Counterparties: Low tech

By Peter Rudegeair
July 27, 2012

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First, Apple released decidedly “meh” earnings this week for the second quarter. Then, Netflix did, too. Then Zynga. Then Facebook. Not all of these companies are in the same boat: Apple reported strong growth but missed analysts’ lofty expectations; Netflix topped analysts’ estimates but experienced a big slowdown in growth. Still, the stocks of all four companies ended the week down: Apple’s shares fell around 3% on the week; Netflix’s were down 28%; Zynga’s were down 36%; and Facebook’s fell 17%.

Apple’s case is probably the most instructive. Part of what’s going on is the continuation of the trend that Larry Summers picked up on at Fortune’s BrainTech conference last year: that the earnings of tech companies are undervalued relative to the earnings of industrial companies. As he pointed out then, once you subtract Apple’s Scrooge McDuck-size pile of cash, Apple’s price-earnings ratio is only about two-thirds of GE’s. But another part of what’s happening is what Peter Thiel highlighted at this year’s BrainTech conference and that we blogged about last week: big tech companies like Apple, Microsoft and Google have excess cash and a shortage of scalable, innovative ideas worth a chunk of it.

Take Apple’s cash hoard in particular (now over $117 billion). Apple may have just plunked down $356 million in cash in its bid for AuthenTec, but that’s only 5% of the $7.04 billion in cash that Apple accrued since the end of June alone. What Matt Yglesias wrote this week about Microsoft could apply to Apple as well: “Innovation is really hard. Staying on top once your core business has saturated the market is really hard”.

Adam Lashinsky made an observation during Peter Thiel’s panel that there is a notable exception to this trend: “Amazon is the only one, in my mind, of the big tech companies that’s actually reinvesting all its money, that has enough of a vision of the future that they’re actually able to reinvest all their profits”. He was almost spot-on: With heavy investments in its business Amazon was able to eke out a profit of a penny per share this quarter. Barney Jopson had a great piece in the FT earlier this month that detailed Amazon’s capital investments, from its own “digital market place with millions of customers, to petabytes of server space and to state-of-the-art warehouse facilities serving myriad forms of commerce”. Investors don’t seem to mind Amazon’s paltry income for the time being. Although its profit, like Apple’s, came in below analysts’ estimates for the second quarter, Amazon’s shares finished up 4% on the week. – Peter Rudegeair

On to today’s links:

Facebook
What investors saw and didn’t like in Facebook’s first public earnings release – DealBook

Economy
GDP growth slows to 1.5%: The US recovery is now the second slowest since World War Two – WSJ

EU Mess
Yields of 7+ percent too much to bear – Spain discussing full-scale, $366 billion bailout with Germany – Reuters
Draghi made his statement, now he has to back it up – Bloomberg
“Convertibility” and the ECB’s monster challenges – FT Alphaville
The irreversible euro: Did Draghi pull a “the crisis is contained to subprime”? – Tim Duy

TBTF
“Millions have suffered needlessly” because of the structure of the bailouts – Kevin Drum
Not the strongest argument: “you can screw [management and risk-taking] up at a small bank or a large bank” – Reuters

Liebor
How one trader tried to blow the whistle on Libor manipulation – and was ignored – FT
How not to rig Libor: the Barclays instructional video – John Carney

Think of the Children
The birthrate is at a 25-year low as Americans put off procreating – USA Today

Good Ideas
Geithner supports the Merkley mortgage refinance plan – Housing Wire
“In many ways … this is functionally equivalent to a principal reduction” – Felix

PR Pushes
What the financial industry needs now: A cheesy promo video with terribly low production values – The Partnership for a Secure Financial Future

Awesome
“Like Finnegans Wake as drafted by the unicorn debate team … atavistically beautiful, like middle school cave art” – Brian Philips

New Normal
The majority of Americans getting jobs have had to switch industries – WSJ

Data Points
Compared with the Super Bowl, the RNC quadruples earnings for strips clubs – NYT

Oxpeckers
The NYT is now supported more by readers than by advertisers – NY Mag

More From Felix Salmon
Post Felix
The Piketty pessimist
The most expensive lottery ticket in the world
The problems of HFT, Joe Stiglitz edition
Private equity math, Nuveen edition
Five explanations for Greece’s bond yield
Comments
11 comments so far

I can’t see how Apple could invest at the suggested level. They made $9B in the quarter. They spent much more than Amazon on their business, from R&D to new facilities. The difference seems to be that Apple sells their products for a higher margin. Some of that is part of retailing but Amazon chooses to at best break even on Kindle Fire. I can’t see how the one choice is “better” or what exactly one imagines Apple could do with its money, given how it already controls its supply chain and has massive data centers, plus offices, in planning and under construction.

Posted by jomiku | Report as abusive

Amazon’s margins are so much lower than Apple’s that of course they are investing it all in the business. You simply CAN’T fully reinvest your earnings when you are at 30% margins.

Posted by thoughtbasket | Report as abusive

Never deduct cash when placing a value on a company. You don’t get a check in the mail after you buy the stock. It’s just another asset that is failing to earn a return for its owners (unless they have a good use for it).

Posted by idaman | Report as abusive

jomiku, Apple can’t invest all of those current profits, let alone the accumulated ones, so they should either pay employees more or distribute them in dividends. They are doing nobody any favors by hoarding all that cash. They say they want to save it for something big, but unless they’re going to buy a carrier or build their own network, there’s not much they can spend $100B on.

If they paid their workers more, their competitors might feel like they have to pay more also. That would help stop the race to the bottom that American companies seem intent on winning (the bottom being what workers in third world countries earn).

Posted by KenG_CA | Report as abusive

KenG, I like the fairness of Apple paying more, but another way to look at it might be that their margins are just too high for the business they’re in. Yes, they can get away with it for various reasons. But how does anyone connected with the company benefit from it? Not employees and not shareholders, unless the ability to generate those margins buoys the stock. In the meantime margins like that leave a huge opening for competing firms to make their own healthy margins while expanding penetration, in much the same way that tariffs would. So they’re ironically helping everybody else in the business.

The fundamental question seems to be how long Apple can count on being in a position to define its own market. They’ve sustained the highwire act for quite a while, but how long can they continue it, particularly without the Jobs mystique? What happens when even their markets begin to approach saturation– do they live off the accumulated cash? Or use it to buy up and become a public utility? What do they have in mind for the lean years?

Posted by Altoid | Report as abusive

Larry Summers’ point is wrong. The difference between GE (or at least, the industrial part of it) and Apple is the long term outlook of its competencies.

There is a decent chance that GE’s current industrial know-how and infrastructures will remain relevant to whatever GE will be doing 30 years from now, as they currently exist. Gas turbines, transformers, down-well sensors, etc, will have evolved by then, probably quite a lot. But at its core, it will be the same business.

With Apple, not so much. If Steve Jobs’ company still exist by 2042, it will have to reinvent itself pretty much entirely from the ground up in two or three completely new incarnations in the meantime. And each incarnation comes with the risk of being the next Nokia.

So the stream of income from GE can be discounted to eternity while Apple’s income can not be assessed into a valuation beyond an horizon of 5 years, may be. That carries a (high) price.

Posted by Frwip | Report as abusive

Altoid, Apple’s competition is allowing their huge margins (okay, that and the fact that wireless carriers are allowed to bundle equipment and service and mask the true cost of phones). If they lowered the price of the iPad, it would increase their already giant share of that market. If they lowered the price of their computers, they would sell even more, as they are the most expensive. But you’re right, nobody is benefitting from their incredible margins, which is why I suggest they increase compensation for heir workers.

I think they can continue to define their markets because their competition is incompetent and uses obsolete strategies (e.g., lower prices for commodity products to gain market share, which gets them less profits). I have been thinking their markets have been saturated for a few years now (how do they sell any ipod touches any more?), but even if people only upgrade their phones every four years (instead of two, since the carriers give them every incentive to do so), that’s still a lot of phones. And I expect they will continue to introduce applications that require more advanced processors and more memory, which will give people a reason to upgrade.

If/when they have lean years, they should shrink their company. It is not fair to shareholders to let an overstaffed company live off accumulated profits. However, with the amount of money they have now, they could afford to survive a no-growth market for years, if not decades.

While lots of people criticize Apple for different problems, my biggest gripe with them (o.k., I think their patent wars are bad for innovation and the economy) is their hoarding of cash. They are effectively sucking tens of billions of dollars each year out of the economy, and it’s doing nothing. they need to spend or distribute it.

Posted by KenG_CA | Report as abusive

It isn’t anything to do with tech or reinvestment, it is simply the bursting of the social media bubble. A few months ago, Felix was justifying Groupon’s valuation despite the lack of earnings. They were reinvesting, just not profitably. Now the stock has disintegrated.

Facebook seems to be reinvesting as well, at least if the tripling of their R&D budget means anything. (Maybe the numbers I saw were wrong?) Again, that can’t justify the price.

Unrestricted growth is an illusion. When the illusion breaks, investors take a look at the profits. If the profits aren’t there, the stock falls.

Posted by TFF | Report as abusive

+1 to Frwip’s point.

Regarding Amazon, it amazes me that the stock trades where it does (trailing PE is 289, forward PE is 84). Amazon perpetually seems to be 2 years away from its investments paying off and producing strong profits, but then the next wave of investment comes along and puts that day off even longer. Amazon has annual revenue over $50 billion – if that’s not enough scale for it to earn decent profits, why should an investor believe that the next burst of growth will get it there? The margins are low to anemic at every line, even for a retailer – gross margin is just under 20%, EBITDA margin is 3.6%, pre-tax profit margin is just over 1%. Wal-Mart and Target generate substantially higher margins by every one of those metrics, and both also generate much better returns on invested capital than Amazon.

Then there’s the ongoing issue of sales tax collection by Amazon. Amazon just started collecting sales tax in Texas within the past month and is going to start in two additional populous states (California and Pennsylvania) this September. I don’t foresee that killing Amazon by any means, but the added cost for consumers is going be an additional headwind for Amazon’s pricing and margins.

Posted by realist50 | Report as abusive

“Good Ideas
Geithner supports the Merkley mortgage refinance plan – Housing Wire”

Says you, PeterR. Says me – half-thought-out ideas that focus on helping those umderwater mortgagors who need help least, put the Feds on the hook for future principal losses and don’t address underwater Seconds or the resale problem – they don’t qualify as “Good Ideas” in my book. Possibly a “good start” on the thinking process, but still a long, long way from “The Elegant Solution”. Dangerous to settle for less IMO?

Posted by MrRFox | Report as abusive

I love Amazon on so many levels, but they are a classic case of analysts having been so wrong about the company’s prospects early in their life that they aren’t going to get egg on their face a second time by pooh-poohing either the stock.

When coupled with the small profits narrative that Amazon’s promulgated, and the limited data transparency that Amazon provides investors (under the guise of willing to be misunderstood by investors for long periods of time), the company has a free pass.

All that said, I do think that they are playing retail chess to everyone else’s checkers game; just not at levels disconnected from any market comparable.

Posted by hypermark | Report as abusive
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