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Jeremy Johnson, CFA
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Most recently, Jeremy held the title of Assistant Vice President at a listed investment bank's asset management group as a buy-side analyst. Previously he worked as a senior valuation analyst for a large international accounting firm. He has also worked in sales for a separate listed investment... More
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  • Apple's Design-Focused iPhone Strategy Remains Intact

    In 1993, two Arthur D. Little consultants, Jean-Philippe Deschamps and P. Ranganath Nayak, penned a seminal piece on product strategy titled: "Lessons from Product Juggernauts". In the piece, the two authors detailed five categories for product strategy: product proliferation, value, design, innovation and service. With the release of the iPhone 5, Apple (NASDAQ:AAPL) has received some criticism for not being innovative. Much of that criticism comes from those that wrongly assuming Apple is trying to be innovative and failing, when in fact, in my view Apple is focused not on innovation but rather on design.

    It is worth taking a step back and reviewing Deschamps and Nayak's strategic categories starting with product proliferation. One need not look further than Samsung to see this strategy at work. The basic outline of the strategy is to saturate the market with options, see which are adopted and then support the winners.

    The second strategy outlined is competing through value. The proposition here is that a company will create a product that is meaningfully cheaper than the competition while offering comparable quality.

    The third strategy, competing through design, has a few hallmarks: the product should be differentiated, appealing to the eye, pleasing to the touch and easy to operate. While these ideals look simple on paper, when it comes to implementation they can be devilishly difficult.

    Competition through innovation involves the continuous introduction of first-to-market product features.

    Finally, competing through service means that a manufacturer will rely on pre- and post-sales communication and support to differentiate itself.

    A company can compete using more than one strategy, but usually one is dominant over the others and often times it is clear that one or more strategies are not in use at all. For example, it would be difficult to defend a position that stated Apple competed through product proliferation. At the same time, while Apple as a company can be innovative, it can use a different strategy for an individual product such as the iPhone, once it is released.

    Having set out the framework, we can turn to analyzing Apple's strategy with respect to the iPhone. Is the company more of an innovator or is it more focused on design? Using the description of a design focused strategy, we can see that Apple checks all the boxes: the iPhone is differentiated in shape and in its surface textures, it is an attractive device both to look at and to interactive with and it is purportedly one of the easiest smartphones to use. As well, the device maintains its design language from one model to the next.

    Meanwhile, can we say that every iteration of the iPhone has been at the leading edge of technology? In the beginning, perhaps, but for the last several versions, the company has left a number of features off the table. At best, it can be said that in the iPhone 5, Apple has created a phone that compares with the competition, but does not exceed it in terms of features.

    The elements Apple has changed have often been in the service of improving the design. Apple's thin screen technology, which is probably the greatest innovation of the iPhone 5, was done in the name of making a somewhat thick and heavy device thinner and somewhat lighter. A review of the product presentation will show that the new aluminum case was given as much attention as any specific technological feature.

    Investors are right to question Apple's strategy - companies make strategic mistakes all the time, but in my view investor's should not question Apple's tactics. They are doing quite well carrying out their design-focused product strategy.

    Tags: AAPL
    Sep 19 10:45 AM | Link | 3 Comments
  • Evaluating Store Overlap Between Walgreen And Rite Aid

    Walgreen Co's (WAG) desire to increase market share and Rite Aid Corp's (NYSE:RAD) poor capital structure have led some to speculate an acquisition may occur at some point in the future. One of the major considerations in evaluating a takeover in this space is store overlap. The following is an analysis of the two store's footprints across the U.S. with a focus on population per store by state for each company and a hypothetical combined company. This analysis is not meant to be exhaustive or definitive, but rather to discover where potential problem areas may be. In order to determine how many stores is really too many, a market-by-market and store-by-store analysis would need to be done which would include all the local competitors not just Walgreen and Rite Aid.

    The following table shows the store footprints, and state population per store for each entity and for the combined companies:

    (click to enlarge)

    The table has been sorted by combined company population per store with states below the national average highlighted in red. Those highlighted in red are not automatically red flags by any means; rather it is a place where we can start the analysis since those not highlighted are likely of lesser concern.

    Within this group, we can see there are three states with no Rite Aid stores which is useful because it gives a benchmark for an acceptable concentration. Illinois and Florida on average have about 21,800 individuals per store. If we look at states where the store concentration is 10% greater than this level, we are left with all the states above Kentucky in the table. A few of these states are likely of little concern because there is not great overlap; for example, Maine, West Virginia, Vermont and Pennsylvania. If we exclude these states we are left with 1,647 potentially problematic (either from a regulatory or business case point of view) stores or about 36% of the total. Of this amount, it is difficult to say how many stores are in actuality problematic - perhaps it is 20% in some states and 40% in others.

    Even in California, a state with no great overlap, there are Rite Aid stores within walking distance of Walgreen stores in certain areas from my experience. If we use 35% as a guidepost for Rite Aid's with a Walgreen in close proximity in the most problematic states then there are potentially 575 stores that would need to be considered. There is likely a second set of states where the percentage is in the 10-15% range, or 200-300 stores, and then the states with no overlap where there are no problems. In total this may mean something on the order of 800-900 stores would be of concern or a little under 20% of the total.

    It is also useful to look at problematic states specifically. Of the larger states, New York, New Jersey, Michigan and Massachusetts all appear to have significant amount of overlap and relatively high concentrations. These four states and four other smaller states with large overlap have 1,564 stores. New York is especially interesting because of Walgreen's recent purchase of a New York focused chain in that state which shifted it from a likely non-problematic state, to a potentially problematic one.

    In order to extend the analysis, the below table shows population per store restricted to individuals 65 and older, on the theory they are heavier users of drugstores:

    (click to enlarge)

    One fact that can gleaned from this table is that while Florida looks relatively concentrated on a total population basis, its concentration 65 and up is much less. This is somewhat problematic because it challenges the above use of Florida as a benchmark for concentration. Illinois and Wisconsin are already circumspect because they are Walgreen's oldest markets and it is highly likely the company has greater market share there than in other states. Rather than focus on precise figures here, we can use this a qualitative factor auguring for some additional caution compared to the total population analysis since it is difficult to determine the precise relevance of 65+ for drug store revenue.

    In order to help readers form their own conclusions, the spreadsheet with the data can be found here. There are a number of methods that can be used to come up with estimates of overlap and some may give more optimistic or pessimistic conclusions. Ultimately, Walgreen is in the best position to judge the long-term financial impact of an acquisition, because it is not just about how many stores would be problematic. For example, there is a possibility that a large set of stores could be sold with little value diminution. There is also the issue of the value in building scale to better negotiate with pharmacy benefit managers who are themselves consolidating.

    Disclosure: I am long WAG.

    Tags: RAD, WBA
    Jun 06 2:41 PM | Link | 2 Comments
  • Gold Price Analysis
    I became interested in gold around the year 2002 because of the long stagnation in price and the aggressive monetary policy being implemented at the time.  I was a teaching assistant in an accounting class at university and we had a stock market contest.  I recommended that one of my student's select a gold stock and since the teaching assistant's were allowed to participate as well, I selected one.  Both our stocks were up 40% in 3 months.  Having caught the gold bug, I began doing further research on the metal.

    After graduating I read an investment piece by Barton Biggs that highlighted the case for gold.  The work wasn't his own, he was in fact passing along some of the analysis of a former colleage whom gained some notoriety by convincing the firm that put option prices were extremely cheap in late 1987.  The volatility smile was born shortly thereafter and this individual secured himself a nice opportunity to set out on his own for his contribution to finance.  Unfortunately, I can't remember this individual's name, but he founded a small firm that dedicated itself to gold market research.  One of the key insights this individual had was that gold performed well in times of negative real interest rates.  Seems obvious in 2010, but this relatively simple analysis with some other supporting facts turned me into a gold bull in 2003.  As a recent college grad with plenty of debt, I had limited means to express a view on gold, but in 2004 I purchased about 2.5 ounces of gold at the equivalent of $390 an ounce.  My opinion on why gold has performed well over the past 10 years is far more nuanced than it was at the time which is to say I don't think I saw all the risks but this is the genesis of my interest in gold and should establish some background for my current view.

    About two years ago, I turned my attention back to the gold market because based on intuition it seemed it was becoming overpriced.  Gold wasn't popular in 2002, but by 2008 there were regular ads on TV for gold and it was a common conversation piece.  My car mechanic recommended buying gold and storing it in Australia.  Having entered the financial markets during the tech wreck, it's impossible for me to not question anything where the positive zeitgeist has become so palpable.

    You often hear people say the dollar as a cash instrument is worthless -- not literally worthless, but that it provides a very poor, even negative return.  This is one of the core arguments today for gold, essentially that it is the anti-dollar.  In keeping with this thinking, it occurred to me compare gold to cash over a long period of time.  I also added a couple other comparisons which cash investors often look at.  To set the stage, here is the chart:

    Let me explain the above graph.  It is a comparison between five time-series all re-indexed to a 100 start point.  I have estimated year-end 2010 levels from those available mid-year 2010 in the case of CPI and personal income per capita, the current price of gold and an estimate of T-Bill interest through year-end which is effectively zero.  

    First, the cumulative return on 3-month T-Bills is charted in blue with an ending index value of $722.51.  Second, the CPI is charted in red over the same period with an ending index value of 494.84.  The CPI is an oft-maligned measure but my own view is that it measures what it was designed to measure quite well.  What it does not measure is the additional costs added each year to a person's expenditures brought about by quality improvements and new products and services added to the economy.  Without getting into the debate further, let me propose an alternative measure by suggesting that gold could be a hedge not just against the price level of goods available today, but also of goods available tomorrow.  To get an approximate grasp of this I have taken personal income per capita which has risen to an index level of 768.44 and charted it in green.  It is interesting that this level roughly approximates that of the returns on short-term interest.  

    Charting the price of gold for this exercise isn't as simple as it seems.  The single biggest issue to address is the start date.  If the starting price is low, it will look like gold is currently expensive.  If the starting price is high the opposite will occur.  Therefore, changing the start year can have a very large impact on the relative returns of gold.  The price of gold was set at $35 until 1968, and under a two-tier system until 1971 which means the gold price isn't meaningful until after these dates.  By 1973 gold was $106 and by 1980 it was $595.

    To determine the start year I have looked at differences in the return on cash, the price level and gold from 1913 to the early 1970s.  Here are some facts from that analysis.  CPI increased 224% between 1933, the year gold was set at $35, and 1973.  Gold increased 204% over the same period.  If you go back four years earlier to 1929 before the deflation of the Great Depression when gold was $20.67 and the price level had been stable for almost 10 years, the gold return would have been 415% (1929 - 1973) while the increase in CPI would have been only 159%.  Just looking at this data, it seems gold in 1973 was fairly priced if not overvalued based on the relative price levels prevailing at the time.  I have also included a time-series which assumes the average price of 1973-1975 as the starting point, which at $143.  This is a more generous starting point for gold.  Let's be clear here before moving on.  If an investor would have bought gold in 1929 and been able to keep it until 1973, they would have outperformed inflation by 256% based on a $106 gold price and 432% based on a $143 gold price.

    Having set the stage, let me address the implications of the graph.  By any measure on the above graph, even the baseline CPI figure, gold was undervalued in 2001.  This I think goes a long way toward explaining its performance over the past 10 years.  In 2010, it seems the story has reversed.  Whereas holding T-Bills was the better course of action on average from 1973 to 2006, now gold firmly has the upper hand.  Furthermore, gold has vastly outperformed since 2001. 

    We should be cautious in drawing too many conclusions from such a simple analysis.  For example, the cost inputs in the production of gold are not aligned well with the CPI.  Gold mining is energy intensive and it could be that gold is following the price of oil more than the general price level.  While the economy has become less energy intensive, the gold price may not have.  In fact, it may have become more energy intensive.  Gold may have shifted from being a hedge against generalized inflation, to that of energy inflation.  This analysis also does not address the future: gold can be overvalued today, but based on future inflation and wage growth it may not.

    To conclude, I think looking at an analysis such as this is just one part of the picture.  The best lesson I can draw from it for my own trading is that today it is likely that gold is more of a symmetrical bet on the future course of inflation which wages and interest will follow, rather than a value investment in an unloved fundamentally undervalued asset.  As an investment, gold has changed -- it is not the same investment it was 10 years ago.  That does not in itself make it a bad investment.

    Disclosure: Long a de minimus amount of physical gold.
    Oct 11 4:42 AM | Link | 1 Comment
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