loss

In a recent but recurring lament I asked why Apple shareholders are not being rewarded for the company's growth. I pointed out that there is no fundamental reason why the company should receive such a low P/E multiple (about 18 ex-cash trailing and 10x forward while maintaining 70% earnings growth for over a year).

There were many objections in the comments. Most of them dealt with recent reasons why doubts might have arisen among investors: Android hegemony or some perceived lack of competitiveness leading to margin compression or some macro hangover from the recession.

In this article I argue that none of these objections hold water. My argument hinges on the fact that there is a precise date when Apple ceased being seen as an exceptionally valuable company and that date precedes any of the causes being suggested.

The day of disillusionment was almost exactly three years ago: January 14th, 2008.

How to pin down the date of disillusionment

Consider the following chart.

The blue area represents either a premium (above 0) or a deficit (below 0) of Apple's P/E (ex-cash) relative to the S&P 500 P/E. This is a re-imaging of a chart, first introduced in June 2010 when I first pointed out that Apple was being discounted relative to the S&P 500.

By measuring P/E I am focusing not on the stock price, which has grown nicely, but the ratio of the price relative to earnings, which hasn't (see the next chart below). P/E is a fundamental measure of potential (its reciprocal is the stock's earnings yield.) It is usually highly correlated to the company's growth. If that P/E is uncorrelated to past growth, there is some significant discounting of future growth. It's the most significant (and simplest) measure of "faith" in a company.

By measuring the company's P/E relative to an index of other large companies (S&P 500 P/E) we can assess whether the company's potential is being valued as extraordinary or whether it's being valued as ordinary. In other words we are measuring whether a company is "special".

The chart shows that until January 14th, 2008 the company was valued at a significant earnings premium--a P/E consistently 50% higher than the norm.[1]

Following the collapse (about 40% drop in share price but 100% drop in P/E premium), there was a small recovery followed by a huge trough in valuation. During the recession quarters Q308 to Q309 S&P earnings fell to zero or below. As a result of S&P earnings collapse the S&P P/E shot up astronomically (as E approaches zero, P/E approaches infinity). Apple's earnings dropped as well but remained positive throughout that period bottoming at 37% growth(!) in Q408. As a consequence Apple's P/E fell as low as 11 while the market's went well above 100 (122.41 peak). The P/E deficit for Apple went 80%: Apple was valued as basically worthless (3x cash).

After the earnings recession, the S&P P/E recovered close to historic levels but Apple's P/E did not. It's in-line with the S&P but does not obtain the 50% premium preceding the recession.

So we can establish that the day that Apple's potential was discounted was nearly six months before the onset of recession.

What other discounting factors can we discard?

How about earnings growth itself? Did the collapse foretell an earnings collapse?

The chart above shows the P/E premium vs. earnings growth (in red). Although earnings growth began to slow soon after the 14th (earnings for CQ407 were not yet announced at that point), growth recovered six months later after the launch of the iPhone 3G[2]. Growth continued throughout 2009 and 2010 reaching new heights last year of 86%.

Still, the company received no premium to the S&P 500 P/E. Companies in the index averaged, at best, a quarter of Apple's growth in earnings.

What about Android? The first Android device did not ship until October 2008 (HTC Dream or T-Mobile G1). There were no appreciable Android volumes until 2009, one year after the drop in relative value and no talk of a threat until 18 months later.

The last objection to be put aside is that of margin compression.

This last chart shows how margins (in brown) behaved during the same time period. They went up. The only slight decline took place during the last few quarters, after the launch of the iPad, long after the collapse.

Regardless of the adjustments with product launches, Apple's GM is the envy of the world and is not at all correlated with the loss of faith in the company.

So What happened on January 14, 2008?

Having led you this far in the story, I'm afraid I'm going to let you down at the end: The cause for the loss of faith is a mystery to me.

There is only one noteworthy event that took place on that date: Macworld 2008 (January 14-18). During the keynote, Steve Jobs introduced the Macbook Air (and Time Capsule and Leopard and pre-announced the iPhone SDK which, six months later led to the app supernova). I remember that day and I remember that the stock began selling off exactly at the point when the Air was mentioned. It has never been the same since.

Obviously, correlation is not causation. The Macbook Air need not be the cause for the loss of faith in Apple as an investment. Or can it? I'm hoping someone can explain this because to me it makes no sense. The product was not a home run but it did not do badly either and its current incarnation seems to be a hit. Whatever sins the original Air may have had have surely been expurgated by now.

Regardless the cause, the bottom line is that, in the eyes of investors, Apple stopped being "special" that day. Its valuation dropped to in-line the S&P and, given its growth, well below what a large growth company should be worth. The company's shares went into the bargain bin and are still there today.

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[1] I should point out that the P/E ratio is based on post 2009 re-stated earnings. The restatement changed the P/E as the "E" changed. This was based on the abolition of subscription accounting for the iPhone. Although it may seem unfair to hold the market to this standard, restatement did not actually change cash flows which were transparent and visible to all, even to amateurs such as myself and the other unaffiliated analysts that published throughout this period. Earnings may be an opinion but cash flow is a fact. Valuation on the basis of cash flow should have yielded the same results as shown above.

[2] That quarter showed a y/y growth of 150% while the stock was in freefall. In fact, it was during that earnings day that Steve Jobs came on the conference call and pointed out the astronomic iPhone cash flow to an audience of analysts more concerned about their own jobs.

One of the most hotly debated subjects in the mobile phone business is the importance of market share. It's also a topic of lore in the PC industry. Briefly the two arguments are:

• Market share matters more because it drives network effects which ultimately drive competition out of the market, creating the opportunity for monopoly rents.
• Profit share matters more because profit is the only fuel that can drive innovation. Any macro downturn or shift in strategy can cause a company to cease investing in unprofitable projects.

The old disruptor's adage: "Be hungry for profits and patient for growth" is challenged by the equally disruptive: "Grow share with lower prices in exchange for new revenue sources."

There are many rich anecdotes to support each strategy, but how about some data? Fortunately we have some: the market and profit shares for vendors covering 80% of the world's largest technology market over a three year period. The vendors are a good proxy for the market, the time frame is long enough to cover seasonality and anomalies and the market is very big (over 1.2 billion devices) and very broad (world-wide).

The only question is how to measure success. One measure is how various strategies benefit the asset owners, i.e. the share holders. Benefit to society, employees and consumers are very difficult to measure. But share holder benefit is easily obtained by measuring change in share prices.

So, here are two charts:

1. The percent change in market share vs. percent change in share price for the top mobile phone vendors.
2. The percent change in profit share vs. percent change in share price for the same vendors. (see note 1 for time frame discussion).

I showed the R-squared value of the correlations. (See note 2 regarding LG and Samsung). At r-squared of 0.36 share price is not well correlated to market share while at 0.76 it is rather well correlated to profit share. To a financial analyst this would seem obvious. After all, share price reflects the present value of future cash flows which are clearly coupled to profit and hence to profit share growth. However, as many technology observers would point out, market share determined the success of Microsoft and Google, and to some degree Nokia.

High market share can cause competitors to be starved of components or ecosystem developers. At the same time, high profit share can cause competitors to be starved of capital.

What does this analysis add to the argument? Note that this data covers a hardware business. Is hardware relevant? It does not scale as rapidly and has a short shelf life. It's also notoriously difficult to distribute. However, outside of the service revenues for cellular voice and data, device hardware is the only pool of money that has any material dimension in the industry. It's also the pool of money with the highest margin in the industry. For the time being and the foreseeable future, hardware is the only business model worth anything in mobile computing.

The data shows that in this particular but substantial market profit share is closely correlated to shareholder value creation. It also shows that profit loss is closely correlated with shareholder destruction. The dominant data comes from Apple and Nokia, which appear to be polar opposites in performance on both measures.

In other articles I've shown how profits have shifted from incumbents to entrants in the smartphone disruption. This shift has resulted in direct benefit and loss to the owners of the two asset classes. To suggest that market share alone is a determinant of "success" in the device market must exclude the effect on shareholders and, ultimately, the management and employees of the companies concerned. The virtuous/vicious cycles will be fed by the profit variable more than any other.

I don't think the market share argument holds water in this market and this data supports my belief. It may be that as value shifts over time away from hardware the benefit will shift as well, but business models alternatives to hardware have not emerged after ten years of experimentation. If anything, the idea of selling hardware as a way of capturing service revenue was pioneered by RIM and perfected by Apple. Nothing I've seen so far is challenging this model. Whoever attempts to siphon the device pool of money (which has remained fairly constant over the smartphone disruption) needs to solve system-wide problems like the dependence on the network and the life-cycle of portable electronics.

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Notes:

1. The dates when performance was sampled are are July 1 2007 to July 1 2010. The latest quarter (3Q10) has not been included in this data as it has not been fully reported. The data will be updated with the latest quarter as soon as it's possible.
2. For many competitors the share price is dependent on more than performance in the mobile phone market. In particular, LG, Samsung, Motorola and Apple have diversified product lines which affect their share prices. Two of those companies (LG and Samsung) are conglomerates and their share performance is dominated by businesses other than mobile so I did not include their data in the correlation measure (though their place on the chart is shown). Motorola and Apple's stock prices were, to a very large extent, driven by their mobile phone performance over the same period so their data is included in the correlation analysis. The other vendors have been primarily focused on mobile phones.

Thanks to a reader's suggestion, I took another look at the profit and market share data from the mobile phone market overview posted last quarter. This time to compare the vendors on two dimensions at the same time.

I plotted the vendors on share of market and share of profit axes in two different points in time: Q2 2007 and Q2 2010. I further broke the chart into four quadrants as shown:

I chose to label the quadrants to indicate the possible categorization of the companies.

• Dominant: large market share and large profit share
• Star: low market share with large profit share
• Fading: high market share with low profit
• Marginal: low market share and low profit

It's interesting to note the shift over the time period of the eight vendors. Whereas Nokia moved from Dominant to Fading, only Apple rose from Marginal to Star. The Marginal players dispersed their placement with Samsung moving laterally toward Nokia while RIM followed in the Apple trajectory and increased profit share while maintaining relatively low share.

Thinking about motion around these two dimensions could be reduced to a vector model. If each vendor is represented by an arrow showing direction and distance moved, we can compare each vendor vs. a symmetric competitor which might account for the loss or gain of share.

The vectors can be paired as follows:

Although the data does not contain all market participants, the shifts in share are quite closely conserved with the vector magnitude (arrow length) and angle (direction) paired. Note how Nokia and Apple swapped Profit without too much impact in Units volume. Similarly, RIM and Sony Ericsson traded profits and volumes quite symmetrically. Samsung also took volume while Motorola lost it. HTC and LG did not change positions dramatically.

Finally, moving all vectors to the same origin leads to this view of share gain/loss over three years in two dimensions:

It becomes quite easy to see who the winners and losers are and by how much.

This model is only an observation of the shifts in market power and is not conclusive about where share was gained or lost, however there is compelling symmetry which also matches the intuition of  observers.

This weblog could be read as a diary of the disruption of the mobile industry. There is lots of topical analysis and opinion, but sometimes I'll post on the "theory" which describes what's going on in a more abstract, and long-term, level. Theory is like a bullion cube: savory, but too concentrated to be enjoyed undiluted. For this reason, the most palatable way of administering theory is through example. So we kick off with an example of what happened to another technology industry as a result of the emergence of a disruptive technology.

The following is a draft article I wrote describing the "electronics industry" for POSTWAR AMERICA: AN ENCYCLOPEDIA OF SOCIAL, POLITICAL, CULTURAL, AND  ECONOMIC HISTORY. It is itself based on a presentation by Clayton Christensen at the Open Source Business Conference in 2004.

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The consumer electronics (CE) industry began in 1920 when radio broadcasting commenced in the United States. Radio technology sustained a growing electronics business throughout the 1930's and 1940's, however, the electronics industry underwent a major transformation after the war. The critical development came after 1948 when the transistor was first invented. The transistor and the subsequent development of solid-state semiconductors dramatically and profoundly changed the industry. The change the transistor brought was not just evident in measures of technical performance but also in the economics of the industry and the business models required of its participants

"Electronics" has a precise definition: technology based on the controlled flow of electrons. Prior to the transistor, the control of electron flow in a system was through a component called the electron tube (or vacuum tube). The tube in its simplest form is a gas-filled glass cylinder, much like an incandescent light bulb, with two electrodes or terminals inside. When the negative terminal is heated it emits a cloud of electrons which the gas inside the tube carries to the positive terminal. This device allows current to flow in only one direction since the positive terminal is not capable of emitting electrons. It is called a diode and is simply a one-way current or conduction valve. Hence the "semi" in semiconductor. Semiconductors can be designed into complex products that amplify, store and communicate; the core applications of CE devices.

The transistor is significant because it is a "solid-state" semiconductor. Solid-state means that it is composed of solid components, unlike tubes which required a sealed gas to operate. The consequence of this shift from gas to solid components completely changed the industry and created unforeseen growth, wealth and societal change.

NEW ECONOMICS

The invention of solid-state semiconductors allowed new economies of production: components were smaller, cheaper and could be produced with a process closer to printing than to assembly manufacturing. Because of the subsequent advances in assembly, the cost of electronics products decreased even as quality and reliability increased. Power requirements and physical dimensions were also reduced, allowing greater portability.

These implications might have seemed foreseeable to the engineers and businessmen of the 1940s who first looked at a transistor, but what happened is something completely unexpected: almost all the companies dominant in the electronics industry in the 1940s and 1950s who spent huge fortunes to perfect the transistor for their products went out of business or withered away to insignificance. New, giant CE companies emerged in Japan who perfected new product categories rather than challenge the incumbents and their existing products.

The emergence of Japan as a powerhouse of CE has been debated as a motivation for changing US industrial policy toward a more interventionist model. Transistor technology was seen as a strategic national defense asset and the innovations and production associated with it were not to be allowed out of US control. Additionally, American politicians argued the case that it was US taxpayer-funded defense, educational and space efforts which produced these innovations, hence they "belonged" to the United States government, and future innovation will similarly need taxpayer funding. Unless something is done, Japan would dominate American industry.

What happened in fact was far more mundane. The transistor disrupted the industry. Small upstarts were able to take the invention, wrap a new business model around it that motivated the current players to ignore or flee their entry. They thus successfully displaced the entrenched incumbents even though the incumbents were investing heavily in the technology and the entrants weren't.

THE INDUSTRY THAT EMERGED

The postwar half-century began with the radio as the center of the CE world. It ended with the television dominant, alongside a whole galaxy of mobile devices.  All employed the transistor, which itself underwent dramatic increases in power and equally dramatic decreases in size. Some of the significant breakthroughs along the way are listed in Table below. Note in the table the absence of any companies which dominated the CE industry before the transistor (RCA, GE, Zenith, Westinghouse, Philips, Magnavox, Curtis-Mathes, ITT, Packard-Bell, Philco, Siemens, Sylvania, Western Electric).[3]

• 1957 Sony TR-63 Transistor Radio. Portability enabled privacy which allowed young people to listen to Rock-n-Roll.
• 1960 Sony portable TV. Made a second television in the bedroom possible.
• 1962 Sony CV-2000, first home videotape recorder. The concept of "time-shifting" was born.
• 1970 Olympus Zuiko Pearlcorder Microcasette recorder. Audio recording became a discrete affair.
• 1972 Pulsar Quartz Digital Watch. Quartz meant cheap but accurate watches for everybody.
• 1972 HP-35 Pocket Electronic Calculator. The end of the slide-rule.
• 1976 Atari Pong Game. A new use for TV: interactive games.
• 1976 JVC HR-3300 VHS VCR. Mass-market cartridge-based video recording. Video rentals took off.
• 1977 Atari 2600 Game Console. Game cartridges added a new category of content consumption.
• 1979 Sony Walkman. Portable high fidelity music for your ears only.
• 1980 Sony Boom Box. Portable high fidelity music for you and your neighborhood.
• 1983 Sony CDP-101 CD Player. Loss-less audio reproduction for all.
• 1984 JVC Camcorder. Home videos were born.
• 1986 Motorola Bravo Pager. Contact somebody even if they are not near a phone.
• 1996 Toshiba SD-3000 DVD Player. Loss-less video reproduction for everybody.
• 1998 Nokia 5100 mass-marketed phone. Easy to use, customizable cheap mobile phone.
• 1998 Diamond Multimedia Rio. Mobile digital compressed music consumption.
• 1999 Tivo Series1 Digital Video Recorder. Skip commercials and freeze real-time video.
• 2001 Apple iPod. All your music with you all the time.

DISRUPTIVE IMPACT

When the transistor was introduced in the late 40s and early 50s, most designers considered it inferior to existing vacuum tube technology as far as performance was concerned; transistors could not handle the power that was required to be used in the main CE products popular at the time, notably, the big tabletop radios and floor standing televisions. The transistor could not amplify sound as well as a tube, but it was small, solid, and used low power. Therefore, RCA, Zenith, and Westinghouse looked at the transistor as a electronics component with great potential, but one needed to be improved to match the tube as an amplifier before it could be used as a substitute.

Every CE company was required to receive a license for the transistor from its creator AT&T, before they could put it in their products. But they took out these licenses in order to experiment with the new technology, hoping they themselves could improve it sufficiently for use in the CE products.  Altogether, these CE companies spent an aggregate $2 billion (in today’s dollars) trying to make solid-state electronics good enough that they could make popular high-end CE products with them.

And while tube companies were trying to fit the transistor into large products, other companies, especially in Japan, were developing the first transistor-based products.  One critical one was a transistor hearing aid, first marketed in 1952. While hearing aids were a tiny market in comparison to radios and televisions, it was a market that valued the miniature size and low-power requirements of the transistor. In 1955, Sony introduced its first pocket radio. The sound quality and reception of those radios was very poor relative to the "console" systems available in living rooms. But Sony chose to sell the pocket radio to teenagers. Teenagers were delighted to have a product that was inexpensive and that they could carry with them, allowing them to listen to the rock and roll music their parents may have disapproved of.

Thus, a booming new market emerged based on a hitherto neglected feature that transistors made possible: portability. Meanwhile, the existing big American CE companies felt no need to change their business plans because the new products, in their opinion, were going to new customers not existing customers. Had Sony tried to sell its pocket radio to the parents, the product would have been judged to be inferior because they had the alternative of a high quality vacuum tube radio in their homes. Then in 1959, Sony introduced its first portable television, and again, the portable television was marketed to a whole new cohort of consumers who could not afford expensive, tube-based consoles. Since the alternative for these consumers was no TV at all, they were willing to accept a product with a somewhat inferior picture and reception.

By the 1960s, solid state electronics had become capable of handling the power required to make larger CE products, making it possible for the big American CE companies to incorporate solid state electronics in the big home products area that they dominated.  And, indeed, by the end of the decade all of the products for the mainstream living room market were using solid-state semiconductors. However, they were largely being made by Japanese companies. The Japanese perfected the semiconductor components through their foothold markets to such an extent that the American offerings were not nearly as good. The venerable vacuum tube companies were doomed.

THE CYCLE REPEATS

The table ends with four company names that are distinctly non-Japanese. The phenomenal process of innovation-based disruption is under-way again. This time, the incumbents are the same Japanese companies that used the transistor to disrupt the previous incumbents while the new entrants are small companies focused on microprocessor-enabled digital media or communications. In a cruel irony, the incumbents framed the innovation of digital media products as not good enough for the living room while the entrants saw it as good enough for a new, non-consumptive mobile or time-shifted usage. The existing customers saw the digital products as inferior while the new customers saw portability as a fair trade-off for quality.

A future article will discuss how the telecom industry saw voice mobility as sustaining but data mobility as disruptive.
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REFERENCES

1. Electronics (2nd Edition), Allan R. Hamley, Prentice Hall, August 3, 1999.
2. The Innovator's Solution, Clayton M. Christensen, Michael E. Raynor, Harvard Business School Press, September 2003.
3. "The Top 100 Gadgets of All Time", Chris Null, Mobile PC, March 2005.
4. Sony, John Nathan, Mariner Books, April 2001.
5. The Road Ahead, Bill Gates, Nathan Myhrvold, Peter Rinearson, Viking Press, November 1995.

Losses from mobile phones totaled 120 billion won ($101 million) in the second quarter, compared with profit of 620 billion won a year earlier, Seoul-based LG said in a statement today. The loss, the division’s first in four years, was triple the size projected by the average estimate of five analysts surveyed by Bloomberg.

via LG Posts Record Handset Loss on IPhone, Smartphones - BusinessWeek.

Nokia's latest quarterly results and forecast caused a 15% drop in the share price on a day when the S&P rose by about 1%. The drop was the largest single day change in the company's valuation since 2004. The cause for the drop was not macroeconomics or performance in the previous quarter, but the guidance provided.

The shock was in an unchanged low margin and a flat market share. Both of these measures of performance were expected to improve as the overall market improved. What Nokia is saying, in effect, is that it will perform no better than the market average. Naturally, its value should therefore be no higher than the market average.

The trouble is that the "market" for mobile phones is abysmally free of value and hence of profits. Taking the sum of profits for all the major incumbents (Nokia, Samsung, LG, Sony Ericsson and Motorola) we find that net profits for the entire industry are, at best, flimsy, at worst, negligible. But this begs another question: why is value missing in mobile devices--a market that seems to be growing faster than almost any other technology market?

First a few facts:

• Focusing only on Devices & Services, Nokia did make a net profit of EUR763 million on sales of 103.2 million phones. That's EUR 7.39 average operating profit per phone. In Q1 Nokia Devices made about EUR 6 per phone, so a slight improvement, but down from about EUR 20 a year ago.
• Sony Ericsson entered its fourth quarter of losses.
• Motorola entered its 9th consecutive quarter of losses.
• Samsung and LG are at about break-even.

So if one were to look at the incumbents, the ~1 billion phones they sell a year seem to be generating barely EUR2 per phone, most of it in the hands of Nokia.

The exceptions are, of course, the entrants RIM and Apple with EUR 60 and EUR 120 profits respectively per phone, orders of magnitude above average.

Nokia seems to be the best of a bad lot. Can Nokia expect to join the entrant cohort or sink with the incumbents? Answering this question forces us to go through a deep examination of what correlates with value in the new device market.