28 Oct The Lato Letter: Volume 1, Issue 29.
One of the keys to long term successful investing is to have a diversified portfolio among many stocks and sectors because not all portfolio holdings can be contributors to positive performance day in and day out. This month, that diversification has helped the Padlock portfolios to stay ahead of the market while two of our bell-weather holdings have had a difficult couple of weeks.
Apple and Google, which have been very strong contributors to the positive performance this year, have both declined recently but those declines, rather than being a cause for concern, have created the opportunity for them to once again lead the portfolios for the balance of the year.
Starting Thursday, October 18th, Google shocked investors by having their earnings released four hours ahead of schedule and having them widely miss expectations. Apple then released their earnings the following Thursday and also disappointed investors by falling slightly short of the consensus estimates.
At the time this is being written, from the day prior to their respective earnings releases, the stocks are down almost 11% for Google and 4% for Apple. Are these drops justified and are they a sign of things to come?
In Google’s case, because of the magnitude of the shortfall from the consensus estimates and the fact that the stock was trading near its all-time high a week ($774 on Oct. 5th) or so before the earnings release, there is some justification for a decline. That being said, I feel that the decline is well overdone and represents a great entry point.
Google is an unusual company that generally does not follow a number of corporate traditions including providing earnings guidance and more importantly not placing much if any emphasis on quarter to quarter earnings releases.
In spite of all notoriety that Google enjoys from sources like YouTube, Gmail and Android among others, Google continues to derive the vast majority of its revenue from advertising via its search engine. As search is migrating faster and faster to mobile devices, Google is also growing its revenues in this area. Mobile search, however, carries lower rates and profit margins and as it may be cannibalizing the more profitable desktop searches, Google’s margins have suffered slightly.
To combat this decline, Google is beginning to derive revenue from other sources and is being a more well-rounded company. Their vision continues to be focused far into the future as they continue to improve their existing businesses and continue to look for new business opportunities. This company is not a company whose best days are behind them but rather one that continues to evolve and create more value for its shareholders even if it is not on a quarter to quarter basis.
With respect to Apple, its stock price was already down almost 13% from its all-time of $705 on September 21st and its earnings were less than 1% below consensus so the sharp decline in the first few hours following the release is arguably less justified. Although less so than Google, Apple is also not a company that is overly concerned about how their long term business planning impacts their quarter to quarter earnings.
Although they do provide guidance, their guidance has been historically very, very conservative. In fact, in the 25 quarters since I first purchased Apple for clients, the company has exceeded their prior quarter estimate by an average of 33%. Nonetheless, Apple’s latest estimate of earnings of $11.75 for next quarter is the first time in three years that they have projected earnings less than the same quarter in the prior year. It should be noted that the last time this happened, aided by a change in accounting, Apple actually reported over double what they had expected only 90 days earlier. Pardon the pun, but on an apples to apples basis, without the accounting change, they would have exceeded their guidance by over 50% that quarter.
As CEO Tim Cook stated several times on the conference call, Apple’s goal is to have the best product possible to meet the needs of the market. In so doing, in the initial stages of a product launch, margins tend to suffer as the production learning curve takes time to bring production costs down and margins up (and it is expected that over 80% of the revenue next quarter will be from products recently announced (e.g. iPhone 5, iPad mini, etc.). Apple is estimating that operating margins for the quarter will be 36% compared to the 40% that they were in this quarter.
Apple has also been constrained by not being able to meet demand as production of the iPhone 5 ramps up. If the production learning curve proves to be more favourable and Apple is not only able to produce more but also produce it at a lower cost, revenues for the next quarter that are 2% above the $52.0Billion guidance and margins that are also 2% higher would translate to earnings in the $13.30 to $13.50 range, just slightly below last year in a quarter that is one week shorter than last year.
Apple’s latest slate of products is superior in terms of design, functionality and user experience. In addition to the products, the Apple ecosystem including iTunes, iBooks, iCloud and the Apple Apps Store provides customers with a vastly superior proposition that can justify a premium price. As Warren Buffett has stated, “I like to look for businesses that are protected by moats that provide longevity to the business”. The combination of the products and the ecosystem provides Apple with a very substantial moat to protect its business for the future.
Thus far, I have discussed two great companies but at their current prices, they are also great investments. If the valuations were not attractive, no matter how good the company is, they may not be good investments. In Google’s case, at its current price Google is trading (ex-cash of $143 per share) at a Price/Earnings (P/E) multiple under 11.5 times 2013 earnings and in Apple’s case, it is trading (ex-cash of $127 per share) at a P/E multiple of just over 9.0 times 2013 earnings. Both of these great companies are trading at below average multiples and yet looking past quarter to quarter earnings, I continue to believe offer very attractive growth profiles and therefore potentially significant rewards for their shareholders.
As a post script to my opinion, this link will connect you to this week’s Barron’s article on Apple.
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