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Intrinsic Value Asset Management (IVAM) was founded by Ken Luskin after a fifteen-year career with Wall Street investment banks Morgan Stanley, Smith Barney, and Bear Stearns. IVAM has been managing separate accounts since January, 1998. IVAM is a licensed investment advisor in the state of... More
  • Tesla, Netflix, Amazon, Salesforce, Apple Are Nifty But Not Thrifty 0 comments
    Aug 22, 2013 2:43 AM | about stocks: AAPL, AMZN, CRM, NFLX, TSLA

    (NASDAQ:TSLA) (NASDAQ:NFLX) (NASDAQ:AMZN) (NYSE:CRM) (NASDAQ:AAPL)

    Caveat Emptor is Latin for "Let the Buyer Beware"

    The ancient language of Latin, has many time honored phrases that are still used today, despite thousands of years of technological progress. Even after thousands of years of recorded history, Human Beings still have the same basic emotional weaknesses that they did eons ago.

    The most powerful emotions relating to investing are fear and greed. Investors tend to be fearful when a stock declines, and greedy after it is has increased dramatically.

    One of Wall St. guru Warren Buffett s famous quotes , attributes part of his success to "being fearful when others are greedy, and greedy when others are fearful."

    The Nifty Fifty

    In the early 1970s, a group of stocks that investors felt could do no wrong, became known as the Nifty Fifty. Investors felt that these Nifty Fifty companies were such good long term investments, that no price was too high to pay for them. Almost all of the of the Nifty Fifty list badly underperformed after the market topped out in 1973. Which is why the Nifty Fifty list is often cited as an example of unrealistic expectations for growth stocks.

    In this article and subsequent ones, I will look at five overpriced growth stocks at a time, that I call the Nifty Five.

    Tesla: Terrific car, overpriced stock

    Tesla shares are now priced for perfection. Which means even if the company executes perfectly over the next couple years, the shares are still fully priced. The price/enterprise value to sales ratio is a good metric for comparing top of the line auto companies, since there are basic limits to the maximum profits that can be achieved per vehicle sold. The top of the line German auto companies have enterprise value to sales ratios of about 1 for Daimler(DAI.DE) , 1.5 for BMW(BMW.DE) and 2 for Porsche(OTCPK:POAHY). Tesla is currently at a run rate of about $2 billion in sales, but they have an enterprise value of about $17 billion. Therefore, if Tesla doubles their sales next year based on additional sales of the soon to be unveiled SUV, the enterprise value to sales will be 4.

    Tesla can only sell so many $70,000 to $100,000 cars a year. BMW,(BMW.DE) Mercades(DAI.DE) , Audi(VOW.DE), Porsche (OTCPK:POAHY) etc, will only cede so much market share before they bring out competitive electric cars at the high end, even if it means losing money on them. Non exotic mass production auto companies must maintain a certain sales base to justify the large investments that must be made in research, development, and plant improvements, to stay competitive. These luxury auto companies have huge resources, and are not asleep at the wheel the way big three in the US were a few decades ago.

    Which is why Tesla plans on rolling out a mid priced car in 2015. But, this is where the grim reality of the auto industry starts to bite. Virtually none of the top worldwide auto companies earns any substantial profits from selling mid to low priced vehicles. The economics of selling mid/low priced cars and trucks is completely different from selling high priced vehicles.

    While Ford and GM may be touting the sales of their mid to low priced cars, they are making almost all their profits from full sized trucks, and top of the line SUVs.

    Selling mid to low priced autos is all about volume. The profit per vehicle is so small, the only way an auto company earns back the development investment is from huge volumes, and incredibly efficient manufacturing. Which is why Toyota was able to earn profits from selling mid to low priced vehicles, while nobody else has been earning much in that price range except maybe Volkswagen(VOW.DE)

    The market cap of Tesla to the number cars they expect to manufacture next year is thru the roof, and off the charts. Manufacturing cars is not a recurring revenue business that might deserve a large multiple of earnings. Manufacturing cars can quickly become a losing business when the competition increases, and/or the economy is weak.

    Tesla already has an enterprise value that is close to that of Porsche, a very profitable speciality auto manufacturer, with sales that are more than 4 times larger than the current Tesla run rate. The current valuation of Tesla is already discounting good news for the next few years, and leaves no room for any disappointment.

    Netflix, Amazon, and Salesforce.com are Riding the Growth Tiger

    Many growth companies must decide how much profit can be sacrificed, so they can continue investing for top line growth. The best legitimate growth stocks in history, such as Gillette, Coca Cola(NYSE:KO), Walmart(NYSE:WMT), McDonalds(NYSE:MCD), etc., exibited steadily rising revenue, and a commensurate rise in profits, during their largest growth phases.

    But, this latest batch of growth stocks, barely earns any profits, and investors do not seem to care. Investors seem to feel, that all that matters is revenue growth, and that no price is too high to pay.

    The current enterprise value to EBITDA ( earnings before interest, taxes, depreciation and amortization), which is a measure of internal cash flow, is about 28 for Salesforce, 43 for Amazon, 85 for Netflix. The same metric for Google, a top technology company, is 14.

    The concept is that once these new technology/internet companies reaches a certain size, economies of scale will magically produce huge profits. But, recent history is proving to be somewhat different than expectations.

    Netflix, Amazon, Salesforce have grown their revenues dramatically over the last few years, but the same cannot be said for their bottom line profits per share. Profits per share should be the most relevant number for most investors in technology companies. Yet, growth investors are content that eventually profits will follow.

    The problem is that without massive investment spending, that reduces profits to a sliver, there is a high probability that the revenue growth will slow dramatically or end.

    Therefore, these growth companies cannot get off the growth stock tiger, or the tiger will devour them. In other words, if the growth ends, growth stock investors will sell, and the stock price will collapse.

    If these growth companies stop spending aggressively, profits may improve, but then investors will be forced to put a realistic multiple on those profits.

    Whereas, if the companies just continue to go head long after growth, investors appear to continue to believe they will be able to have their cake, and eat it too.

    The bane of all investors is unrealistic expectations. Which leads us to the last of this edition's Nifty Five.

    Apple Trees do Not grow to the Sky

    While Apple does not appear expensive on an enterprise basis to current profits, neither did what was then called Research in Motion, now called Blackberry. Neither did Nokia appear expensive after the growth bloom first came off the high valuation rose. Neither did Motorola appear expensive immediately after its last best selling phone, the "razor" flip phone, growth stopped.

    While Apple has many other products, the iPhone accounts for about 60% of sales, and 80% of profits. The main reason for the profitability of the iPhone stems from US carrier subsidization plans. Even though the iPhone's technological edge has been eclipsed by other phones, Apple has still managed to get a better price from US carriers, than most competing phones. The $500 billion question is how long customers and service providers will pay premium prices for a product that is no longer clearly superior. The history of the consumer electronics industry says not much longer.

    Sales stagnation is the first thing that usually happens to successful consumer electronic companies, after a period of what investors believe will be never ending domination. The next thing that happens is called price and margin erosion. Finally, there is significant decline in sales, while profits evaporate over a very short period of time.

    Apple just finished the first phase, and investors drove the shares down almost 40% off its highs. Even after subtracting the cash in the bank, Apple has one of the largest market caps in the world.

    Approximately 90% of Apple's profits come from the sale of consumer electronic devices, with only 10% or so coming from recurring revenue. Investors somehow believe that consumers will continue to replace old Apple iPhones with new ones for the next 10 years, despite the history of the consumer electronics industry in general, and the mobile phone history specifically.

    Of course there are some people who have trapped themselves into buying so many iTunes songs, that they cannot bare to switch to another device.

    But, purchasing iTunes is akin to purchasing CDs, they do not transport well. So, most people are realizing that a music service is much more efficient and cost effective way of accessing a huge amount of music wherever you are.

    Once most people realize that they do not need iTunes anymore, that is the last piece of glue that keeps them stuck in the Apple walled garden.

    The recent 25% bounce in Apple shares is based upon financial engineering and not upon improved earnings and growth prospects, in my opinion.

    Just because Apple pulled off one of the most amazing consumer electronic " hat tricks" of all time in one decade( iPod, iPhone, iPad) investors seem to believe that every new product will be a huge winner, and not another Lisa computer.

    The 80 year history of consumer electronics, shows that most companies do not dominate for more than a decade or so. More importantly, the law of large numbers starts to kick in once a company's market cap becomes the largest in the world.

    Furthermore, the secret sauce in the Apple pie is no longer around. Of course Apple still has a talented group of people, but it was Steve Jobs that drove them to produce "insanely great" products.

    In my opinion, Google's Android and Chrome OS is doing to Apple now, what Microsoft's OS did to Apple in the 80s and 90s. Asian manufacturers will produce products on razor thin margins, and destroy Apple's margins, similar to what happened the last time. In fact, it may be even worse this time, because Android and Chrome are open and free, whereas Microsoft's OS added a significant cost to the competing computer systems in the 1980s and 90s.

    Apple's products are still receiving unsustainably high margins, but the second phase of decline has just started. Competing smart phones are in many cases superior, and the same has happened with tablets. Almost all consumer products become commodities after a while, and Apple has relatively small recurring revenue from these products. Even when there is a profitable recurring revenue stream, as with printers, the competition gets so intense that they are being sold for less than cost.

    It is only a matter of time, probably no more than a few years, before Apple's margins decline down to slightly above the level they were before the hat trick started in 2004, in my opinion.

    Bottom line, after Apple's margins return to a sustainable level, and sales decline along with them, the shares will no longer appear cheap on a cash adjusted earnings basis.

    Conclusion

    Tesla, Netflix, Amazon, and Salesforce are super expensive based upon forecasted sales and earnings, and any slight downward adjustment could send these stocks down dramatically.

    While Apple is not expensive based upon forecasted sales and earnings, I believe forecasted earnings are simply unsustainable based upon the history of the consumer electronic industry.

    When Apple's margins and earnings collapse the share price will follow. In other words, Apple shares are not cheap, because the earnings supporting this conclusion are unsustainably high, in my opinion.

    This article is not meant as a short sale recommendation for the average investor, as selling short is extremely risky. The take home message is meant mainly as a warning to current holders of these stocks, and to those investors who are considering purchasing them.

    With that warning, I believe now is the time for professionals that are looking to hedge other holdings, consider selling short these stocks.

    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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Themes: short-ideas Stocks: AAPL, AMZN, CRM, NFLX, TSLA
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