Top 2 Growth Stocks, And 1 To Avoid

Includes: AAPL, AMZN, LNG
by: Amir Houriani

Originally, I titled my article as "Top 5 Growth Stocks for 2012," but quickly found myself at odds with fully supporting 5 companies for 2012. Instead, I decided to avoid doing what every other analyst does, which is to give a huge list of stocks with barely any strong analysis. I saw deeper value in keeping the list short, but with strong supporting analysis. I fully stand behind Apple (NASDAQ:AAPL) and Cheniere Energy (NYSEMKT:LNG), while standing against Amazon (NASDAQ:AMZN).

Buy: Apple

If you've been following me, you're already aware of my full support of Apple and its future valuation. Apple's core business is in designing and selling premium consumer products, including the iPhone, iPad, iPod, and iMac. Its product lines have consistently experienced tremendous demand, quickly making it the most valuable company in the world.

Apple's key driver for success is its skill in creating exactly the products consumers are looking for: something sleek, intuitive, and innovative. Through this differentiated business strategy, Apple has penetrated and dominated every market it's entered. The recent earnings report brought another record earnings season for Apple, mainly through its strategic global market penetration and unforeseen iPhone and iPad demand.

Prior to Apple's 2012 Q2 earnings release, during its falling stock price, so-called analysts began touting the idea that Apple's iPhone and iPad sales would underperform, leading to an unfavorable earnings release. During this same period, I did an analysis of Apple's projected earnings, and calculated an EPS projection of $12.04 in my article, coming very close to Apple's actual $12.30 record earnings. The "X-factor" in Apple's tremendous success hasn't come solely because of its innovative product line, but from its strategic global expansion, which has driven sales and profitability through the roof.

Apple has recently begun a full-fledged penetration of the Chinese mobile markets and has experienced tremendous growth thus far, outperforming the entire industry quarter after quarter, and year after year. Apple continues to supply consumers with highly innovative products that they demand, in a way that makes sense to the consumer. The iMac, iPod, iPhone, and iPad's tremendous success comes from Apple's strategy of creating intuitive products that work like how we want them to work; making them easy to use and easy to adopt.

Apple is currently competing against Nokia (NYSE:NOK), BlackBerry from Research In Motion (RIMM), Microsoft (NASDAQ:MSFT), Google (NASDAQ:GOOG), and Samsung in the high-end smartphone marketplace. Microsoft and Nokia came together in creating the Lumia, a Nokia phone running on the Windows platform; fortunately for Apple, the phone's initial release has been a flop, resulting in Nokia giving a $100 rebate for technical issues to the purchasers of the phone. It's worth mentioning that consumer reviews haven't been unanimous either.

Samsung's Galaxy, running on Google's Android platform, is essentially playing copycat on Apple's iPhone. Recent reports now verify that Samsung is the #1 manufacturer of high-end smartphones, but that is not currently a threat for Apple since its competing with Samsung in new and untouched markets, like in China. The size of the "pie" is increasing very quickly, fueling double- and triple-digit sales growth for both Samsung and Apple. (For a more detailed analysis of Samsung's competitive stance to Apple, take a look at my previous article titled Apple Vs. Samsung And Google?) Apple currently maintains a strong competitive edge in the mobile market, with its market size increasing tremendously. Nearly every Apple product's sales has outperformed the entire market: whether it be its computer, phone, or tablet sales.

One of my followers requested that I create a list of Apple's other pros and cons (risks), so here it is:


1) Very high overall gross and profit margins, coming in at 47.37% and 29.66%. The best way to analyze this is by comparing it to its most similar competitor, Samsung. Samsung has a gross and profit margin of 33.4% and 11.2%. Essentially, Apple is capable of generating profits more quickly.

2) Apple's most demanded products are also its profit drivers; the iPhone at a 75% profit margin and the iPad at a 42% profit margin. These high margin products, which are in overwhelmingly high demand, will continue to keep Apple as the world's most valuable company.

3) Nearly limitless global market potential. These global markets, like China and India, have been relatively untouched by high-end smartphone manufacturers, leaving them ripe for the picking.

- Sales in Europe increased 46.13% Q/Q (keep in mind Europe is still in deep economic turmoil)

- Sales in Japan increased 91.13% Q/Q (even after recovering from the disastrous tsunami in 2011)

- Sales in Asia-Pacific increased 114% Q/Q

- Sales in retail stores increased 37.9% Q/Q

4) Apple is utilizing cloud technology, which will be paramount in creating very strong customer loyalty and promoting increased sales from retained customers. I went into more details about the iCloud and its ability to create long term value in this article.

5) It is widely accepted that Apple will be releasing its own TV. This is a very profitable market that's willing to pay large premiums for high-end televisions. The Apple television will be synchronized through the iCloud, from where you can stream shows and movies.

6) Excellent brand image. This is absolutely key in creating long-term value and creating a loyal customer base. When consumers think about Apple, they associate high quality products, intuitive products, and corporate trust. Trust in Apple is important as it is beginning to penetrate markets like the iWallet and mobile commerce, which store sensitive information like credit card numbers. In order to successfully do so, Apple needs to be trusted by its consumers, which it is. Google, on the other hand, is stained with privacy and trust issues, creating a huge bulwark in its path to these markets.

7) Churn Rate and customer subscriptions. So, why should Verizon (NYSE:VZ), AT&T (NYSE:T), and Sprint (NYSE:S) subsidize the iPhone? Seriously, why should they eat about 75% of the costs? Because Apple's iPhone is able to retain customers, providing long-term valuation to the service carriers; in fact, Apple's iPhone has the highest customer retention rate over all smartphones.

Sprint just recently released its quarterly report, showing losses of $863 million; however, Sprint's CFO consistently emphasized how paramount Apple's iPhone is to their long-term success. Of all new subscriptions last quarter, 44% of them were with iPhones and of those who signed up with Sprint, 40% of them broke their contracts with other carriers. A deeper study of the iPhone's significance revealed that of all the new iPhone subscribers, 60% signed up solely for the iPhone and would not have considered switching if Sprint did not carry the iPhone.

Also, to note, although carriers pay a much larger subsidy for the iPhone, it pays off its value fairly quickly. The rate of customers exchanging their iPhones for other smartphones is half of what other smartphones are experiencing, signifying that customers who sign up with the iPhone are much more likely to stay with the iPhone because of its strong positive effect on customer experience. The iPhone also experiences among the lowest early-life customer service calls, which is crucial in building strong customer loyalty early on. In addition, Sprint just experienced the highest percent of customers on contract, largely attributable to the iPhone.

With respect to Sprint, and all other carriers, the iPhone has become a staple in customer retention through its low churn rates, increased customer experience, and increased customer subscriptions.

I found this research report to be extremely helpful in illustrating the economic impact of churn rates. Essentially, even a 0.1% reduction in churn rates leads to increasing profit tremendously. Another article illustrated that increasing customer retention (through lower churn rates) by merely 5% can lead to a 25%-100% increase in bottom-line profitability.

The traditional business model used to be to make a quick sale and forget about the customer, however, studies have shown that customer retention and customer loyalty are paramount in increasing profitability. Mobile carriers are fighting in an unimaginably fierce market environment, making customer retention key in continued economic success. The iPhone's ability to retain customers and bring in new customers has make it the most sought after mobile device in the wireless communications industry.

8) Investor future valuation. This is much more important than people give it credit for. Investor valuation is how much current investors think the company is really worth, and how much it will be worth. A vast majority of investors believe that Apple is sustainable, and even undervalued, at $604. More importantly, after the quarterly report recently released, analysts reiterated their buy ratings at the $750 range for this year. This will help support Apple's current valuation and increasing future valuation.


1) Increasing global competition. Although Nokia and BlackBerry are really the companies suffering from increased global competition, this same risk applies to Apple as well. Apple's greatest competitors are now Google, Samsung, and Microsoft. Apple has done a phenomenal job in retaining large market share during such intense competition. Currently, Apple and Samsung are competing in capturing the largest possible market share in China because of its nearly untapped market. This isn't a threat yet to Apple, but after the markets mature and market shares are established, Apple will need to focus on retaining and expanding its market share against competitors like Samsung.

2) Android phones. Google's Android phones have had deep market penetration since their release and have posed a threat to Apple. The reason for this quick penetration is because Google has been eating the cost of the phones, selling them at or below cost, in hopes of creating income from its search engine and Apps market. It's true that the Android phones have been getting better, but they're still a far cry from the iPhone. Android's platform is crippled with glitches and holes which creates a very negative customer experience. I, my family, and friends, all started with the Android phones, but are now switching to the iPhone because of our terrible Android experience. Yes, the Android is cheap and has attained a large market share very quickly, but it has very little customer loyalty and many of its current customers are switching to the iPhone.

3) e-Book price fixing. A case against Apple and book publishing companies was recently opened by the Department of Justice regarding it fixing electronic book prices. The case is fairly strong against the book publishing companies, but is falling apart against Apple. In my opinion, this was meant as a warning shot to other companies considering fixing prices.

4) iPhone subsidies. If current issues regarding carrier subsidies on Apple's iPhone are still on your mind, view this article which details my counter-argument to the subsidy rumor.

I tried creating a balanced Pros/Cons list with what I currently know, but I definitely may be missing some things. If there is anything else you want me to cover in my future articles, please just ask in the commentary section.

Buy: Cheniere Energy

Cheniere Energy is a Liquefied Natural Gas export facility located in Houston. I wrote an analysis called Cheniere Energy: Why It Could Be The Greatest Investment of The Decade, but was surprised by how little investors really understood about the company and the current natural gas market. It currently holds an exclusive natural gas exporting license to none-U.S. Free-trade associated countries, giving it unrestricted global exporting rights. Recently, Sempra Energy (NYSE:SRE) was also given an export license, but its exporting ability is limited only to approved countries.

Liquefied Natural Gas has been the key success in natural gas exports during the 21st century. It's a process of freezing natural gas to such a cold temperature that it liquefies and condenses into 1/600th its usual volume. This makes transportation cost-efficient and makes arbitrage opportunities from exporting natural gas very lucrative.

Recent developments in the natural gas market in America have made Cheniere Energy's potential astronomically high. A combination of a severe natural gas glut with an expanding global economy have created a perfect situation for Cheniere Energy to profit from.

As many investors know, we're currently experience a natural gas price glut because of immense natural gas over-supply from a process called hydrofracking. In fact, this process has been so successful that it has become the reason why natural gas prices in America have plummeted from over $13/btu to under $2/btu. Another way to look at this is that in 2000, the U.S. natural gas production was 53 bcf/d (billion cubic feet/day) of natural gas; that figure sky rocketed to 83.17 bcf/d by January, 2012.

U.S. supply has simply outweighed domestic demand, resulting in the plummeting natural gas prices. Although we're experiencing an over-supply of natural gas domestically, global markets are experiencing natural gas shortages. By the end of 2011, Japan's average LNG price was at $14.97, a large premium to our suppressed prices. Reports indicate that prices in China and India fetch similarly high premiums.

Cheniere Energy is currently in a very unique position. It's stationed in a country experiencing a massive natural gas over-supply, with a business process allowing it to capitalize on this once-in-a-lifetime arbitrage position. Recently, Cheniere Energy has been given regulatory approval for a $10 billion expansion of its LNG exporting facilities, to be functional by 2015. The global economy's turnaround has been paramount in sustaining high global natural gas prices which are, and will be, paramount in Cheniere Energy's success. With China, India, and South Korea's expanding economies, demand for liquefied natural gas will increase sharply, providing increased future profitability for Cheniere Energy.

This report projects that from 2009-2035, global consumption of natural gas will rise by 56%; however, I am more optimistic. Developments since the release of the report, like much quicker domestic and global recovery, lead me to project a greater projected demand for natural gas by 2035. The "cogs" are falling into place, not only from cars running on natural gas, to federal and state tax incentives for businesses to utilize natural gas, but also from a global requirement for this sustainable, cheap, and clean future energy source.

Yes, Cheniere Energy is in an amazing situation now, but it does have its risks. It's currently facing a large debt load, but has received $2 billion financing from Blackstone, and is currently in line for $4 billion financing with banks for expanding its facilities. Unfortunately, Cheniere Energy is heavily leveraged, which exposes it to unique risks. In my analysis, the benefits outweigh the risks. Not only are we experiencing extremely strong global demand, but we're also experiencing strong political pressures domestically to make America the energy exporter of the world. In president Obama's recent State of the Union address, he explicitly stated natural gas as being our key to transforming America from an energy importer to an energy exporter.

We're in a perfect trifecta:

1) Large oversupply met by stagnating domestic demand has led to a natural gas price freefall.

2) The global economy is picking up quickly and they need natural gas... lots of it.

3) Strong domestic political pressures are creating the foundation for natural gas to replace oil.

Natural gas exporting will facilitate increasing the price here, benefiting companies like Chesapeake Energy (NYSE:CHK), Baker Hughes (NYSE:BHI), and Halliburton (NYSE:HAL).

Stock to Avoid: Amazon

Over the years, Amazon has experienced absolutely tremendous revenue growth, growing an outstanding 33.8% quarter-over-quarter. With all this growth, we would expect to see similar growth in earnings; however, earnings are actually on a decline, decreasing 36.4% quarter-over-quarter. Before displaying what my analysis concluded, I'll lay the framework for why I took this certain approach.

Whenever a corporation increases its revenues, certain variable costs associated with that revenue have to increase with it. To simplify things, we expect that when revenue increases by 1% that its operational costs increase by 1% (though segmented operational costs increase at different rates). I calculated quarter-to-quarter analysis of the percent increases in revenues and associated costs. I did this to see how well Amazon was managing its costs, and these were my results:

Cross-analysis between 2012/2011 income statement:

  • Net sales: +36.36%
  • Cost of Sales: +31.8%
  • Fulfillment: +51.5%
  • Marketing: +46.8%
  • Technology and Content: +63.21%
  • General and Administrative: +50.38%
  • Other operating expenses: +39.4%
  • Total operating expenses: +36.27%

Notice how the total operating expenses increased nearly identically with net sales, but that doesn't help us much in finding what's hurting Amazon's income. The variable expenses show that Amazon has been unable to keep its costs under control under Fulfillment, Marketing, and Technology, but because of the nature of marketing and technology expenses and their unpredictability, we'll put them aside for now. This also makes sense because their total expenses only shadow Amazon's fulfillment expense.

So, what is fulfillment? It's all the logistics behind getting your order to you, from the point of sale to the point of delivery. Since Amazon isn't a value-added intermediary, but rather, a supply-chain system, making this fulfillment process efficient is crucial to Amazon's long term success. Essentially, Amazon profits from keeping this particular cost as low as possible to optimize its earnings; unfortunately, they've been doing a poor job at it.

We would expect Amazon's fulfillment expenses to increase with sales, but at a lesser rate; essentially, if revenues increase by 10%, we expect fulfillment expenses to increase by less than 10%, which would signify an expertise on Amazon's part on keeping these costs low. From what we've seen, a 1% increase in revenues corresponds to a 1.42% increase in fulfillment expenses, which, in my opinion, is a troubling sign.

Also, a second very crucial thing to note is Amazon's earnings. Amazon's recent quarterly report was absolutely terrible. Its stock experienced a massive 15.75% appreciation from Amazon "beating" estimates; however, these estimates were so low that they weren't difficult to beat. In the case of Amazon, lets avoid doing an analysis on how Amazon performed relative to estimates, but rather an analysis of Amazon to itself. Although Amazon "beat" estimates, it's quarter-to-quarter earnings dropped by a brutal 36.36%, but from further analysis, I realized that it's actually much worse than it appears on the surface.

Amazon's core net income, after taxes, was actually $41 million and not the widely accepted $130 million. If you take a look at the income statement, there was a very large increase in income due to an "Equity-method investment activity" which increased the income by $89 million. Historically, this figure has ranged from (-20,+15); though there have been severe losses in previous years. Essentially, Amazon's equity investments are 20-50% stakes it has in other companies. Since the stake is so large, Amazon has to report the other company's income as its own, rather than traditionally reporting an appreciation or depreciation of its equity investments portfolio.

In my analysis of Amazon's true current situation, I saw value in calculating Amazon's actual earnings per share, excluding this subsidiary income from affiliate companies. I did so because, from a statistical standpoint, the very large increase in equity-investment income throws off most people's analysis. After excluding that income, I came to an EPS* of actually $0.09/share. It's true that the $89 million is considered as Amazon's income, which is why I'm not going to put much weight onto the $0.09 EPS* calculation excluding that figure.

What really pushes my reason to avoid Amazon's stock comes from a combination of factors. Although Amazon is experiencing large revenue growth, it's also experiencing a drastic reduction of its profit margin from 2% to 0.9%. Also, its current valuation is completely absurd at a P/E of 186.31; even if investors are accounting for large future growth, Amazon's current valuation is unsustainable. This is one of the few stocks I would claim as being in bubble territory. Even accounting for large future revenue growth, the forward P/E is 88.61, which is still ridiculously overvalued.

Finally, what put me off is Amazon's PEG ratio of 6.38, which signifies that its stock is currently severely overbought. The PEG ratio is a useful metric in determining how well valued a company is. It's calculated by dividing the current P/E ratio by the future 5-year earnings growth rate. As a rule of thumb, a PEG of 0-1 signifies an undervalued company, while a PEG ratio above 1 points to an overvalued company. Now, think for yourself where 6.38 stands at. This also points to unsustainable bubble territory.

Recently, Amazon has implemented a new fulfillment process with Kiva Systems - a process already utilized by Zappos, which has shown very favorable results. This will drive down Amazon's fulfillment costs, but results wont begin until Q3 2012. This will be something to look forward to.

Ultimately, I see Amazon's current valuation as unsustainable, and believe its stock is overweight. I hate to do a "history repeats itself" assessment, but I believe a review of it would be helpful.

E-Trade (NASDAQ:ETFC): Prior to ETrade's stock collapse, it was trading at a Trailing P/E of 171.73

America International Group (NYSE:AIG): Though AIG's stock collapse was due largely to unsystematic risk (risk unique to the firm), its P/E ratio of 443.11 definitely contributed to its stock's freefall from $1233 to a low of $6.01 within 2 years.

Netflix (NASDAQ:NFLX): I view Netflix as being very similar to Amazon. During its peak, before the crash, it was considered a "perfect" company with constant double-digit revenue growth. Prior to its collapse, its P/E was at 105.5.

The overarching theme is that even though corporations may have very large projected earnings growth, if the stock is experiencing a dangerously high P/E, then it will correct itself. Amazon is trading at a P/E of 186.31 with a forward P/E of 88.61, which is still overvalued. In my opinion, stay away from this stock.

Note: Amazon's core EPS is calculated excluding income from large equity investments in affiliate companies and is not part of GAAP standards. It is used solely to isolate Amazon's core income from an analytical viewpoint.

Disclosure: I am long AAPL, LNG. I may initiate a long position in Sprint upon further research.

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