American entrepreneurial success story:

I first bought [the stock] around ’96 or ’97 – I’d gotten involved in an investment club, gotten hooked on frappuccinos and just was totally taken with the concept. It felt much less like a franchise and more like a hip new concept back then – just going in to one felt like an escape to me. I read Howard’s book and really liked his philosophy, in general and specifically for Starbucks – the whole idea of capturing the European coffee house “3rd place” resonated with me.

I made my first buy and kept adding to it from time to time, back when I still qualified for a Roth IRA! They continue to be successful in expanding the concept in places I never would’ve believed it would work – Asia, specifically. I wasn’t sure they could sell coffee to tea lovers! But everywhere you go – any country in Europe – they are busy. There’s always a line, and people wait regardless of how many are in front of them, if the barista is annoying – they don’t leave the line. I think it lost some of its hip luster – they’re on every corner so are much more of a commodity – but with the addition of the music label, etc they’re recapturing some of that coffeehouse vibe.

I haven’t sold any of my shares – I think they will continue to rock on… They are nowhere near the saturation point when you view it globally. Example – I recently moved offices, to a building 2 blocks west of where I was [in Washington, DC)] and further away from the action of restaurants, delis, etc. I never would’ve believed how much difference those few blocks would make, but now I rarely take the time to walk 4 blocks to Cosi vs. right across the street to a local deli – even if I prefer Cosi’s food. I just can’t/won’t take the extra time.

When you think how often people just want to take a break from work, popping out to the neighboring Sbux works – every one is always busy because it’s there. I think that’s why they’re still successful – they’re not only hip, they’re hip and convenient. They’re also branding themselves as a “meeting place” – they’ve aligned themselves with (don’t know how official that is, but they have meetup cards now, preprinted with order forms that your group can fill out and give to a barista and they bring the drinks for you). I’ve noticed quite a few meetup groups at my local Sbux – book clubs, political discussion groups, you name it. One of the great things the company does is continue to evolve and find ways to be relevant while staying true to the “3rd place” coffee house idea. They are pretty darn smart!

In the fiscal year ended September, 1997, Starbucks generated $967 million in revenue. Ten years later, analysts expect $9.33 billion for an annual growth rate of 25.4%. Meanwhile, the stock is up exactly five-fold, or 17.5%/year. In 1997 just 17 (1.2%) of Starbucks’ stores were outside of the U.S. Today, international store count is around 4,000, or 29% of the total.

The law of large numbers applies, even to SBUX, as growth rates have slowed from 35% ten years ago to a still impressive 20% today. Enterterprise value is $21.2 billion on $5.2 billion in gross profit (58% gross margins). EV/gross is 4.08, near the low end of the 4.00-8.00 range of the past 10 years.

Lehman Brothers reports Q3 results

The headline for Lehman’s (LEH) 3rd quarter read: EPS of $1.54 beats estimates by 7 cents, -2% from a year earlier. Behind the numbers, the company EPS got an extra 12 cents from a lower tax rate and 1 cent from lower share count due to stock buybacks. Total miss: $0.13 per share. CNBC trumpeted strong year-over-year growth in investment banking, asset management, and net interest income. On its conference call, the company’s executives claimed to see light at the end of the credit crunch tunnel.

Year-over-year results were a mixed bag:

  • Asset management: $479 mil, +29.0%
  • Commissions: $674 mil, +19.5%
  • Trading & principal investments: $1,612 mil, -26.9%
  • Investment banking: $1,071 mil, +47.5%
  • Net interest income: $479 mil, +50.6%
  • Net revenue: $4,308 mil, +3.1%
  • Pre-tax income: $1,205 mil, -11.9% (28.0% of net revenue, down from 32.7%)

Comparisons to the 2nd quarter were generally ugly:

  • Asset management: +14.0%
  • Commissions: +18.7%
  • Trading & principal investments: -44.2%
  • Investment banking: -6.9%
  • Net interest income: -2.4%
  • Net revenue: -21.8%
  • Pre-tax income: -35.9%

At the end of the 2nd quarter, Lehman held $412 billion in long-term investments. Yet, despite carnage in credit land through most of the 3rd quarter, the company only took $700 million in asset writedowns…

The Firm recorded very substantial valuation reductions, most significantly on leveraged loan commitments and residential mortgage-related positions. These losses were partially offset by large valuation gains on economic hedges and other liabilities. The result of these valuation items was a net reduction in revenues of approximately $700 million.

The most troubling aspect of the quarter was that the balance sheet continued to grow and leverage increased:

  • Total assets: $656.0 bil, +38.4% y-o-y and +8.3% from Q2
  • Total assets / tangible equity: 37.2x, vs. 34.7x in Q2 and 31.5x in Q3 ’06


  1. Core business is deteriorating.
  2. Company has taken serious blows to its balance sheet, yet appears unwilling to face the music (likely expecting a new wave of asset inflation, a la the Bernanke Fed).
  3. Company is addicted to perpetual balance sheet expansion and incapable of reigning it in.
  4. The upcoming 10-Q should make for interesting reading.

How government intervention alters the soda market

In “Jonesin‘ for a Soda,” high school student Max Raskin shows how agricultural subsidies lead to unintended consequences in the soft drink market:

When a government guarantees profits to those large corporations with powerful lobbies, the market loses its natural regulating mechanism. Instead of weeding out the most inefficient companies, the state subverts the consumer and keeps these companies propped up with corporate welfare. This is particularly true with respect to the agricultural industry.

In the absence of tariffs, importation quotas, and subsidies, the natural tendency of the market would be to produce cheap foreign sugar, which soda manufacturers would then import to sweeten their product. Domestic farmers are naturally opposed to this system because they cannot compete with more efficient foreign firms. So, instead of competing for the dollar votes of the millions of individuals who form the free market, these large corporations have the power to lobby a select group of politicians to confer them with special privilege. When a businessman tries to secure his profits not through free competition, but through state privilege, he is not acting as a market entrepreneur, but rather as a political, rent-seeking one.

Corporate sugar daddy – ADM:

In this case, the political entrepreneur was Archer Daniels Midland, a company that lobbied Congress to pass draconian quotas on sugar importation. But why would ADM, a corn producer, want to artificially raise the price of foreign sugar? A basic lesson of economics is this: when the price of a good is raised, all other things being equal, people cut back on their consumption, and (depending on the elasticity of demand) they look for substitutes.

High fructose corn syrup, which is made from cornstarch, which ADM grows, is such a substitute.

Venal politicians gave ADM what it wanted when Congress passed the restrictions in 1982. So now, in addition to manipulating the country’s tariffs, the Office of the United States Trade Representative sets limits by country on the tonnage of sugar that can be imported annually.

John Barnes of the New Republic writes, “In 1979 the entire corn sweetener industry produced just 1.7 million metric tons. Since the imposition of the sugar quota, industry production has soared to 5.5 million metric tons, more than 80 percent of it accounted for by ADM.”

Furthermore, as James Bovard, policy analyst at the Cato Institute notes, “At least 43 percent of ADM’s annual profits are from products heavily subsidized or protected by the American government. Moreover, every $1 of profits earned by ADM’s corn sweetener operation costs consumers $10.”

The mega soft drink companies also benefit:

While the public has been forced to suffer inferior product, large corporations reap the benefits. The ubiquitous use of high fructose corn syrup did not freely come about on the market, but was rather a product of the protectionist schemes of the federal government.

Under a system of tariffs, subsidies, and restrictions, we get companies like Coke and Pepsi producing collectivist drinks for the masses. There is nothing exciting about these products because there is nothing exciting about the system that produces them. Interventionism is restrictive; it confines the innovative human mind, while the laissezfaire economy unleashes it.

Yet against all odds, the remnants of a market economy still find ways to innovate and satisfy the consumer:

The story could end here, as it usually would, with the populace swindled because of the state, but thankfully it doesn’t. In spite of the morass of anti-market policies, companies like Jones Soda have sought to satisfy a consumer demand for potable, domestic soda.

In January of 2007, the company switched from high fructose corn syrup to cane sugar. Though it cost the company over one million dollars to alter its machinery, CEO Peter van Stolk defended the new sweetening agent, “because it tastes better and they [consumers] feel better about it because it’s pure; it’s sugar. They know what it is.”

Though there has been a controversy over a link between high fructose corn syrup and obesity, van Stolk is a CEO who has little interest in babysitting his clients. Instead, his rationale for the switch was simple: he saw that his customers had been demanding a change in the product, so to make more money, he gave them what they wanted. The company’s entire product is now made with natural cane sugar, and they have managed to limit the rise in price to a modest five percent.

Jones Soda is the kind of company that would arise if the state would divorce itself from the economy. Unlike the mega-corporations Coke and Pepsi, Jones caters to the individualist spirit of America. Along with continually changing the photographs on its labels, Jones soda allows customers to individualize their own twelve packs with whatever picture or message they choose. Similarly, with over sixty-four flavors, including Caramel Cream and Lemon Drop Dead, Jones embodies the personal nature of free enterprise.

My comments:

  1. The ability of market entrepreneurs to continually overcome adversity is inspiring.
  2. ADM remains on our blacklist as a blatant political entrepreneur.
  3. Hats off to Jones Soda, though the stock is not cheap at 40x estimated ’08 earnings, and the company is tiny at $30 million in annual revenue vs. $26 billion for Coca Cola.
  4. Other unintended consequence of government intervention in the free market: high fructose corn syrup’s contribution to the obesity epidemic in this country.
  5. Max, if you’re looking for a job in the investment business after graduating from college, let us know.

Barron’s: Bullish on Cabela’s

Jim McTague wrote a positive piece about Cabela’s in this weekend’s Barron’s. Not much new here.

On profitability of retail stores, their growth driver:

The company says local and state jurisdictions pay about 30% of its construction costs. David Ewald, a consultant from Minneapolis, figures that Cabela’s and Bass together have received more than $1 billion in state tax breaks and subsidies. Little wonder Cabela’s enjoys a return on investment of some 30% from each new store.

Cabela’s runs its stores efficiently. It averages about $348 in sales per square foot, versus $197 per square foot for rival Dick’s Sporting Goods (DKS). Other competitors, like Bass Pro, which will have 48 stores by year end, and L.L. Bean, with eight retail stores and 13 outlet stores, are privately held and do not publish retail-sales data.

On debt financed expansion plans:

Cabela’s plans to add 14 stores by the end of 2008, including huge outposts in East Hartford, Conn., and East Rutherford, N.J., where the outdoors set is more likely to tool around in shiny Escalades than mud-splattered, tree-scraped Cherokees.

CFO Ralph Castner says the expansion will require borrowed money. Cabela’s plans a private placement of more than $215 million in bonds, which will bring its debt-to-capital ratio into the low-40% range from a current 35%.

The company issued $215 million in bonds in February 2006 at around 6% and borrowed about $60 million more in the second quarter of this year.

At $21.60, stock has EV/annual gross of 2.08 vs. 3 1/2 year range of about 2.00-2.75.

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