Bloodhound System's  Instablog

Beginning tomorrow after the close, Apple's (AAPL) CEO, Tim Cook, takes the next step to avoid becoming John Sculley. On the heels of the results from suppliers, Cirrus Logic (CRUS) and LG Electronics (LG), which reported inventory gluts related to the iPhone5 yesterday, all eyes will be on Tuesday's quarterly earning release to see if Apple's management is able to arrest the decline. The stock is in a downward trend, and the next few quarters will reveal whether this is the middle or the end of Apple's growth journey. I can't say what lies ahead for Apple. However, as Pitbull might say, to understand the future of Apple, we got to go back in time.

The only people who lost more dollars in Apple than those holding the shares over the last six months, was maybe the unfortunate Ronald Wayne who sold his stake in the company to Steve Jobs and Steve Wozniak for $800 in 1976. Apple's decline from its peak at just over $700 in September of last year to $392 today has been a harrowing trend straight down for a group of investors that rode its tidal wave of profits on the way up. Apple's stock has not seen these prices since it broke out of a six month sideways pattern in December 2011.

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For a long period of time, Apple was the perfect combination of hot products and a hot stock. With BUYs and OUTPERFORMs abound from almost every major firm, and the stock at $680 on September 10, 2012, Monness, Crespi, & Hardt came closest to top ticking it all. They initiated coverage with a BUY and price target of $835 per share. By January, they still had a buy, but lowered their target to only $670 noting, "Supply chain checks leave us comfortable with 47 million iPhones in 1QFY13, but suggest less than 40 million builds for 2QFY13." They weren't the only sell-siders burned by Apple's fizzle, but just the most unlucky.

At its peak, Apple was the largest capitalized company in the world, and just prior to its peak, it was the largest company ever (surpassing 1999's Microsoft in nominal terms). At that moment, its capitalization was greater than $200 billion ahead of the next largest company, Exxon (XOM) - a gap as largest as the market value of International Business Machines (IBM).

Apple has experienced significant growth for sure. The company single-handedly redeveloped an entire category of electronics and saw competitors flail about trying to take a bite out of Apple. It solidified the supremacy of its product line when it created the central hub of iTunes in 2003. Apple has yet to see year-over-year quarterly sales decline since, and is one of only six companies that produced such continuous quarterly sales growth (the others being BRLI, CNQR, EZPW, GMCR, JJSF, LDR). Even more impressive is also its continuous growth in operating income during the same period. That puts Apple at the top of the heap. No other publicly-listed company has had successive growth in quarterly sales and operating income over that time. It's growth only accelerated as the company remained on the cutting edge of consumer products.

Potentially due to the law of large numbers or the slowing of the curve of product differentiation, Apple's sales growth peaked following the release of the iPad in 2010, and has been in decline since the Verizon iPhone launch. Sales in the quarter that ended this past December grew 17.7% year-over-year. Although nice growth for many, it was far less than the 70+% growth in 2011 and 2010 and the 54% in 2009. Many have begun to question whether Apple's best days are behind it.

Apple has seen moments of lower sales growth during its rocket ship-like ride before. In the quarters following the release of the iPhone 3G (which also happened to coincide with the fall-out of the economic tsunami that was the Fall of 2008), Apple grew sales only 5.8%, 8.7% and 11.7% in the first, second and third quarters of 2009, respectively. However, the one major difference between now and then is that the decline in growth now is also coupled with a decline in gross margins.

Apple's quarterly recent gross margins peaked in the period ended March 31, 2012 at 49.3%. Since that quarter, Apple's sales growth has moderated, but it's gross margins have also declined. Last quarter, at 41.5%, was the third consecutive quarter in a row of margin decline. Since Prodigal-CEO Steve Jobs returned to Apple in 1996, Apple has only once seen three consecutive quarters of decline once (in 2005), and then only marginally (pun fully intended). If Apple reports a fourth consecutive quarter of margin decline this coming Tuesday, it will be the first time it has seen such an occurrence since 1993. During that period, after decades of gross margins as high as 60%, Apple lost its luster under the directions of CEOs John Sculley and Michael Spindler and saw gross margins plummet from 47.6% to 25.7% over six consecutive quarters.

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The early 1990s was a bit of a lost period for Apple. After a number of successful years following its IPO, it split with founder Steve Jobs, and the company made a number of missteps. Apple didn't really know what it was - was it a software company, or hardware? Consumer or enterprise? The R&D budget swelled, and a number of high profile products flopped. It was a textbook example of how fast a hot company can drop. Sales slowed (although didn't really decline until several years later prompting the return of Jobs), gross margins declined swiftly, and returns on equity dropped into single digits. In the 18 months between early 1992 and the Fall 1993, Apple's stock fell 68%, and price-to-book was cut in half from 3.2x to 1.6x.

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Apple is in a much stronger position now than it was back then. However, their own experiences of 20 years ago can be a vivid example of how quickly the numbers can change in this industry. Apple has transitioned from hot growth stock to a true value play multiple times over its life. The next couple quarters will say much about what stage Apple is in. It either needs to get its mojo back by rebooting sales and maintain margins, or it is likely headed lower.

Nevertheless, Apple is still a giant. Its 44% decline notwithstanding, Apple is still the second largest company (Google, Berkshire Hathaway and Wal-Mart make up the other top five). Oddly enough, even as the second largest cap company, it is unclear whether Apple is a growth company, a value investment or with this decline, potentially, a yield play. It doesn't quite fit any billing.

Let's take a look at AAPL today.

One of the most reported items about Apple besides its stock price is its cash holdings. As of December 29, their reported balance was approximately $137 billion, and is held as follows:

At $392 per share, the cash value represents 37% of Apple's total market value. Although some of that cash is needed to run the business, it plays a crucial role in valuation. Current consensus earnings estimates call for September year end earnings of $43.90 per share. On the face of it, Apple's P/E would be 8.9x 2013 earnings. However, two adjustments are likely needed. All that cash is unlikely to be productive in Apple's ability to generate return on its equity, and therefore should be valued as a separate asset. Its market value excluding the value of that cash is $231 billion. Approximately $2 per share of the annual earnings is coming from interest on its cash balances - equating to a 1.5% return on cash. Therefore the remaining business is expected to generate $41.90 per share on $245 per share from the operating business, or less than a 6x multiple. If you assume that the treasury department needs its short-term cash (which is unlikely to have earned any interest) to operate the business, but invests longer term the non-essential cash, it would suggest more like a 7x multiple. And this is a company that has generated greater than 30% ROE since the first quarter of 2011, and a greater than 20% ROE since September 2006.

A multiple of 7x is significantly below that of IBM, Starbucks, Google, Oracle and Microsoft - even after backing out their cash balances as well. Clearly at these levels, Apple's stock is reflecting an expectation of low growth going forward, if not an outright destruction of value.

Unless they can reinvigorate growth, it appears that Apple is a business that is undergoing a transformation from growth to value. Right now, it's neither. Growth stocks don't often trade at 7-9x earnings, yet value stocks don't trade at 3.1x book value. Currently, Apple is in a bit of a no-man's land which we think is dictating its current price performance. The growth & momentum investors have moved on, but the value players have yet to be enticed. Something has to give. Apple could mitigate the problem by increasing it's dividend - they certainly have the cash to do so. At a 3%, Apple has an attractive, but not stunning dividend yield. The current dividend would unlikely support the stock during a period of prolonged margin and/or earnings decline.

Bloodhound has a library in its database of over one million pre-computed strategies. Apple shows up in less than 4% of all those strategies. The strategies range in size of holdings (10-, 20-, and 50-stocks). Strategies that hold 10 stocks and currently own Apple is approximately 10,000, or less than 1% of the library. It is interesting to note that more than 80% of those strategies were in the black for 2013 despite Apple's compounded losses. 10% of those strategies were beating the S&P 500, and 20% of those were beating it by more than 500 basis points.

By seeing which strategies would be recommending purchase of Apple, we can reverse engineer what categories of investment the stock falls within. It shows up in none of our value strategies, yet remains in a number of "high-quality" portfolios. Apple currently ranks 112 on the Earnings Growth Leaders strategy, which means it ranks high in the criteria, but not high enough to make it into the portfolio. However, Apple did move into one of our model strategies, the Lynch - GARP portfolio, 17 days ago. GARP - growth at a reasonable price - is a function of growth and price. Apple has emerged on the radar of another model strategy, the Buffett Diversified Yield. Apple currently ranks 73rd in the model strategy's universe that looks at dividend yield as well as healthy margins, solid returns on assets and non-excessive price-to-book values.

Apple no longer ranks among the top fundamental growth stories, but it has yet to become a value play. Currently, it sits somewhere in the middle. Although a popular follow, the stock has lost its sponsorship. It begins to show up on screens of GARP investors, but not yet value investors. Apple will need to either reverse fundamental trends, directly increase its dividend, or see further price decline to attract yield and value investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

From www.bloodhoundsystem.com/blog/index.php/2013/03/marks-on-equity/

On March 11, we highlighted a Barron's article on Howard Marks. Right on cue, Marks released his letter to investors this week. Thanks to ValueWalk we are able to provide you with a copy of it.

I'll save you some time - skip the first four pages. Uncharacteristically, Marks spends a majority of his letter fixated on a grammatical misrepresentation of an esoteric topic. Equity Risk Premia is an important consideration for investing for sure. Author and practitioner, Antti Ilmanen, does a fine job in defining and cataloging it in his book, Expected Returns. However, Marks belaboring the issue on its mundane use by P&I is not particularly enjoyable.

On the other hand, his insights on today's equity market are interesting. Marks earned his stripes as a distressed bond investor, and as such, usually provides a unique insight on equity markets. His review of earnings yield over different historical points and comparison to that of today is a nice educational tidbit.

To gauge relative price-attractiveness, it isn't unreasonable to compare the earnings yield on a stock against the yield on a bond (or against the risk-free rate)… [In the post WWII period], the ratio between the yields was 6.25%/3.00%, or 2.08x. At the high in 2000…the yield differential or equity risk premium was a skimpy 1.12%…. [Today, we have] a yield differential of 5.25% (6.25% minus 1.00%), or 525 basis points, and a yield ratio of 6.25%/1.00%, or 6.25x.

To quote Yale Professor Robert Shiller, "we have a tendency to dogmatize and oversimplify. But the world is not simple; it cannot be reduced to a simple framework." Marks completely recognizes this in spades.

"The problem with basing a pro-equities argument on the yield comparison is that most of equities' current attraction on that basis comes from the lowness of interest rates. Just about everyone knows (a) interest rates are artificially low because of central banks' efforts at stimulus and (b) rates will be considerably higher at some point in the intermediate term. In that case, rising rates would render stocks less attractive (all other things being equal, but they're not)"

He tackles a number of Pros and Cons that face the equity markets, and makes certain conclusions.

So now we have a somewhat improved fundamental environment, a generally more optimistic group of investors, and stock prices that are a fair bit higher. No one should say the likelihood of improvement is entirely unrecognized today, as would have to be the case for this to still be stage one. I think the existence of improvement is generally accepted, but that acceptance is neither extremely widespread nor terribly overdone. Thus I'd say we're somewhere in the first half of stage two. Pessimists no longer control market prices, but certainly neither have carefree optimists taken over… I'm quite comfortable imagining a few years of equity performance that provide a pleasant surprise relative to what I think is the prevailing expectation of 6% or so per year. [his emphasis]

He ends with a theme that we have discussed here to great extent. He knows not for sure that equities will perform in-line with his predictions. However, he is unlikely to feel regret that he missed any major move in bonds. With 10-year Treasury rates near 2%, there is little to "miss." Investing is about risk/reward. Predictions rest on probabilities, and the probability of great near-term returns in bonds is quite low.

As seen: http://www.bloodhoundsystem.com/blog/index.php/2013/03/healthcare-lobbying/

Healthcare spending among government and individuals alike, has been one of the hottest push-button issues of the last 20 years, and just as fiery now, if not more so. More than one-sixth of the U.S. economy is devoted to health care spending and that percentage continues to rise every year, outpacing inflation.

One of our favorite blogs, Zero Hedge, published a somewhat spurious analysis of government lobbying called, Who Spends The Most Dollars Lobbying Washington, DC? The author notes that healthcare companies lobby Washington as a payoff to protect their own profitability, and the dollars at stake are enormous.

"[B]etween Pharmaceutical and health product industry, hospital and nursing homes, health professionals and health services, HMOs, or more broadly Pharma/Healthcare/HMO, the total lobby dollars spent between 1998 and 2012 was a staggering $5.3 billion, or nearly three times greater than the second most generous industry: insurance, and well above Oil and Gas at $1.4 billion, and Securities and Investment at $1.0 billion."

They reference this chart from OpenSecrets.org:

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I'm no fan of government lobbying groups or their collective efforts - that's for sure. However, that said, to be fair to the industry, lumping hospitals, drug companies, and HMOs among others into one lobbying group is purely ridiculous. They are separate groups seeking to accomplish complete separate agendas. It would be the equivalent of lumping together a group of oil & gas drillers, public utilities, alternative energy groups, gasoline wholesalers and electric transmission companies and calling it "Energy."

When divided into respective groups, Pharmaceutical/Health Products still leads the pack, but at a less egregious margin. Since 2000, pharmaceuticals remained one of the top lobbying efforts consistently year after year. Although the author takes some of the data to absurdly wild and out-of-context conclusions about ROI, the fact remains that lobbyists for the pharmaceutical industry spend lots of cash to protect their constituents. One could interpret it as payment to keep their seemingly "monopolistic" practices, or payment to prevent populist action that leads to unintended consequences.

Clearly spending on healthcare has metastasized as seen in this chart through 2004, and the dollars have only gotten worse. Good for the industry, bad of consumer…

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…Or is it? Arguments can be made, such as this one in Forbes, that "health is wealth," and spending on healthcare is a sign of economic growth. Others use increased life expectancy as a valuable barometer.

Either way, a number of issues emerge regarding healthcare and the welfare of the state. Who receives and who pays for healthcare remains a prickly political issue despite landmark passage of Obamacare. Therefore, it should not be surprising that companies are spending dollars to have the ear of their favorite politician. I'm not sure it means buying political monopolies, but rather protecting interests in an ever-changing and often "easy-pickins" dynamic.

The cost of pharmaceuticals plays an important role in this debate. We have conducted an analysis on the historical profitability of the industry, and its effect on the aggregate ROE, and will re-publish on Seeking Alpha shortly. If companies are protected by their lobbying efforts, one would expect to see it in their financial results. The analysis of those numbers may not answer everyone's questions, but you may come away surprised by the results.