Why I Sold Apple And Bought Yahoo

| About: Apple Inc. (AAPL)

I have two brokerage accounts I manage or help manage. I have my own IRA retirement account, where I employ a dividend-growth investing process and I also help my youngest son with his account.

I started a Uniform Gift to Minors Act (UGMA) account for my son shortly after he was born. Money received for various milestones were placed in the account for his use later in life. Initially, when the funds were minimal, the money was invested in a stock fund. As my son and the account grew older, enough money was in the account that individual stocks could be bought. I wanted my son to learn about investing and have some ownership of the account, so I let him pick the stocks he wanted to own. My one rule was he had to give me his investment thesis as to why we should buy a particular stock. Being young and a user of technology, many of his ideas centered around technology.

Love of Apple Products - Leads to Apple Stock!

In 2012, he came to me and said he wanted to buy Apple (NASDAQ:AAPL). He has an iPhone and iPod and is a fan of their products. His thesis was, Apple made great products, more and more people are using the iPhone and as smartphone use grows their sale numbers would grow. He also said the iPad was selling well and its use would also grow. In addition, everyone bought music from iTunes. He also thought the stock was cheap. I told him the stock had a high price and he would be limited to the number of shares he could buy. He wanted to buy Apple anyway, so in April 2012, he bought Apple for $578.00. Obviously, that trade has not turned out well.

Since the stock was purchased, Apple has raised the number of iPhones sales, the number of iPad sales and continues to dominate the music download business with iTunes. Apple has also bought back shares, raised dividends, and expanded into foreign markets. Yet, the stock price has slid.

I believe Apple's stock price stays in a trading range because everyone understands that Apple makes technology products, technology products that can quickly be supplanted by a superior product. For example, in the most recent quarter, iPhone market-share was down across most markets. Make no mistake, Apple is still the leader in the high-end market, but competition is definitely intensifying.

More Sales - Flat Profits!

I also believe Apple has been unable to provide the financial growth numbers investors are looking for. The first two paragraphs of the most recent earnings report shows Apple's dilemma.

"Apple® today announced financial results for its fiscal 2014 first quarter ended December 28, 2013. The company posted record quarterly revenue of $57.6 billion and quarterly net profit of $13.1 billion, or $14.50 per diluted share. These results compare to revenue of $54.5 billion and net profit of $13.1 billion, or $13.81 per diluted share, in the year-ago quarter. Gross margin was 37.9% compared to 38.6% in the year-ago quarter. International sales accounted for 63% of the quarter's revenue.

The company sold 51 million iPhones, an all-time quarterly record, compared to 47.8 million in the year-ago quarter. Apple also sold 26 million iPads during the quarter, also an all-time quarterly record, compared to 22.9 million in the year-ago quarter. The company sold 4.8 million Macs, compared to 4.1 million in the year-ago quarter."

Apple sold a record number of iPhones and iPads, had record revenue, yet profits were flat at $13.1 billion. One has to ask themselves, how many iPhones and iPads, Apple has to sell to materially grow their profits.

I found it interesting when I looked at the 1st quarter 2012 earnings release, that profits were once again approximately $13.1 billion. Here are the first two paragraphs from that report.

"Apple® today announced financial results for its fiscal 2012 first quarter which spanned 14 weeks and ended December 31, 2011. The company posted record quarterly revenue of $46.33 billion and record quarterly net profit of $13.06 billion, or $13.87 per diluted share. These results compare to revenue of $26.74 billion and net quarterly profit of $6 billion, or $6.43 per diluted share, in the year-ago quarter. Gross margin was 44.7% compared to 38.5% in the year-ago quarter. International sales accounted for 58% of the quarter's revenue.

The company sold 37.04 million iPhones in the quarter, representing 128% unit growth over the year-ago quarter. Apple sold 15.43 million iPads during the quarter, a 111% unit increase over the year-ago quarter. The company sold 5.2 million Macs during the quarter, a 26% unit increase over the year-ago quarter. Apple sold 15.4 million iPods, a 21% unit decline from the year-ago quarter."

As you can see, Apple sold many more iPhones and iPads in 2014 than 2012 and had much higher revenues. Yet, the profits for the 1st quarter of 2012, 2013 and 2014 were almost exactly the same. Also note, margins in 2012 were 44.7%, which have since fallen to 37.9%.

More Competition & Saturation!

In my opinion, Apple will be hard pressed to continue growing sales at a record pace. Competition is intensifying and in some markets, like the United States, the smartphone market is becoming saturated. AT&T (NYSE:T) during their recent conference call stated smartphones are now 93% of sales, which leaves little room for future growth in the United States. Going forward, it is a battle for market-share, which often leads to price discounting.

Tablets are also seeing more competition and the space is getting muddy as hybrid products like phablets (combination phone and tablet) become more popular.

Both, operating income and total income fell in 2013 from 2012 results. Margins fell and cost of sales increased. Note - Amounts below are in millions.

2013 2012
Cost of Sales $186,606 $87,846
Operating Income $48,999 $55,241
Net Income $37,037 $41,733
Click to enlarge

As competition increases, Apple has to work harder and promote more to make a sale.

Unless Apple develops a new product, which they may, they face the law of diminishing returns. How much better can the iPhone 11 be than the iPhone 10. At some point, you have improved the phone as much as it can be improved.

No Catalyst on the Horizon!

Buying Apple at $578.00 was a mistake. Although it looked relatively cheap at the time P/E wise, it was actually expensive. The calls that Apple was going to $700.00 should have been ignored. However, that is history. The question is where does it go from here and I currently do not see any reason, including rumored products, why the stock will move significantly higher.

If the new product is a smartwatch, I think the Samsung failed launch of their smartwatch shows the public is not clamoring for a smartwatch. Sales of the watch were poor. If it is the long rumored Apple TV, it will have to be quite a device to materially grow earnings, as the battle for control of the living room is an intense one.

Seeing nothing on the horizon to move the stock much higher it was time to sell Apple.

Why Yahoo (YHOO)?

Woman with a Plan!

For years Yahoo has been a mismanaged company, failing to advance their once strong position as the leading internet website, poorly handling a buyout offer from Microsoft (NASDAQ:MSFT), and in recent years, failing to update the website itself. This all changed in July 2012 when Yahoo named Marissa Meyer CEO. Since becoming CEO in 2012. Meyer has instituted major changes that have helped advance the business and drive the stock price up over 100%.

Marissa Meyer developed a plan, the plan stated People > Product > Traffic > Revenue. Yahoo hired a large number of new employees and in some cases acquired companies to essentially acquire the talent. Their mission, was to improve the user experience and develop a mobile presence which did not exist for Yahoo. That part of the mission, although not complete, has begun. The website has been upgraded, new web magazines have been created and the look of the site has improved. Paid clicks, which had been falling quarter over quarter are now on the rise. So to, are the number of ads and the price per click. The Yahoo mobile offerings have exploded, with new financial, news, weather, email and other apps. These upgrades have indeed driven improved traffic. After years of decline, website traffic is up 30% since March, 2013 and mobile use is up 50% during the same period. Overall, Yahoo has 400 million mobile monthly users. I personally use and enjoy Yahoo's weather, financial and news apps. Meyer has been pushing Yahoo to embrace the platform shift to mobile and it is working.


Tumblr is a social network website owned by Yahoo. The service allows users to post multimedia and other content to the site, while also blogging about various topics. Tumblr has seen significant growth, in fact, Tumblr's per visit revenue is growing faster than Facebook's. Facebook collects $1.22 in revenue every time someone logs on. Tumblr has grown revenue per visit from $0.25 in 2012 to $1.10 in the 4th quarter of 2013.

Revenue and Earnings Not There Yet!

The last piece of the puzzle, revenue, has not yet arrived. Revenue fell 2% in the 4th quarter and was roughly flat for the year. Meyer stated growing revenue was a priority going forward.

For fiscal year 2013, Non-GAAP operating income was $935 million, a decline of 11% from 2012. Non-GAAP income was $1.646 billion, up 4% from 2012. Non-GAAP diluted EPS was $1.52, a 16% improvement over 2012.

Analysts have raised concerns about the revenue, but looking closer you can see encouraging signs. Paid clicks grew 17% year over year, although price per click fell 3%. However, the net result was 13% growth in click revenue. Display ads sold grew 3% in the 4th quarter. Price per ad fell, but that was driven by the introduction of "stream match ads", which are the ads that get intermingled with other stories. These ads are sold at a lower price point, but have shown great acceptance.

Costs Under Control!

Capital spending in 2013 was down 33% from 2012 and 43% from 2011. Non-GAAP total operating expenses were $870 million a quarter, which is flat versus the 4th quarter 2012. Controlling costs is something often overlooked by new CEOs who are eager to show bottom-line results. However, in the long run, controlling costs is essential to running a business well. Yahoo has minimal debt, so servicing debt is not a concern.

Share Buyback!

In 2013, Yahoo bought back 129 million shares at an average cost of $25.95 a share. Yahoo had just over 1 billion shares outstanding at the end of the year. Management intends to continue buying back shares this year at approximately the same rate.

With just over 1 billion shares outstanding, the Yahoo share buyback, if continued at the current pace, will have a measurable effect on earnings per share going forward.

The Wild-card!

As many of you may know, Yahoo owns a 24% stake in Alibaba the huge Chinese e-commerce internet company. Alibaba has been growing rapidly, reporting 51% year-over-year growth in revenue for the quarter ending in September. According to Bloomberg, Alibaba processed $5.75 billion worth of online transactions in a single day in November, setting a new world record. That would be two and a half times more than all American retailers record on cyber Monday. Alibaba's goal, is to overtake Wal-Mart (NYSE:WMT) as the world's largest retailer by 2016.

Alibaba's rapid growth rate is expected to continue, which has investors salivating at the chance to get in on the initial public offering (IPO). Alibaba is said to be working towards an IPO, but as of yet no date, or even an exchange, has been determined. Valuations for Alibaba have been all over the place, I recently saw the company valued at $145 billion and I saw valuation at $200 billion.

Assuming the valuation is between $150 billion and $200 billion, Yahoo's 24% stake is worth $36 to $48 billion. Since Yahoo's current market valuation is $36 billion, one can easily see how valuable the Alibaba stake is to Yahoo. Yahoo has agreed to sell 40% of their stake when Alibaba has their IPO. At that time, Yahoo will have a one-time cash infusion of $14 to $19 billion. Yahoo management will have the luxury of deciding what to do with that cash. Massive buyback, one-time dividend, invest in the business, make an acquisition, or all of the above. As a shareholder, that is a position you want to be in.

How I See This Playing Out!

As I write this, Yahoo is trading around $36.00, their stake in Alibaba has a value that is at least equivalent to Yahoo's current market value. Which means the core Yahoo business, which in my opinion is improving rapidly, is being given little or no value.

As we have seen with Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR), once the Alibaba IPO date is set, a frenzy will build as the date draws closer, especially if Alibaba lists in New York. That frenzy, like we saw with Facebook and Twitter, will drive the valuation of Alibaba higher and higher, which in turn will drive Yahoo higher. At that point, owners of Yahoo will then have the choice of selling Yahoo, or holding Yahoo to see what management does with the cash and see how the core business, along with Yahoo's just under 10% remaining stake in Alibaba performs.

No matter how I look at Yahoo, I see the shares moving higher and I believe they have the chance to move much higher. Looking at Apple, I did not have the confidence. What I just described in this article, I described to my son. My son did have some questions about Alibaba, like when it will go public and how does that help Yahoo, etc. After considering what I told him, he agreed it was time to make the trade. So on Wednesday, January 29th, he sold Apple and bought Yahoo. Wednesday, was the day after Yahoo had reported, what some saw as, disappointing earnings. He was able to pick up Yahoo for $34.89 a share. An entry price I am very confident will look cheap in the months ahead.

Disclosure: I am long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: My son is long YHOO and FB in an UGMA account I am custodian for.