May 2008 Update and Company Reports
Stock
market performance is highly correlated to investor expectations for the future
output of goods and services. Last year,
mortgage credit problems shattered an optimistic consensus, creating the
expectation of a recession, and, in turn, causing financial market
depreciation. Although the credit crunch
and a retrenching consumer will continue to fuel negative news, the markets
have priced it in, and have likely seen their lows. The pain of today’s depressed economy and dearth
of liquidity has changed the behavior of Americans. New home buyers and securities investors
alike will be wary of the two-edged sword of leverage, as will the bankers who
provide that leverage. More saving and
less spending by Americans is already the norm.
This new fiscal conservatism explains the weakness of consumer
sales. Jobs, on net, have not been lost
as in previous slowdowns; people are just afraid to spend. And, compared to $1 trillion potential losses
in mortgages, keep in perspective that U.S. National Income: Compensation of
Employees[1] was $7.8 trillion last year and
The
seeds for a better market have been planted.
Americans are working harder and smarter, driving higher output. The lesson of the first quarter earnings
reports is clear: The weak dollar has made American products dramatically less
expensive overseas. Export sales of
products made in
There
are still two notable threats to the
William Wrigley (WWY 78) has been a legacy position for many of our
long-standing clients, some of us having owned it for decades. Mars, the privately held
confections manufacturer, will be acquiring all Wrigley stock for $80 per
share. The transaction is likely to
close this year, in view of the exposure to increased capital gains tax rates
next year. We are sorry to see it go; it
has been a terrific investment. At this
point in the stock market, there are many replacement opportunities. One is the superb Swiss company Lindt, which
makes the beloved Lindt Lindor Truffles, and has an impressive record of
sustained growth.
Apple (AAPL
$188) is the premiere innovator in consumer technology. According to CEO Steve Jobs, Apple attempts to
exist at “the intersection of technology and the humanities.” Over the last few years, Apple has built an
entire ecosystem around this mission statement with evolutionary products and
services such as the iPod and iTunes for music, the iPhone for personal
communication, the Apple TV for movies, and a myriad of software applications
for the MAC line of computers. This
ecosystem is a reinforcing cycle where sales of one product lead to greater
sales of another product. For example, as
of this month, Apple has displaced Walmart as the number one music retailer in the
Apple may very well be the world’s
best retailer. The company opened its
first store seven years ago to critical reviews from Wall Street skeptics. The preferred business strategy at the time
was Dell’s model of internet-only sales. Another computer brand, Gateway, was in the
process of closing its stores after failing miserably with a brick-and-mortar
retail effort. Most analysts covering
the company were skeptical, and one quipped, “I give them two years before they
turn the lights out on a very painful and expensive mistake.” Fast forward to today: Apple now has 208
stores; it reached $1 billion in retail sales faster than any other retailer in
history; the company opens a new store every nine days; average revenue per
store is $28.4 million, more than ten
times the average revenue of
comparably sized retailers; roughly 11,000 people visit each store every week,
compared to 250 people who were going to Gateway stores each week; and finally,
revenues at the Apple stores increased 74% over the last year.
Apple’s retail strategy is to make
visiting an Apple store a special experience - to become the Starbucks of
computer stores. It is not just a place
to buy technology products, but also a place “to be.” The Apple stores are rather small in size,
with superb layout and design, located close to where people live, work, eat
and shop. The retail stores give Apple
an opportunity to bring the Apple message directly to consumers. The stores are staffed with well-trained
technical experts who provide face-to-face training and hands-on learning. Over one million people per week visit the
stores for technical assistance and in the last quarter alone Apple delivered
over 580,000 one-hour personal training sessions. This kind of interaction with customers and
potential customers provides Apple with a sustainable competitive advantage in
the consumer technology marketplace.
Historically, Windows-based computers
(PCs) have dominated the market while Apple’s computers (MACs) have been an
also-ran. Recently, due to Apple’s
superior innovation, the tide has turned. Apple has now surpassed Dell as the number one
supplier of laptops to the higher education market. Visitors to Apple stores learn that MACs and
PCs are not that different, and that MACs are easier to use. The most important addition to the MAC
operating system in recent years is a program called Bootcamp, which is now shipped with every MAC. Bootcamp enables the MAC to run Microsoft
Windows, so that PC-only software can function on a MAC. Consumers who were previously reluctant to
purchase an Apple computer because they needed to use PC-only software are now
free to purchase a MAC. Meanwhile,
Microsoft’s new operating system, Windows Vista, is getting mixed reviews. The numbers speak for themselves: overall
growth last quarter in the personal computer market was 11%, while MAC sales
grew 51%. In 2007, over 50% of all MAC
sales were to people who reported never owning a MAC before. This exceptional growth signals that Apple is capturing
market share from its PC competitors.
Apple is very secretive about future
products and analysts expend a substantial amount of energy trying to guess
what the company will unveil next. The
iPhone, for instance, was in development for over two years before Wall Street
received any hint that Apple would release such a product. The introduction of this product stunned both
its customers and the cellphone industry.
Never has the user interface to such a sophisticated device been
designed to be so inviting and intuitive for non-technical users. It set off a shockwave in the cellphone
industry as manufacturers panicked to build “IPK’s” – iPhone killers –
competing phones that mimicked the iPhone’s ease-of-use. As analysts who follow Apple, we must speculate
on Apple’s next innovation. We predict
that the 3G iPhone will be announced in June, adding cellular broadband data to
this amazing device, hopefully powered by a QUALCOMM’s chipset.
Given Apple’s mission statement of
delivering products and services at “the intersection of technology and the
humanities,” there is a world of opportunity awaiting Apple over the next few
years. Analyst consensus earnings
estimates for 2008 through 2012 are $5.20, $6.35, $7.78, $9.53, and $11.67,
respectively, supporting a rapidly rising intrinsic value calculation of
approximately $140. In addition, Apple has roughly $26 per share in cash
($20 billion) and its cash hoard is growing every quarter. The company will most likely utilize this cash
to either repurchase shares or make some minor acquisitions over the next few
years, both of which would further increase earnings per share. Apple’s stock price could reach $250 per share
over this timeframe.
Steven L. Ré, CFA and David R.
Marchesani, CFA May 15, 2008
This report contains the current opinions of the author and such opinions are subject to change without notice. It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The information contained herein is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results. Earnings projections often miss and markets go up and down. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.