Tuesday, October 7, 2008

The Next Ten Years

In the ongoing effort to keep my eye on the ball, I thought I'd have a look at the ten-year chart printed by some companies that have interested me for various reasons. Here is the ten-year chart for Apple (AAPL), Microsoft (MSFT), and American Capital (ACAS):
We've all read the boilerplate investor warning that past performance cannot guarantee future results, but there is something about past performance we can learn about a company with consistent management. Microsoft is still run by Ballmer, Apple is still run by Jobs, and American Capital is still run by Malon Wilkus. What we can ask, therefore, is what conditions have changed that might make each of these management teams perform differently over the next ten years.

The company with the most change over the last ten years is arguably Apple. Apple had just returned to profitability from the long-suspected brink of death, and proceeded to grow sales so that its fixed investments were no longer consuming its revenues, and expanded margins by an order of magnitude. Apple introduced highly-successful new products that showed Apple could provide a worldwide online market place, and could deploy its operating system on bomile devices. While it's possible to deploy further new products, becoming recognized as a plausible going concern and growing gross margins to thirty percent are just not stunts one can repeat. Apple is pulling in substantial cash each quarter and has accumulated nearly $24 per share in liquid assets, but since Apple doesn't distribute these to shareholders and hasn't a history of making particularly productive use of cash not invested strategically. Akamai, ARM Holdings, Earthlink, and Samsung come to mind as investments that either materially aided Apple's opportunities or produced an attractive financial return, or both; but managing cash not deployed in Apple's own business has never appeared to be a particular strength of Apple.

Apple approaches the next ten years with a stronger balance sheet and with a product array that reaches a much larger addressable global market. Although it is regionally strong in the United
States in sales share of music players, there is considerable global growth yet to capture. In the computer segment -- where Apple derives most of its revenue -- Apple shows continued growth and is nowhere near reaching global market saturation. Moreover, Apple has been able to maintain product distinctiveness, and has resisted being turned into a commodity vendor as it's grown.

As discussed here, Apple may have a lot of things going for it, and it may have even better growth in some segments (like mobile phones, for which manufactured quantities have been projected from hardware ID numbers) than predicted. Given the significant number of unknowns in Apple, it may be hard to pick a price at which Apple's future earnings stream has been mispriced and offers a "deal". However, Apple has long been subject to wild speculation and -- bargain or no -- it's likely that Apple will again one day be mispriced on the high side. The question, of course, is whether Apple's future makes mispricing on the high side down the road a very reassuring exit strategy. The answer there, of course, depends how bullish one is on 3G iPhones in China and Russia and elsewhere, and whether Apple will eventually offer mainstream enterprise tools to expand its footprint beyond the consumer and creative markets it has traditionally targeted.

Microsoft is arguably the company with the least different over the last ten years. Even as its competitors' products become recognized as legitimate alternatives in the operating system and application markets, Microsoft has maintained both dominant share in these markets and tight control of the APIs and file formats that prevent customers from easily discarding Microsoft as a supplier. The one place it seems significant losses exist -- dwindling browser share -- isn't even a revenue generator for Microsoft. Microsoft continues to bring substantial cash every quarter, and there's no end in sight.

Unfortunately, the stability of this revenue hasn't resulted in a catapulting share price: the shares are priced in expectation of the revenues, and of the $0.13 dividend MSFT pays shareholders (from after-tax profits; MSFT has no special tax status). The 2% or so dividend doesn't move the needle much on the chart of stock-price returns given above.

Microsoft's efforts to grow its business into new segments may have resulted in unit sales, but so far the lifelong financial impact of efforts like the XBox are negative, and the Zune is thinly-enough sold that even if it would be a commercial success for a different company, it's economic impact on Microsoft isn't material and likely won't be. Microsoft knows in principle what it needs to do to grow shareholder value -- produce new highly-desirable products in high-margin product segments -- but Microsoft hasn't executed. There is a difference between knowing the path, and walking the path.

Microsoft's inability to shut off its obsolete products to force upgrades into customers' computers suggests that its control over its customers is less complete than it was in 1995, while raising the embarrassing possibility that Microsoft's new products just aren't worth using. Microsoft is still making money from these customers, as they must buy (or rent) operating systems for new machines at Microsoft's current prices even if they "downgrade". Microsoft's substantial revenues from operating system sales are likely to continue showing growth as the market for computers as a whole grows, even if Microsoft's share of the pie does slip a bit. Microsoft's position hasn't changed that much in ten years.

Based on the chart, that might not be a good thing.

American Capital
American Capital has grown its global reach and expanded its funds under management and has demonstraded to an occasionally skeptical market that it can keep paying -- and raising -- its regular quarterly dividends. At today's price below $17, and in light of the 2008 dividend of $4.19, American Capital has a dividend yield of over 24%. Interestingly, although ACAS pays a dividend on the basis of taxable income in order to maintain its tax status and thus in theory might pay a fluctuating dividend, ACAS has never lowered a quarterly dividend. Moreover, the deal flow facing ACAS during an economic downturn offers fire-sale opportunities of a sort that should provide tremendous returns down the road as the economy inevitably recovers (whether next year, or a few years out). Given that ACAS historically trades at about 1.4x NAV, one would need to more than double ACAS' price to bring the price in line with historic norms.

Unlike the previous two companies, whose liquidation value isn't of much use in valuing their shares, ACAS as a BDC must routinely state the current market value of its assets, and thus can be more readily identified as a bargain. Currently, ACAS trades at a discount of over $10 to its last-published NAV. ACAS' last few years of sales have shown that ACAS' valuations are fair, as specific sales and even whole-portfolio cross-sections have been sold -- and each time within a few percent of the last-published valuation.

Whether looking at the fact that ACAS shares would yield a 58% gain just to reach NAV, or that ACAS has shown the ability to pay substantial dividends in the past and forecasts rolling $500 million of taxable 2008 income into 2009 to cover future dividends that look to yield about 25% on the current price (which as I write is under $16 per share), it seems ACAS is the screaming deal in this line-up. ACAS may not have a track record of exploding by orders of magnitude, but it has a business model that enables consistent returns without fear of market saturation. One need not hypothesize un-annuonced future products to understand where ACAS will make its profit.

With most of the $500 million authorized for share buybacks still available for share purchases during periods the company isn't barred by its compliance officer from purchasing shares off the market, prices this far below net asset value are extremely attractive. With shorts -- who have added an extra 20% of the outstanding shares to the float by selling shares they don't own -- having driven down the price of the shares by reducing the scarcity of available shares, ACAS has an opportunity to retire more than 10% of its outstanding shares from the market. This would serve to magnify future returns. For example, the $0.04/sh/q ACAS gets from its investment in AGNC won't shrink merely because ACAS has fewer shares or less cash. Portfolio companies controlled by ACAS, whose profits flow to ACAS' bottom line due to balance sheet consolidation, aren't going to start earning less because of a changed share count. Even if the recession drives down operating earnings at portfolio companies below the 80¢/q ACAS once enjoyed, these businesses stand to benefit from a recovery like other businesses; the application of those profits to a smaller base of shareholders will have a magnifying effect on long-term ACAS returns.

Unlike AAPL or MSFT, at which share issuance has been dilutive, ACAS has made a point of issuing shares only when it can raise greater-than-NAV funds and thus increase the net value per share. Management has made a point of avoiding bad deals, even when criticized for it or when it causes a quarterly number to be blown. Because ACAS manages permanent capital and is in the habit of looking at the long term rather than the quarter, management's interests are much better aligned with long-term shareholders than management at many companies.

ACAS distributes most of its taxable income to shareholders in the form of dividends as a requirement of its tx status. ACAS' shareholder distributions are at present $4.19/share per year, which is greater than the pretax profit (per share, per year) at Microsoft. To sustain a dividend like ACAS', Microsoft would need a profit per share of something over $6/share per year. Microsoft's recently-closed fiscal year raked up less than $2 per share in earnings after its tax expense.

Microsoft may have a float far too big to be easily manipulated by non-delivering short-sellers, which is some protection against marketplace lunacy, and it may have more predictable earnings than Apple, which offers some protection against Apple's wild speculation-driven volatility. However, Microsoft hasn't got the potential for growth of either company, as its new products don't seem to be moving the needle at all. Moreover, the total returns offered by Apple and American Capital over the last ten years easily outpace the sideways slide of Microsoft's shares. Microsoft may have had a fat one-time dividend not captured in the above chart, but it's dwarfed by Apple's returns and easily eclipsed by the steady quarterly dividend churned out by American Capital.

American Capital had great success deploying assets in quality investments in the last downturn, and there's no reason to believe its solid management won't continue to do the same. American Capital's growth has an excellent outlook, and while it may not be as stratospheric as that one might fantasize at Apple, it has the benefit of being easier to understand as a source of growing recurring revenue.

For the next ten years, The Jaded Consumer sees Apple as the safer bet for high risk-adjusted returns. For stratospheric returns, one can speculate on the next revolution Apple may deliver to the world; but for people who would like Treasury-bill returns without the federal guarantee, there's always Microsoft.


Anonymous said...

newbie questions: why does the chart on this site start in 2004? also, am i wrong of is the aapl price off..?

Jaded Consumer said...
This comment has been removed by the author.
Jaded Consumer said...

The chart is a screen grab from Yahoo Finance, and in my browser I can see a year label every two years from 1998 to 2008. I can't guess why your browser might be displaying something different, but if the numbers are too small to read in this shrunken chart I can see why it might add confusion. I would link to the chart directly, but Yahoo and Google both use some kind of interactive tools now for chart generation, and I can't easily get a fixed URL to the exact data I want displayed in the chart.

The prices shown for these companies seems consistent with what I've seen elsewhere, though you can't always bank on Yahoo. Note that this chart shows percent change, not absolute price. It's easier to see at the 0% line.

Thanks for the comment; I hope you're doing well at the moment -- it's been a crazy month or so.