Wednesday, April 23, 2014 - A Brilliant Future From Cool Ideas

A Brilliant Future From Cool Ideas

by Sinclair Noe

DOW – 12 = 16,501
SPX – 4 = 1875
NAS – 34 = 4126
10 YR YLD - .05 = 2.68%
OIL - .2- = 101.55
GOLD un 1284.70
SILV + .06 = 19.55

It’s earnings season, and this is a chance to compare and contrast. This morning, Facebook posted earnings of $642 million in net income, or 25 cents a share, in the first quarter, versus $219 million, or 9 cents a share in the year ago period. Overall revenue grew 72% year-on-year to $2.5 billion in the first quarter, topping estimates. Facebook now has 1.28 billion active users, and more than 1 billion do their Facebook stuff on a mobile device. Then Facebook announced their Financial Director was resigning. Shares were up about 3%.

Nobody puts on a better presentation than Apple, that’s how they grew to be the most valuable company in the world. Steve Jobs would walk out and announce Apple had created a new mp3 player, and also a new way to connect to the internet, and also a new camera. Wow, three new products, nope…, he would hold up the iPhone – just one very cool thing from Apple; tech geeks heads would explode.

Today, Apple posted earnings of $10.2 billion or $11.62 a share, on revenue of $45.6 billion. Analysts expected the company to report earnings excluding items of $10.18 a share; Apple reported a 4.6% rise in March-quarter revenue to $45.6 billion; Apple sold 43.7 million iPhones in the quarter. Then they announced they were adding to their stock buyback with an additional $30 billion over the next year. Then they announced a 7 for one stock split, to make their $500-plus shares a little more affordable. Wow, the share price exploded in after-hours trade by about 8%.

You see the difference.

The really cool thing that Apple is now working on is something you’ve probably never heard of and wasn’t part of the earnings report today. Apple is making sapphires. Natural sapphire is a gemstone variety of the mineral corundum, a crystalline form of aluminum oxide. Corundum is colorless, but in natural sapphires, various impurities create a range of colors: chromium makes the gem red, becoming a ruby; iron and titanium create the prized cornflower blue of a true sapphire. Synthetic sapphire is colorless, unless deliberately colored.

Sapphire has been used in a variety of specialized applications for years, where its purity, clarity, high stable dielectric conductive properties, and high optical quality, along with its hardness, have made it worthwhile despite its relatively high price. Think lasers and high end, luxury watch faces.  Apple is making a billion dollar bet on sapphire as a strategic material for mobile devices such as the iPhone, iPad and perhaps an iWatch. Though exactly what the company plans to do with the scratch-resistant crystal, and when, is still the subject of debate.

Apple is creating its own supply chain devoted to producing and finishing synthetic sapphire crystal in unprecedented quantities. The new Mesa, Ariz., plant, in a partnership with sapphire furnace maker GT Advanced Technologies, will make Apple one of the world’s largest sapphire producers when it reaches full capacity, probably in late 2014. By doing so, Apple is assured of a very large amount of sapphire and insulates itself from the ups and downs of sapphire material pricing in the global market.

The Arizona project was revealed in November, with Apple paying $578 million for GTAT to install and run its advanced sapphire growth furnaces in a plant built and owned by Apple. The news triggered a frenzy of speculation that Apple planned to use sapphire crystal sheets to replace the glass currently used in touch displays for its 2014 iPhones, iPads or a new line of “wearables” such as the long-rumored iWatch, or all of the above.

That’s only the tip of Apple’s investment. Once the synthetic sapphires emerge from the furnaces, they’ll be shipped to Apple’s supply chain partners in Asia for slicing, polishing, laser cutting, coating and eventual assembly. No one has used sapphire in large-scale consumer electronics or consumer goods products. Apple created a sapphire cover for the iPhone 5 camera lens, and for the iPhone 5s Touch ID fingerprint sensor. It’s mainly the sheer foundry capacity that Apple is creating in sapphire that fuels the speculation that it has big plans for sapphire in bigger uses, such  as a replacement for the cover glass, presumed to be Corning Gorilla Glass, in at least the high-end iPhone model.

A sapphire cover would presumably be less likely to break or scratch, but the big payoff could be the ability to change the underlying LCD technology of the screen, rendering more colors and using less power than today’s LCDs, while improving the speed and accuracy of the touch interface. 

It will cost more, by some estimates about $20 more per screen, but what it shows is that when Apple believes in a new technology or material, they’re willing to take a hit on the bill of materials costs. Of course, to commit for the long term, there needs to be a convincing cost reduction roadmap somewhere.

Some think technology stocks are poised for a 2000-style crash. And if they aren't ready to fall now, they may be soon. What is it about financial bubbles that make them so hard to detect? One reason is that memories are short. Some 20 years ago Wall Street merrily poured into technology stocks, and was horribly burned. Not many years later, the rest of America piled into residential real estate with similar abandon, and similar results. Meanwhile, big tech companies are using their stock to fund eye-popping mergers and acquisitions, most famously Facebook's $19 billion takeover of WhatsApp in February (of which $12 billion is in Facebook shares). Apple seems to be able to continue to do cool stuff, and maybe a billion dollars is a good price for a better iPhone screen. Maybe it’s a sign of over valuation in tech. David Einhorn of Greenlight Capital thinks tech may be ready to resume its slide, but it is a cautionary tale:

We have repeatedly noted that it is dangerous to short stocks that have disconnected from traditional valuation methods. After all, twice a silly price is not twice as silly; it’s still just silly. This understanding limited our enthusiasm for shorting the handful of momentum stocks that dominated the headlines last year.

Now there is a clear consensus that we are witnessing our second tech bubble in 15 years. What is uncertain is how much further the bubble can expand, and what might pop it.

In our view the current bubble is an echo of the previous tech bubble, but with fewer large capitalization stocks and much less public enthusiasm. Some indications that we are pretty far along include:

The rejection of conventional valuation methods;

Short-sellers forced to cover due to intolerable mark-to-market losses; and

Huge first day IPO pops for companies that have done little more than use the right buzzwords and attract the right venture capital.

And once again, certain “cool kid” companies and the cheerleading analysts are pretending that compensation paid in equity isn’t an expense because it is “non-cash.” Would these companies be able to retain their highly talented workforces if they stopped doling out large amounts of equity? If you are trying to determine the creditworthiness of these ventures, it might make sense to back out non-cash expenses. But if you are an equity holder trying to value the businesses as a multiple of profits, how can you ignore the real cost of future dilution that comes from paying the employees in stock?

Given the enormous stock price volatility, we decided to short a basket of bubble stocks. A basket approach makes sense because it allows each position to be very small, thereby reducing the risk of any particular high-flier becoming too costly. The corollary to “twice a silly price is not twice as silly” is that when the prices reconnect to traditional valuation methods, the derating can be substantial. There is a huge gap between the bubble price and the point where disciplined growth investors (let alone value investors) become interested buyers. When the last internet bubble popped, Cisco (the best of the best bubble stocks) fell 89%, Amazon fell 93%, and the lower quality stocks fell even more.

In the post-bubble period, people stopped talking about valuing companies based on eyeballs (average monthly users), total addressable market (TAM), or price-to-sales. When the re-rating occurred, the profitable former high-fliers again traded based on P/E ratios, and the unprofitable ones traded as a multiple of cash on the balance sheet.

Our criteria for selecting stocks for the bubble basket is that we estimate there to be at least 90% downside for each stock if and when the market reapplies traditional valuations to these stocks. While we aren’t predicting a complete repeat of the collapse, history illustrates that there is enough potential downside in these names to justify the risk of shorting them.

So is there a tech bubble, or isn't there? Maybe tech stocks aren’t overvalued; the market is more balanced now than it was in 2000. Back then, tech stocks accounted for 14% of all earnings in the S&P 500, but a third of the index's capitalization. Nowadays the two figures are about the same at 19%.  Nor is the IPO market overly frothy like it was 15 years ago. In the first quarter of 2000, 115 companies went public, raising $18 billion; in the first quarter of this year, 63 IPOs raised $11 billion. Moreover, the IPO market isn't as crazed as it was 15 years ago: The first day run-up in share prices after their IPO is a third of what is was in 2000, evidence that investors haven't lost all sense of proportion.

The problem is that bubbles, tech and otherwise, can easily be analyzed away. No one expects the tech bubble to explode using exactly the same formula it did 14 years ago. Tech is more bubble-prone than other industries. Investing by nature is betting on the future, but in the case of tech, the future is a growth story based on extracting a brilliant future from a cool idea.