Financial Alchemist

Apple Inc (AAPL): Are Investors Overlooking Cash Earnings?

noreply@blogger.com (Turley M Muller) — Wed, 30 Jul 2008 15:27:00 +0000

Apple Inc (nasd:AAPL) $157.08: I believe investors have become overly fixated on Apple’s expected accounting income, while ignoring Apple’s impressive free cash flow generating ability. Free cash flow, not earnings reported in the accounting statements, determines the true value of a firm. AAPL’s high margins coupled with minimal capital investment needs, enables it to produce robust free cash flow. Another issue is the iPhone accounting treatment, which conceals the true magnitude of its cash generation. According to my estimations, the 3G model’s cash flow per unit is higher than its predecessor. In addition, Apple receives these cash flows much sooner compared to the old model. Not only will Apple sell many more 3G models, the per-unit impact on cash earnings will be much greater. Therefore, when shifting focus to cash earnings, as opposed to accounting earnings, AAPL looks attractive at current levels.

Earnings Expectations:
At the Q3 earnings call, Apple guided well below expectations for Q4, and gave a weak gross margin forecast for FY09. Shares took a hit and prompted Wall Street analysts to reduce their 4Q08 and FY09 estimates. Consensus estimates for FY08 & FY09 are $5.20 & $6.05, respectively. Early this year, the FY09 estimate was ~$6.50, then drifted lower to ~ $6.35 where it hovered for several months. Since Apple announced its margin guidance, the consensus FY09 EPS estimate has plunged to $6.05.

Apple shares currently trade @ 27x FY09 EPS, with expected annual growth of 16%. A 27x multiple for 16% growth isn’t exactly cheap. However, evaluating Apple on an EPS-multiple basis is misleading due to Apple’s iPhone accounting treatment. Considering Apple’s cash flow/share, the stock looks attractive.

Wall Street estimates are for accounting income- what Apple is expected to report, not what Apple will actually earn. Cash flow is the true metric that matters, not accounting earnings. Accounting earnings are a product of a firm’s finance department, and cash earnings are a product of customer behavior. Thus, one shouldn’t place too much emphasis on accounting income and quarterly estimates.

The amount of cash flow available for distribution to owners determines intrinsic value. Accounting income and cash flow are not the same, and often accounting income is a poor proxy for distributable income, hence intrinsic equity value.

Evolution of Market Expectations:
The 3G iPhone developments- new markets, new revenue model, lower price points, and new features, etc didn’t seem to affect AAPL shares much. However, concerns over Steve Jobs’s health and guidance have pressured shares. iPhone demand has been relentless since the launch as stores struggle to keep supplied. Analysts have raised their forecasts for unit sales, yet earnings estimates have only changed slightly (before CC).

Earlier this year, investors and analysts were questioning whether Apple would achieve its stated sales goal of 10 million units in CY08. Some began to think the iPhone was going to turn out to be a disappointment, and that expectations were certainly excessive. However, iPhone sales projections rose significantly with the June announcement. Many analysts raised estimates to more than 20 million for 2009. Yet, there was then the question of reduced profitability due to the reduced price points. Originally, the thinking was that volume could certainly expand but the effect on the bottom line would be subdued due to shrinking margins. Yet, it was soon agreed that margins won’t be significantly impacted due to the larger-that-originally expected subsidy payment. Instead of receiving a cut of monthly carrier payments over 24 months, Apple will receive an upfront lump-sum payment that is likely equivalent.

So, we have a massive increase for iPhone sales expectations with profitability remaining somewhat intact, yet AAPL shares react moderately and analysts only revise estimates slightly higher. Ostensibly, earnings estimates didn’t change significantly due to the iPhone accounting treatment that spreads revenue over 24 months. Thus, iPhone sales won’t really impact the income statement until a much higher run-rate persists for many quarters so that revenue recognition has had time to catch-up.

Shares reacted little to the June announcement, until somebody pointed out that Jobs looked unhealthy causing the stock to tank. Shares later recovered only to get slammed again after the Q3 earnings call when management refused to elaborate on Job’s health condition. Panic over Job’s health has abated, but concerns regarding Apple’s gross margin guidance and susceptibility to a weakened consumer still linger.

3G Produces More Cash Flow & Sooner:
The transition from shared payments from carriers to an upfront subsidy payment increases Apple’s intrinsic value.

Apple’s cash flow will increase from receiving an upfront, one-time payment opposed to recurring monthly payments. Originally, when an iPhone was sold, Apple only received cash associated with the handset sale, revenue which probably averaged around $430-$440. Apple then would receive $15/mo (guesstimate) for the next 24 months, $360 in total payments, or PV of $319 @ 12% discount rate. Present value of total CF is ~$750/unit, However, this isn’t a very realistic assumption to model. Actual revenue/unit is significantly less due to several reasons.

First, not all units receive full 24 months of payments due to iPhones being lost, stolen, broken, etc. Monthly payments are then attributed to the replacement unit and the original device no longer generates monthly revenue payments. AT&T shares revenue per iPhone customer (activated device), not for each device sold. Thus, Apple has sold two handsets yet only collects $15/mo, or theoretically $7.50 per device.

Second, not all iPhones sold were activated with a participating carrier (unlocked), so a significant percentage of legacy iPhones (maybe 40%-50%) don’t receive carrier payments. Unlocking has actually been beneficial because is has allowed Apple to sell units that it would have never sold, and it has generated product exposure in foreign markets. Yet, for the sake of modeling, and for cash flow comparison between the former and current revenue models, we can’t assume that the average monthly payment is $15 across all units.

Third, many units will be replaced with 3G iPhones before the full 24 months elapses. 2.5G iPhone owners that upgrade to the subsidized 3G model contribute maybe 12 months (or less) worth of payments. Piper Jaffray’s survey on launch day found 38% of 3G buyers were current iPhone owners.
Just for the sake of illustration, assume 50% of iPhones are unlocked (or lost/broken), and one-half of the other 50% upgrade to the 3G model after 12 months. This leaves 25% with 24 months of revenue payments At $15/month shared carrier payment, the average unit revenue/month is $5.63, or $135 over 24 months. Assuming ASP of $430, total revenue/unit is $565 (not accounting for time value of money). Therefore, it’s unrealistic to assume that the legacy iPhone revenue model was bringing in $790/unit ($430 + $15 x 24m)

With the subsidy payment model, there isn’t any uncertainty as to what the actual realized revenue/unit will be, since all payments occur on the front-end. Sales thus far have been skewed towards the 16GB model, which AT&T is offering for $299 with a 24-month contract, or $699 for no commitment. Similar arrangements exist in foreign markets, and the pricing works out to be roughly equivalent on a currency translation basis. So, AAPL could be capturing over $600/unit, a more conservative figure would be $550 or $500. Thus, Apple is likely receiving revenue per unit commensurate to the 2.5G iPhone.

A major point that I feel is overlooked relates to the timing of cash flows. For example, consider the following illustrative assumptions. Apple receives $600 upfront on the 3G opposed to $450 upfront and $150 in total cash payments spread over 24 months for the 2.5G. The accounting will look the same for both models since total revenue/unit is equivalent, and in both cases is recognized over 24 months resulting in revenue of $75 per quarter. Even though both scenarios appear to be similar from an accounting standpoint, the cash flows are different. All cash flow from the 3G hits at the time of the sale, where as just a portion of 2.5G cash flow occurs on the front-end.

To summarize my points:
1) 3G iPhone realized revenue/unit is higher- not every 2.5G iPhone generates shared carrier revenue, and not all units that have attached payments will survive the full 24 months.
2) Time Value of Money- Apple receives 3G iPhone revenue upfront, whereas the previous model entailed deferred revenue payments. Not only is there the opportunity cost of forgone investment alternatives, the cash payments are uncertain.
3) 3G model’s production cost is estimated to be about $55 less that the original model.
4) Demand, demand, demand. More markets, more features, cheaper price. The first iPhone took more than two months to sell 1 million units, which the 3G iPhone surpassed its first weekend.

The new 3G iPhone and revenue model will dramatically boost Apple’s cash flow that should result in a higher valuation. Not only is demand substantially stronger for the 3G model, but the actual revenue/unit realized will be higher, and the cash flow will occur sooner.

iPhone Impact:
If Apple sells 20 million iPhones next year assuming: $500 ASP, 50% gross margin. 30% tax rate, it will generate incremental cash flow of $3.90/share. Assuming that Apple sells 5 million in each quarter, the accounting treatment would only recognize $1.23/share for 2009. Cash earnings are more than 3x higher than reported earnings. Using more aggressive assumptions: $600 ASP, $250 COGS, the iPhone would produce $5.50 CF/share. Subscription accounting would only report $1.72/share.

The assumptions I am modeling for FY09: 20 million units, $350 subsidy, 65% 16GB ($299) & 35% 8GB ($199) = $614 ASP, $233 production cost, 30% tax rate. This calculates out to 5.32B in after-tax cash flow, or $5.92/share.

Apple’s FCF/share (ttm) is roughly $6.84, a price multiple of 23x. In contrast, Apple trades 31x EPS (ttm). I estimate that $1.10 of the $6.84 CF/share is iPhone related, thus FCF/share associated with all other segments is $5.74. With a 25% growth rate, non-iPhone CF increases to $7.18/share in FY09, and adding $5.92 from iPhone, CF for FY09 totals $13.10/share. This figure equates to a price multiple of 12x, and as mentioned previously, Apple is trading 27x FY09 EPS estimate of $6.05.

This is more or less a “back of the envelope” exercise, but the purpose is to illustrate the vast difference between Apple’s cash flow and accounting EPS due to iPhone revenue recognition.

Apple’s Free Cash Flow-
Apple is an impressive free cash flow generator. The primary components of free cash flow are 1) NOPAT- net operating profit after-tax 2) Working-capital requirements 3) Investment in fixed assets (capex).

Apple’s has negative working-capital requirements due to rapid inventory turns. AAPL turns its inventory about every 7 days, or 50x a year. Apple’s collection period for outstanding receivables is slightly more than 20 days, yet it doesn’t pay its suppliers for roughly 90 days. Thus, Apple doesn’t need to sink additional cash into working capital as sales increase since it’s funded through trade credit. This would allow more cash to be distributed to shareholders since it doesn’t need to be retained to fund operations.

Apple’s capital investment needs are quite modest. FY07 capex was $735 million and $893 million for the last 4 quarters. This equates to roughly 3% of revenues, and when depreciation is taken out, net investment is approximately 1.7% of total sales. A sizable portion of Apple’s capital investment relates to retail store growth. Apple’s stores produce extremely high revenue per square foot, as well as attracting consumers unfamiliar with the Apple brand. Retail stores perform a marking function for Apple due their appeal that generates substantial foot traffic. The stores are also ideal for cross-selling Macs to consumers who have come to purchase an iPhone or iPod. Thus, Apple’s retail store strategy has proven to be a very worthwhile investment.

Much of Apple’s assets are intangible, thus not reported on the balance sheet. Intellectual capital and brand equity are just two examples. Relatively speaking, Apple doesn’t have to spend heavily on developing these assets. Apple’s marking spend is 2% of revenue as it enjoys doses of free advertising from the media and word-of-mouth from satisfied users. Apple’s research and development expense is just slightly more that 3% of sales. In comparison, R&D for Yahoo ~16%, Google ~13%, and Amazon ~ 6%.

Conclusion:
In summary, EPS (ttm) is $5.11 or 15% net margin, and free cash flow as a percentage of revenue is 20%. As iPhone sales increase, these two metrics will diverge further, yet the focus should be on cash flow. It’s widely accepted that the iPhone has a much higher gross margin than the overall Apple business, yet due to subscription accounting, the iPhone’s impact on overall gross margin is very minimal. Thus, panic over the gross margin forecasts is misguided because on a cash basis, gross margins would be much higher. Investors should then place less weight on Wall Street earnings estimates. Therefore, when evaluating Apple on its prospective cash flows, shares look attractive under $160.

Disclosure: None

Authentidate (ADAT): Exploding Demand for Shares

noreply@blogger.com (Turley M Muller) — Sun, 27 Jul 2008 23:11:00 +0000

Authentidate Holding Corp. (Nasdaq: ADAT) $0.78- Authentidate has been on a tear recently with shares up 189% from an all-time low of $0.27 reached on July 7. In May, I wrote about ADAT when it was trading at $0.43 and recommended the stock since I believed it was undervalued. Since its trading low, daily volume has averaged 108k for the subsequent 14 trading sessions. For the 14 sessions prior to its low, ADAT’s average daily volume was 17k. Hence, there has been strong demand for ADAT shares. This trend bodes well for continued share price appreciation.

I think there are a couple factors responsible for the recent rally. First, ADAT is a good value with $0.53 cash/share and is expected to reach cash flow breakeven in the next 2-3 quarters. Second, ADAT recently announced a new joint venture with EncounterCare Solutions, Inc. (OTC PK: ECSL that represents its entry into a new market vertical. This new segment offers a significant opportunity for revenue growth and profitability.

ExpressMD Joint Venture Press Release (June 10, 2008):

The joint venture called ExpressMD^TM Solutions will provide in-home patient vital signs monitoring systems and services to improve care for patients with chronic illnesses and reduce cost of care by delivering results to their health care providers via the Internet. ExpressMD Solutions will combine EncounterCare's Electronic House Call^TM patient vital signs monitoring appliances with a specially designed web-based management and monitoring software module based on Authentidate's Inscrybe^TM Healthcare platform. ExpressMD Solutions will enable unattended measurement of patients' vital signs and related health information. Patients' data will then be securely sent electronically to each patient's health care provider for review. ExpressMD Solutions will be designed to aid wellness and preventative care, and deliver better continuity of care to specific patient segments such as the elderly, special needs or pediatric patients with chronic illnesses who require regular monitoring of serious medical conditions.

According to a January 2008 research study conducted at the State University of New York at Fredonia, the demand for patient monitoring systems in the primary healthcare sector in the United States is forecast to increase 5.9 percent per year to an estimated $12 billion market by 2012 based on expected contributions to positive therapeutic outcomes and efficiencies. Additionally, the study indicates that the market for self-monitoring activities will also expand as treatment for chronic care patients, especially patients with asthma, diabetes and heart disorders focuses on preventative care.

Using ExpressMD Solution's offerings health care providers will be able to easily view their specific patient's vital statistics and make adjustments to the patient's care plans via the Internet. ExpressMD Solution's easy to use patient monitoring system is intended to provide patients with increased peace of mind and improved condition outcomes through a combination of care plan schedule reminders and comprehensive disease management education on their in-home communication unit. The service will provide intelligent routing to alert on-duty caregivers whenever a patient's vital signs are outside of the practitioner's pre-set ranges.

Health care providers and health insurers also are expected to benefit by having additional tools to improve patient care, and reduce overall in-person and emergency room patient visits.  "EncounterCare's expertise with in-home patient monitoring technologies and Authentidate's expertise in online healthcare systems and securely managing patients' documents has allowed us to shorten the development cycle and ready this solution for delivery in record time," said Ron Mills, CEO of EncounterCare Solutions, Inc.  "The ExpressMD Solutions joint venture will allow Authentidate and EncounterCare to leverage existing portions of our respective healthcare products as well as existing healthcare industry relationships from both companies," said Ben Benjamin, President of Authentidate Holding Corp. "The telemedicine market is a large market that we believe will benefit from our document management capabilities. By entering this market through a joint venture, we will be able to strongly penetrate an emerging market, while expanding the use of our platform within the health care community.

ExpressMD Signs First Contract with Cyntrist:

On July 8^th, it was announced that Authentidate and EncounterCare had signed their first user contract with Cyntrist, for use in remote monitoring of Diabetes patients located through out the Southeastern U.S. The opportunity in the Diabetes space is colossal. In a recent study, the CDC reported that 24 million Americans (8% of population) are afflicted by Diabetes, a number which has increased by more than 3 million in just two years. The ExpressMD solution provides physicians with the ability to remotely monitor patients’ glucose levels, weight, etc. on a daily basis and adjust treatment as needed. Not only does this enhance the quality of patient care, it reduces the need for regular office visits, thus reducing the cost of medical care. The advantages are compelling, and with such a large addressable market, ADAT may benefit substantially.

Conclusion:

The recent news comes after Authentidate management had stated that they believed cash flow break-even could be attained by CQ1 2009. The implication was that existing business was likely sufficient to attain that goal, for it was an issue of customers ramping up implementation. Now, with these recent developments regarding the ExpressMD joint venture, Authentidate’s prospects have become even brighter.

A Look at the 3G iPhone's Profitability

noreply@blogger.com (Turley M Muller) — Tue, 15 Jul 2008 23:19:00 +0000

Apple’s 3G iPhone appears to be quite profitable. The fully subsidized price from AT&T is $199/$299 for the 8GB/16GB models, respectively- requiring a 2-year contract. If a current AT&T customer has recently purchased a discounted phone, then the price may increase up to $399/$499, depending how much subsidy AT&T needs to recover on the old phone. Without a 2-year contract from AT&T, the iPhone will cost $599/699.

The actual amount Apple receives per iPhone is uncertain. Wall Street analysts estimate AT&T is paying a $300-$350 subsidy. The AT&T pricing scheme suggests the subsidy may be as high as $400 per unit.

Even though $200 is the industry standard for smart phone subsidies, there are many reasons that support the higher estimates.

1) AT&T is increasing data plan by $10/mo and no longer offering 200 free text messages. Most iPhone plans will increase by $15/mo. This equates to a $360 increase over the life of the contract.
2) AT&T’s average revenue per user (ARPU) is roughly $50/mo, where the iPhone ARPU is north of $90/mo. Thus, iPhone users generate $960 more per 24-month contract.

Therefore, a $350 subsidy is quite reasonable and perhaps conservative. Using this assumption, Apple receives $550/$650 from AT&T.

A recent estimate by iSuppli puts the production cost at $173 for the 8GB unit. The 16GB model adds only $16 more to cost; yet it sells for $100 more than the 8GB device. Gross profit for the 8GB model is $376 at a selling price of $550. The 16GB model has a gross profit of $460 selling at $650. The gross margins calculate to 68% and 71% for the 8GB/16GB, respectively.
The 16GB adds $84 in incremental gross profit, or nearly a $1/share per 10 million units. Thus, the model mix can significantly impact the income statement.

Initial data suggests that consumers are favoring the 16GB model. This is very positive since the $16GB produces $100 more in revenue and has a higher gross margin.

According to the retail store availability information on Apple’s website, the 16GB model has been dramatically outselling the 8GB model. However, one problem is the supply of 8GB versus 16GB is unclear. Early Saturday, Apple’s website reported 20 stores sold-out of 8GB, versus 28 stores sold-out of 16GB-white and 53 for the 16GB-black. This indicates significantly higher demand for the 16GB models.

It’s also likely that Apple had a larger stock of 16GB devices due to higher demand for larger capacity historically. In addition, it’s less advantageous to carry to little stock of the higher-priced model since running out of the 8GB may persuade a consumer to trade up to the 16GB. Conversely, higher supply of 16GB models prevents losing potential sales of the higher-priced model when a stock-out forces one to purchase the cheaper model.

A survey by Piper Jaffray of 283 line waiters this weekend reported that 66% planned to purchase the 16GB model. This ratio of 2:1 would support the data gleaned from Apple’s website regarding iPhone availability.

Regions Financial (RF): Due for a Bounce?

noreply@blogger.com (Turley M Muller) — Thu, 19 Jun 2008 04:36:00 +0000

Regions Financial (nyse:RF) has plummeted to $11.40 from its July 2007 levels of $32. For most of 2008, RF traded in the $18-22 range, but since May, RF has been on a pronounced downtrend. It’s also important to note, that the regional banking group as a whole, has been extremely weak for the past several weeks. Regions fell 7.4% on Tuesday, June 17th, and then fell 10.4% on Wednesday. In the last 30 days, RF has plummeted 45%. Also under pressure are Suntrust (STI), Key Corp (KEY), Fifth Third (FITB), BB&T (BBT), and Wachovia (WB). Looking at the table, most of the 3 & 6 month cumulative losses occurred just in the last month.

The obvious question- is the selling overdone? Regions may be due for a bounce. The two key possibilities that must be examined are 1) Has indiscriminate selling of the regional bank industry unfairly punished RF shares? 2) Does the market know that disappointing news from RF is imminent- or consensus EPS estimate revisions?

Regarding the first possibility- if shares have been unfairly crushed, then answer is simple: RF should be bought. In order to ascertain if RF’s situation differs from the rest of its peers, the second possibility needs to be examined.

It’s tough to predict negative news announcements and earnings misses. However, it’s rather apparent that investors have been pricing in these events. Thus, the balance of risks appears favorable. If earnings come in below the consensus, or if the dividend is cut etc., it’s likely that much, if not all, are already reflected in the share price. Therefore, disappointing news wouldn’t adversely affect RF’s stock price. If news turns out to be better than expected, then RF should rally. Hence, the potential upside exceeds the risk to the downside; this creates a favorable risk-return tradeoff

Asset Quality:
Regions Financial doesn’t have any sub-prime exposure. It did have a sub-prime origination business- EquiFirst, but those mortgages were sold servicing-released and not retained on the books. Regions sold EquiFirst to Barclays back in 2007. In addition, Regions isn’t exposed to non-traditional mortgages such as option ARMs or loans with teaser rates. Regions primary concern is its $11.5 billion construction loan portfolio with $447 million in non-performing loans. Regions hasn’t had to take any major write-downs, and earnings have held up in the past several quarters relative to peers.

Earnings Expectations:
Analysts are forecasting EPS of 48 cents for the June quarter, which is down from 54 cents 90 days ago. For FY08, the consensus estimate is $1.95, down from $2.14 three months ago, but has been steady for the past month. Regions is trading 5.8x this year’s EPS estimate. This is quite low given RF’s 12.8x 5-year average and industry average of 13.5x. This might suggest that investors expect Regions to earn half of the current consensus, or 97 cents for FY08.

The trailing 12m dividend is $1.50, a yield of 13.2%. The stock price definitely reflects a cut or elimination. A 5% dividend yield at the current share price would be 57 cents. Assuming a 60% payout ratio, EPS would need to total at least 95 cents over the next 4 quarters.

It appears that analysts haven’t revised RF estimates down to reflect current market expectations. Why do investors think estimates are too high? It’s likely concerns center on Regions construction lending portfolio as it has been deteriorating. 3.5B of the 6.2B residential homebuilder segment consists of vacant lot and land, which could experience high losses. Regions management states that they are moving aggressively to manage losses in this portfolio.

Regions recorded a loan loss provision of 181 million for 1Q08, down from 358 million in 4Q07. It’s likely that Q2’s provision will have to return to at least 400 million. Even so, RF has been reducing costs through last year’s merger with AmSouth. In the march quarter, merger cost saves totaled 127 million, and management expects total cost saves of 700 million by year-end 2008. In addition, Regions Financial also owns Morgan Keegan, a strong brokerage firm, which will help diversify revenue streams during this downturn.

Short Interest:
RF’s short interest surged 13.1 million shares (27%) during the last period reported (May 15-30). This represents about 9% of the outstanding share float with cover ratio of 6.3 days. Since the last report, short interest has likely increased further given the declining share price. Short interest represents future share demand as shorts must buy shares to cover their positions.

Option investors are betting on further share declines in RF shares. On Wednesday, trading in Regions Financial's options surges to eight times the normal daily volume, as investors bought 48,000 puts and 8,000 calls. Activity was heavy in the July $10 puts, trading at 95 cents and will be in the money if RF slides below $9.05 before July 18.

It’s quite evident that investors are negative on RF. This positive aspect is that weak sellers are folding there hands and negative expectations are being priced-in. With so many investors negative, the supply of sellers begins to dry up, as the supply of future buyers increases. If future developments are not a dire as expected, then RF should see a nice bounce as short-sellers scramble to cover positions.

Conclusion:
Capital ratios are decent- Tier 1 capital ratio is 7.3% and Total capital ratio is 11.1%. These are well above the minimum requirements of 4% and 8%. Regions book value / share is $28.82 resulting in a P/BV of 0.4x.

Thus, the selling of RF shares has been warranted, but has it been overdone? Or, is there more selling to come? Regions revenue streams are diversified with its banking, brokerage, and insurance businesses. Regions is also aggressively improving its cost structure through its merger cost reduction plan. The combination of these factors should help offset, to a degree, future write-downs and loan losses. RF has adequate capital ratios, thus I don’t foresee a major equity capital raising.

I believe current share prices can withstand a 50% reduction to earnings and the dividend, as these possibilities are priced-in. Thus, I think, with a considerable amount of negative news already discounted, there is significant upside potential. Hence, the balance of risks is favorable possibly making RF due for a bounce.

What Can Push Apple's Shares Higher?

noreply@blogger.com (Turley M Muller) — Thu, 12 Jun 2008 02:17:00 +0000

Apple Inc (nasd:AAPL)- Apple has surged to $180 from $120 where it was trading back in February. Of course, Apple was trading near $200 at the end of December 2007, but sentiment turned and Apple’s shares plummeted January through March before reversing, and staging a rally in April. Shares have been stuck in the $180’s since May. The pivotal question becomes: “what can/will push shares higher?”

Apple’s stock may have gotten ahead of itself at the end of last year (2007), when it hit $200. Analysts were bullish and nearly all had a price target above $200. Then January arrived, Apple provided weak guidance and the Street flipped out. Sentiment quickly turned negative, and heavy selling drove Apple lower. A couple analyst downgraded the stock, and most revised their price targets lower to the $150-175 range. As industry data reports showing potential robust Mac sales became available in March, Apple shares began to recover. Apple announced earnings in April that showed strong Mac sales. This further quelled apprehension and eliminated the overly pessimistic attitude on Wall Street. As the chart illustrates, price targets were revised upward. In short, I believe Apple shares collapsed due to worries that they were overvalued, then information subsequently supported those high share prices, thus Apple’s stock returned to that level.

Apple has been stuck in the $180s since the beginning of May. Nothing has been able to power shares beyond the current range. There have been several analysts raising price targets. However, the effect on Apple’s share price has been insignificant. Apple announced the July arrival of its new 3G iPhone, yet Apple shares were still unsuccessful in breaking out into the $190s.

Apple has announced the expansion of iPhone countries from 5 to 70, as well as a much lower price point of $199. However, EPS estimates for FY09 have only slightly budged.

According to the EPS revisions table, most recent changes to the consensus estimates have been downward.

In my opinion, I think the catalyst for a move higher will be upward revisions to EPS estimates. I don’t think they currently account for the immense sales potential of the new iPhone, as well as the momentum in the demand for Macs. Albeit, Apple is giving up the monthly subscription revenue payments from AT&T, thus the increase in volume will becoming at a lower margin. This might possibly be why Apple’s shares have failed to respond more positively. There are a couple things to consider. First, there have been estimates that the new phone’s manufacturing cost is half of the current iPhone. Second, the MobileMe service at $100 per year adds revenue potential associated with the new iPhone. Sales of iPhone applications from Apple’s App store is another avenue to boost revenue. Most importantly, iPhone sales will expose the Apple brand to many who lack experience, and ultimately boost Mac sales.

I think we will gain more clarity in July, when the new iPhone hits stores and Apple releases Q3 results. It’s likely, until then, there won’t be many developments capable of really moving the stock, other than possible EPS estimate revisions.

Apple isn’t cheap trading at 35x FY08 consensus EPS estimates and 28x FY09. Apple may actually be cheaper if you believe those estimates are too low. I think the estimates are likely too low, thus Apple would be trading at slightly lower multiples. I think Apple could be bought on any weakness or pullbacks, since Apple’s share price reflects the fundamentals as opposed to pure sentiment, as it did last fall and this winter.

Disclosure: none

Consumer Spending Outlook

noreply@blogger.com (Turley M Muller) — Tue, 10 Jun 2008 02:03:00 +0000

Current economic conditions are challenging, especially for the consumer. Given a multitude of factors, I am skeptical of the popular belief that GDP growth will pick up significantly in the second half. I expect GDP growth will remain flat to sluggish well into 2009. I can’t foresee significant economic growth returning until the consumer regains strength. Historically, roughly three-quarters of GDP is related to consumer consumption, thus economic growth hinges on the health of the consumer. I have highlighted the primary elements affecting consumption.

Consumption is a function of monetary inflows (spending capacity) minus compulsory monetary outflows with respect to the level of willingness to spend net inflows. A consumer’s spending capacity is a combination of wages, investment income and access to borrowed funds. Compulsory expenditures are basic necessities, such as food, housing, energy, clothing, health & education, and taxes. After purchases for non-discretionary goods and services are satisfied, a consumer can choose to either spend or save the remaining money. The decision to save vs. spend depends on consumer sentiment and outlook on the economy.

Since we are focusing on GDP growth, we must evaluate at the margin, how current conditions have changed from those previous. There are multiple factors responsible for overall consumption. I can’t think of any major factors positively affecting spending other than the tax rebates. Most factors are neutral or unfavorable, with a major factor- home equity borrowing, being very negative. In this decade, GDP growth was largely dependant on equity withdrawals, which significantly boosted consumption. This is my key concern- the demise of the housing market and the evaporation of home equity. Since 2000, GDP without equity withdrawals would have never surpassed 1.25%.

Consumers have a reduced capacity to spend and face higher costs for essential goods/services, which leaves less money available for discretionary spending. Due to weak consumer confidence, disposable income will likely go more towards saving and debt reduction than being spent.

Consumption:
Wages + Investment Income + Borrowed Funds + Sentiment
- Taxes
- Mortgage/rent payment
- Compulsory Spending
= Disposable Income

CONSUMER SPENDING CAPACITY:
Wages:
I expect slow consumer wage growth due to the increasing supply of labor. Labor demand is weak as evidenced by the monthly decreases in payrolls we have been witnessing this year. When the economy is shedding jobs, then the unemployment rate rises (all else equal). Wage growth primary occurs when employers have to compete for labor in a tight market. When labor is abundant, there is less need to offer higher wages to attract and retain labor. In addition, corporations are trying to preserve earnings by controlling costs, thus there is less impetus to increase workers’ wages. Instead, companies will be looking to boost productivity. This is likely a reason we have been seeing strength in the technology sector.

In aggregate, job losses means there is lost income that otherwise would be spent, adding to total consumption.

Investment Income:
Investment income should continue to be soft. Financial firms, such a banks, generally pay large dividends. A large number have recently reduced or cut their dividend. Interest income from savings accounts and bonds has decreased due to falling interest rates. Income can also come from capital gains on investments and real estate. The stock market has been volatile, and one would have to go back to 2006 levels for gains on S&P500. Thus, in general, there are probably less profits that can be taken from an investor’s stock holdings. The second half of the ‘90s GDP growth was bolstered by a surging stock market.

Falling home values mean potential capital gains have fallen as well. Unless the house was purchased more than several years ago, there will not likely be any gain on sale.

Available Credit:
The most crucial aspect of consumer spending is ability to borrow funds. The major sources of borrowing are mortgage cash-outs, home equity lines of credit, and credit cards. In this decade, consumer spending was driven by home equity withdrawals. At the beginning, rates fell to historic lows resulting in mortgage refinances. Monthly payments were reduced along with equity withdrawals. During the middle years, home values appreciated significantly causing home equity levels to rise contemporaneously. The robust gains in home equity, coupled with easy credit that allowed high LTV, enabled consumers to use their homes as a major source of funds.

Recently home values have been plummeting which is causing reductions in home equity levels. 16% of homeowners with a mortgage have zero or negative equity. Moody’s expects that number to increase to 25% by June 2009. Average level of equity for a US home is 46%, which is the lowest level since the 40’s. At the beginning of the decade, home equity was nearly 60%, and hovered in the mid to low 50’s until 2007 when in broke below 50% as home values began to decline. Considering inflation-adjusted home values rose 70% from 2000 to 2006, one would expect equity levels to rise as well. Of course, cash-out equity refinancing must be considered. Thus, value created from home appreciation was withdrawn and consumed. Lax credit standards and loans allowing higher LTV (loan to value) also contributed.

With equity levels at historic lows, the amount of equity available to be withdrawn and spent is relatively minimal. This is compounded by the reduction of LTV ratio that banks will lend.

Foreclosures will add to the already bloated housing supply, which stands at 11 months. Demand for housing is weak due to tightened credit and reduced investor appetite for mortgages. These factors will continue to pressure home prices, and without appreciation, equity withdrawals will not increase.

Consumers pulled back on their borrowing during the first quarter, slowing the growth in their new debt to a 3.5% annual rate, less than a third of the growth rate seen two years ago and the slowest growth since 1992. New mortgage debt was particularly weak, growing just 3%, the slowest increase since 1970. Home-equity loans fell by $7.3 billion, the first decline since 2001.

COMPULSORY SPENDING:
With rising inflation, essential goods are becoming more expensive which leaves less funds available to spend on other goods and services. Even though spending on essential goods/services contributes to GDP, it can reduce discretionary spending leading to weakness and job loss in those areas. Inflation is rising in areas where demand is inelastic, such as food and energy. The dollar has been declining making imported goods more expensive. Not only does this reduce spending in other areas, it takes money from the domestic economy to be recycled in foreign markets.

Food Inflation:
Food prices have been rising to very high levels. The primary reason is due to a significant increase in demand coming from emerging markets where standards of living have drastically improved. Since nutrition is a top priority, consumers spend will first spend on food until satisfying that requirement, before challenging expenditures to other areas. Thus, huge demand increases will occur from those with the highest propensity to purchase food, which are those who are undernourished. In many countries, people are able to eat 2 to 3 meals a day instead of just 1 or 2.

The cost of food production has risen due to higher fuel and fertilizer costs. In order for farmers to produce a crop, the price must be high enough to cover costs or they will choose not to supply it. Essentially costs are passed on to the consumer if producers don’t incorrectly forecast demand resulting in excess supply.

Ethanol production has led to increased corn acreage, which has affected other food prices. Since more land has been devoted to corn, land available for producing other grains has decreased, hence reduced supply. Higher grain prices have translated into higher feed costs for livestock farmers, which drives up prices of meats.

Higher Energy Costs:
The price of oil has skyrocketed over the past two years. Price of gas has about doubled. Heating oil and natural gas prices have risen too. Transportation costs generally spread throughout all areas of the economy causing rising prices. Transportation for an individual, such as driving, has become much more expensive and there isn’t much that can be done to significantly alleviate the increased costs. Heating a home has become more costly as it’s another area where demand can’t be reduced much to offset rising costs.

Rising Cost of Imports:
Americans import many of their goods. The weakening of the dollar means that foreign goods become more expensive. China has been a major source for inexpensive goods, especially since its currency has been very undervalued for a longtime. With inflation is China skyrocketing and pressure to revalue the Yuan, the dollar has been weakening against the Chinese currency and will likely continue for some time. A significant factor in keeping inflation low has been cheap Chinese imports.

SENTIMENT:
The mood of the consumer is important in determining whether they will spend or save/pay down debt. The current economic landscape plays an important role. If consumers are optimistic about the economy, then they will save less, increase debt levels, and spend more. The wealth effect is equally important. Rising asset values make the consumer feel more wealthy, thus increasing discretionary spending budgets.

The net worth of U.S. households and nonprofits dropped at an annual rate of 11.3% in the first quarter to $55.97 trillion. It was the biggest drop in wealth since late 2002. Net worth had grown by more than $20 trillion from 2002 through the end of 2007, as home values and the stock market boomed.

Consumer confidence has plummeted. Home values, the consumer’s largest asset, are dropping. Consumer debt levels are high (nothing new). With these factors, consumers are less sanguine about spending and will be more reserved. They will likely take on less debt and save more.

CONCLUSION:
As I outlined above, there are multiple challenges facing the American consumer. The pivotal question is: “what will energize the consumer?” Historically, home equity borrowing has been the primary source, yet it will be some time before this is a material source for consumer funds. The consumer is also facing higher costs on staple goods and bleak employment outlook. Consumption has been by far, the largest component of GDP. Thus, I expect GDP growth to be tepid and consumer discretionary stocks to struggle. There is a bright spot- exports, the weak dollar is causing exports to surge. This is especially important because foreign funds pour into the American economy and are recycled domestically.

Festival of Stocks #90 @ Circle of Competence

noreply@blogger.com (Turley M Muller) — Thu, 29 May 2008 17:08:00 +0000

This week’s 90th edition of the Festival of Stocks is at Circle of Competence. Be sure to check out this week’s articles!

My article Authentidate Remains Undervalued was included in this week’s edition.

I recommend taking a look at some of the posts on Circle of Competence. It’s a new blog launched by Jeff Annello a couple months ago, and he has written some terrific material in short time. Mr. Annello focuses on Value Investing and its icons, such as Warren Buffett.

You can catch up on past editions by visiting the Festival of Stocks homepage. There you can also find out how to submit an article for next week’s Festival or learn about how you can volunteer to host an edition of the Festival of Stocks on your own blog.

Authentidate (ADAT) Remains Undervalued

noreply@blogger.com (Turley M Muller) — Sat, 24 May 2008 03:22:00 +0000

Authentidate Holding Corp (nasd:ADAT)- $.43-This is an update to previous notes (1.CF Break-Even 12 months 2. Traction in Germany 3. Attractive Speculative Play). I remain optimistic towards ADAT given management’s forecast of cash-flow break-even in the December or March quarter. ADAT announced this intention earlier this year, and has continued to reiterate its guidance. I truly believe management would not provide this guidance unless they were very confident that it could be accomplished.

ADAT is trading for less than its $.53 cash/share and $.90 book value/share- and it has no debt. Thus, ADAT’s share price reflects the expectation that it will soon burn through its cash and close its doors. Management believes they can reverse the burn rate well before cash dries up. There is little doubt that significant revenue potential exists, rather doubt has been cast on its timing. The key issue facing investors is whether ADAT will run out of cash before revenues amass to a break-even level. In short, Management believes (so do I) that break-even will be achieved with cash to spare. When ADAT becomes cash-flow positive, I think we could easily be looking at a $2-$3 stock.

The business model is promising, but has been slow to gain traction. The introduction of the Inscrybe platform has accelerated adoption and generated impressive revenue growth. Due to the ~70% gross margins and amount of leverage in the model, there is considerable upside potential in profitability. After attaining sufficient revenue volume to cover fixed expenses, a very large portion of incremental revenue falls to the bottom line.

In my opinion, Authentidate is undervalued. Granted, there are significant risks, but the share price doesn’t reflect ADAT’s true value. Authentidate is unknown to many investors, and its low share price and trading volume make it difficult for institutions (and individuals) to invest. On average, 50k shares, or 25k in dollar volume, change hands daily.

Without analyst coverage, investors look to ADAT for company news. Management has been hesitant in providing details on business. Back in 2003-04, ADAT shot up to $20/share, and when expected sales traction failed to occur, the share price plummeted. Of course, this invited every ambulance-chasing law firm on Wall Street to file class action lawsuits. Even though those suits never materialized, it drained Authentidate’s strategic focus and checkbook. I believe this has led management to be more guarded in its statements to investors. The irony is that ADAT is claiming cash flow break-even in CY08. Given ADAT’s history of not providing much guidance, logic suggests that management would not make such a claim unless it was highly certain it will be achieved. The company also hinted that once progress begins to appear in the financial statements, that it will be much more involved with the investing public. In essence, the share price is not a product of broad based opinion, rather transactions of a few, thus ADAT is inefficiently priced.

About Authentidate:
Taken from Authentidate’s Press Release
Authentidate Holding Corp. is a worldwide provider of secure workflow management software and web-based services. The company's automated and trusted workflow solutions enable enterprises and office professionals to employ rules-based electronic forms, intelligent routing and transaction management, electronic signing, content authentication, identity credentialing and verification and web and fax based communication capabilities. Customer benefits from the company's offerings include reduced costs, improved productivity and service levels, automated audit trails, enhanced compliance with regulatory requirements and the reduction of paper-based processes. The company has offices in the United States and Germany. In the United States we offer our patent pending content authentication technology in the form of the United States Postal Service® Electronic Postmark® (EPM). See USPS EPM

ADAT plans to achieve break-even through cost reduction and revenue acceleration.

Revenue Growth:
Authentidate will need a run-rate of 4 million-plus per quarter for cash flow break-even. Revenue in the March quarter was 1.7 million with US segment revenue (Inscrybe) increasing 18% sequentially. Growth Yr/Yr was 33%, thus accelerated in the recent quarter. Most of Authentidate’s customers are still in the initial – intermediate stage of implementation, thus revenues will continue to increase just from roll-out.

My thinking is that the current customer base is likely sufficient to generate the required level of sales for break-even. My theory is this is why ADAT is comfortable with stating its goal of break-even in the coming quarters. If they know a customer’s billing is (x) amount at (y)% implementation, then that ratio should hold as implementation nears 100%.

The major customers are Apria, American Home Patient, Lincare, Liberty Medical, and several others. These healthcare providers’ business models are largely driven on working-capital management. There is a long delay from the time services/products rendered to patients until reimbursement from Medicare/other insurers. Much of this delay stems from extensive paperwork and physician signatures that must be completed and collected before these agencies can be reimbursed. Authentidate’s services aid in drastically reducing days sales outstanding (DSO), hence working capital requirements.

Home medical equipment providers, such as Apria and American Home Patient, benefit significantly from using Inscrybe, in turn, they persuade physicians to sign-up. Some physicians using Inscrybe have then turned to agencies not using Inscrybe, and have recommended that they start using Authentidate’s platform. That illustrates a powerful, viral process in which adoption can easily and rapidly spread. (see MD interview).

Doug Guy, SVP at American Home Patient commented about incorporating Authentidate’s solution (ADAT PR 4/23/2007) "We are realizing significant operational efficiencies as a result of deploying the Inscrybe eCMN capabilities in our billing centers and branch locations. Over the past 12 months, we have seen a 65% reduction in turnaround time of documents processed by physician offices through Inscrybe, a significant reduction in unbilled dollars, and a marked improvement in internal document processing throughput. Besides a direct impact on our bottom line, it has improved the service experience for our physician and patient communities." 

Market Potential:
The market potential is massive. Enormous. The state of Indiana has been using Authentidate’s technology for DMV and court-related documents. In Germany, firms are authenticating electronic invoices for VAT tax compliance standards. The legal, financial, real estate, medical, and likely almost every other industry could benefit from using ADAT’s document security solutions.

The core issue is developing a critical mass of users, since adoption spreads virally. Hence, a user wanting to send documents requires the counterparty to use the technology as well. Think of a fax machine. The first fax machine was useless since it requires another fax machine to receive. Yet, as fax usage increased, more and more people purchased fax machines so they could correspond with those already using fax machines. Thus, adoption rates begin at a slow pace but accelerate quickly resulting in exponential growth.

Authentidate is expanding its addressable market. Over $500 billion are spent annually administering healthcare. $10’s of billions are spent handling business and legal documents. Document-intensive industries are stuck in a paper-based world, however, Authentidate provides solutions for migrating to a more efficient, electronic based environment. The following table is from Authentidate’s May 2008 shareholder meeting. It highlights the potential markets and revenue streams available to Authentidate.

Cost Reduction:
Operating expenses have been averaging $5-6 million per quarter, but have been trending down. Costs should continue to fall as ADAT recently cut 20% of its workforce, mostly mid-senior level positions. In addition, severance costs and legal fees will soon go away, further decreasing Authentidate’s expenses. Management is highly focused on cost control, and it should be able to continue to make progress in this area.

Operating Performance History: 
Authentidate sold its DocStar and DJS marketing group to focus solely on security solutions. Looking at historical financial statements doesn’t represent an accurate picture of Authentidate’s current operations. For example, income statement found on Yahoo Finance shows sales of $17.5m-2005, $16.5m-2006, and $5m-2007. These figures include revenue from discontinued business segments. Revenues from continuing operations only, are illustrated below.

2003: 950 
2004: 1250 
2005: 2822 
2006: 3870 
2007: 4998 

Sales growth for the past 5 years has averaged 56% per annum. Management declined to give specific guidance, but insinuated that Inscrybe (August release) will accelerate customer adoption and usage rate causing a significant increase in sales growth. Gross margins have historically ranged 60-70%. SGA expenses have been the primary problem, totaling $16.8m fro FY07. For the 3 quarters already reported for FY08, ADAT recored 4.4 million in sales.

Conclusion:
Authentidate is on pace to achieve cash flow break-even in the next 6-9 months, and subsequently become profitable on a GAAP basis. The stock trades for less than cash, hence no value is attributed to ADAT business nor as a going concern. The stock is undervalued because very few know about ADAT and its prospects. The scant trading volume confirms this, thus if more investors knew the facts surrounding ADAT, it would be trading higher, in my opinion. As ADAT moves to profitability, we will see increased interest in ADAT shares accompanied with higher prices.

Disclosure: Long ADAT

Comparing Valuations: Yahoo vs Google

noreply@blogger.com (Turley M Muller) — Thu, 15 May 2008 08:03:00 +0000

Comparing price-earnings multiples and expected growth rates of Yahoo and Google several items become apparent. Yahoo is extremely overvalued as an independent company with its current share price reflecting the likelihood of a buy-out. Google is the better value of the two, but Google alone is fairly valued.

First, let’s run through the numbers I gleaned from Yahoo Finance and Nasdaq.com

Yahoo Valuation:
Yahoo shares currently trade 57.7x FY07 EPS of 47 cents. Looking forward, Yahoo trades 59x FY08 EPS estimate of 46 cents and 48.5x FY09 estimate of 56 cents. These EPS estimates translate into Yr/Yr growth of -2.1% (FY08) and 21.7% (FY09). Yahoo’s annual growth rate has averaged 23.3% the last 5 years.

Taking a slightly different perspective, Yahoo’s combined EPS for the last 4 quarters is 48 cents, and consensus estimates for the next 4 quarters total 52 cents. This represents 7.3% growth. The P/E multiple using EPS for the next 4 quarters is 52.7x. Using a PEG ratio to standardize value with respect to forecasted growth (Multiple/Growth), Yahoo has a PEG of 7.23.

Google Valuation:
Google shares currently trade 37x reported FY07 EPS of $15.59. Looking forward, Google trades 28.6x FY08 EPS estimate of $20.14, and 23.3x FY09 estimate of $24.74 . These EPS estimates translate into Yr/Yr growth of 29.2% (FY08) and 22.8% (FY09). Google’s annual growth rate has averaged 75.4% the last 5 years.

Taking a perspective of last 4 quarters versus upcoming 4 quarters, Google’s combined EPS in the trailing 4 quarters is $16.74, and consensus estimates for the next 4 quarters total $21.23. This represents 26.8% growth. The P/E multiple using EPS forecasts in the next 4 quarters is 27.2x. Using a PEG ratio to standardize value with respect to forecasted growth (Multiple/Growth), Google has a PEG of 1.01.

The difference in the two’s valuation is stark and quite apparent. Google’s forecasted growth is higher than Yahoo’s, yet it trades at lower multiples. That suggests Yahoo is overvalued relative to Google. But, does that mean Google is undervalued and should be bought? And that Yahoo is overvalued and should be sold?

Yahoo Analysis:
In my opinion, Yahoo is certainly overvalued as the company exists today. Its current valuation hinges on a business combination, most likely with Microsoft. Of course, this is the reason that Yahoo shares are trading at such high levels. It’s not a surprise why Ballmer balked at Yahoo’s $37 asking price since colossal synergies would have to be extracted from a combination to justify that high valuation.

Even at $33, $31, or Yahoo’s current share price, a suitor would really have to leverage Yahoo’s assets to unlock value. Now, common thinking concedes the value in Yahoo’s assets already exists, yet management and its strategy have been poor- leading to weak performance. Hence, strategic synergies and proper management may quickly boost Yahoo’s cash flow to a level that would justify such valuations.

The fact that Yahoo shareholders are irate that the board was holding out for $37 shows that they believe that valuation to be unreasonable. $31-33 is better than $27. If it weren’t for the possibility of a deal, the share price would be much lower, perhaps a teenager. However, Carl Icahn reportedly will launch a proxy battle to replace Yahoo’s current board. Such attempts are generally difficult to execute since ownership is fragmented and diffuse, however shareholders are angered and Icahn has established a track record.

In summary, under Yahoo’s current strategies, analysts don’t foresee much growth. Yahoo’s lackluster performance the past several years is not expected to change going forward, pursing the same course. Yet, shareholders and Carl Icahn believe Yahoo’s potential value is much greater than what historical performance and earnings projections would suggest- value contingent on business combination or management change.

If no deal (of some sort) ever comes to fruition, then YHOO shares would likely be cut in half. Ostensibly, there is inherent value not recognized in Yahoo’s performance, but if Icahn is not successful in removing a stubborn board, then it’s unlikely anyone else would be either.

Independent Yahoo- nearly all of Yahoo’s revenue comes from search and display advertising. Yahoo has been losing share in search; Google’s superior algorithms boosted its share into the mid sixties. In the English lexicon, Google has become a verb “Google xyz,” meaning to perform an internet search. Yahoo is still the second most popular search engine, but I believe most yahoo searches are secondary events. Yahoo’s content attracts users, who in the course of their visit, become compelled to search for a particular item and do so on yahoo, instead of navigating to Google. Conversely, users not on Yahoo’s portal choose to navigate to Google opposed to Yahoo to perform a search query. Hence, some of Yahoo’s search traffic is a matter of circumstance, and not necessarily one’s usually first search engine choice. Hence, the content from the portal aids in generating search traffic, but without a superior search engine, search depends heavily on traffic the portal attracts.

53% of Yahoo’s revenues come from advertising on its own properties, and segment revenues increases 18% in Q1. Yahoo attracts traffic through its news, finance, sports, and mail content/services. There isn’t anything proprietary about the content Yahoo provides, thus can be duplicated. In addition, Yahoo is buggy. Yahoo Mail doesn’t work right (search & spam filter), sometimes pages don’t render correctly and tables fail to populate. Groups and message boards are filled with spammers.

In my opinion, there are many things that have gone down hill on Yahoo’s site. Social networking sites and blogs are gaining traffic, traffic that could be going to Yahoo. Much of what Yahoo has now, could be duplicated, perhaps by Google. Google provides similar content and services, such as mail, messenger, maps, etc. and in my opinion, is better. In sum, Yahoo is dependent creating content and services that will attract visitors to its website.

Yahoo also provides advertising to third parties or affiliate sites, but segment revenue (33%) and margins have been declining. In Q1, segment sales fell 7%, after accounting for the drop in margin (shares more with partner), net revenues declined 13%. Yahoo’s total net revenue increased 9% for Q1. Google’s revenue growth was 42%.

Google Analysis:
At $576 / share, Google is fair-valued. In mid-March, I was bullish on Google when it was trading around $440. In my Google valuation analysis, I pegged Google’s fair value at $540 / share. I think, given the take-over turmoil engulfing Yahoo, and the ensuing distraction and departures, has boosted Google’s lead further. Thus, a $600 share price for Google is reasonable, but not attractive.

I am reluctant to place a valuation higher than $600 on Google due to its spending. GOOG has very high profit margins, but absent from the income statement is capital spending. Capex as a percentage of total revenue has been in the mid-teens for the past several years. R&D as percentage of sales has increased as well, from 10% (FY05) to 13% (FY07). Headcount has also significantly expanding leading to declining sales/employee & income/employee ratios. The significance- On the margin, each incremental dollar of revenue growth is accompanied by higher costs and investment. Hence, Google’s prospective growth generates less incremental corporate value compared to its past growth. Nothing new here, just the law of diminishing returns taking hold.

Conclusion:
Owning Yahoo at these levels is purely a bet on an acquisition. There is some upside to $31 or perhaps $33, but there is some downside risk as well. Owning shares of the acquirer (whoever that may be) is a bet that synergies will enhance value and that the purchase price was not excessive. Owning Google is a pretty safe bet with the upside potential balanced with downside risk.

Advantages to Controlling Hardware Selection and OS Development

noreply@blogger.com (Turley M Muller) — Tue, 13 May 2008 01:42:00 +0000

PC Magazine contributor Sascha Segan shares his insight on Microsoft’s recent missteps with Vista and Mobile OS in this month’s edition (June ’08). His primary thesis is that there is a disconnect between Microsoft’s OS and the capabilities of hardware components. Microsoft develops software on the assumption that the hardware installed-base would contain the latest, most powerful processors and graphic cards. This became problematic for MSFT when chip and device makers chose to keep costs down by utilizing lower powered circuitry. In short, Microsoft OS is built for the hardware of tomorrow as opposed to that of today.

Firms such as Apple (AAPL) and Research In Motion (RIMM) control the OS and hardware for their products. In my opinion, this gives them an advantage over Microsoft who must tailor its OS to the hardware of multiple manufacturers.

According to Segan, Intel needed to contain its costs, thus it opted for motherboards that included non-Vista-friendly integrated graphics as opposed to a dedicated chip set. Even though Vista operated poorly integrated graphics designed PCs, Microsoft approved its operability. This hardware-software gap caused significant performance issues for consumers.

Eventually, PCs become more powerful thus performance catches up to the needs of the Microsoft’s OS. In past years, this wasn’t a significant issue. However, today, consumers have a more viable alternative as evidenced with the populatity of Apple’s Macintosh. Consumers may not wait for performance to catch up, rather they may be inclined to purchase a Mac instead.

Segan also claims that MSFT has made the same mistake with Windows Mobile OS. It’s designed for processor speeds not found in the majority of mobile handsets. Segan adds “given a choice of making it faster or making it cheaper, most manufacturers will pick cheaper”

We have seen that Vista has had a rocky introduction, and Microsoft recently announced that a “downgrade” to XP would be available for less powerful machines. Mobile OS has been less than stellar as well, albeit improving. My experience with Mobile OS was horrible. I finally ditched the device after becoming fed up with the “spinning hourglass” popping up when trying to answer a call.

I believe Segan’s article illustrates the advantage Apple obtains from controlling both software and hardware functions. This gives Apple total control over the user experience as well as making it very difficult for users to duplicate.

I was dismayed when PALM decided to go with Windows Mobile OS for its Treo handsets. This creates several problems. First, MSFT Mobile OS places constraints on PALM’s innovation of its mobile devices. The user experience is dependant on MSFT not necessarily on PALM. Second, it limits PALM’s ability to differentiate its handsets. There isn’t mush difference between PALM devices and others running Windows Mobile OS, given that the hardware is the easiest component to replicate. Even if competitors are able to replicate Apple’s or RIM’s devices, the software is still different and protects from “knock-off” models.

Apple has a distinct advantage; it’s devices run seamlessly. Vista’s troubles may partially be responsible for the surge in adoption of Mac computers. The simplicity of Apple’s iPhone OS may prove to be a huge weapon against Windows Mobile OS devices, especially when the iPhone become more price competitive.

Apple recently agreed to purchase PA Semi, a private boutique microprocessor design company known for robust, low-power designs. The true nature of Apple’s plans for the acquisition is unknown; however, PA Semi would aid in creating chips that are optimal for Apple’s OS. In addition, instead of contracting chip production, Apple retains proprietary secrecy by manufacturing the hardware in-house. This further enhances its competitive advantage by making it extremely difficult for imitation devices.

Apple and RIM will continue to outshine other mobile handset device makers using Windows Mobile OS. Even if Mobile OS drastically improves, these manufacturers lack differentiation and will have to compete on price. This increases pressure to utilize less powerful components, which will affect performance. RIM and Apple select the hardware needed to support the OS and do not have to make sacrifices detrimental to performance. MSFT, on the other hand, must design its OS according to the specs of the available hardware. However, since MSFT doesn’t control which hardware will be actually used by manufacturers, it faces a more challenging task.