The Jaded Consumer

Foolish Return Analysis

2012-01-11T20:35:00.008-06:00

A while back, the Jaded Consumer ran an article on The Motley Fool's seemingly opposing investing advice and the dizzying array of stock picks offered in its numerous paid newsletters. In it, The Motley Fool's method of comparing users' stock picks to the S&P 500 index performance was criticized in passing as mishandling dividends. The point of this post is to illustrate that comparisons on The Motley Fool between users' stock picks and the S&P 500 are absolutely rubbish when dividends are involved.

The Motley Fool's method of handling dividends is not to add their return to the capital return. This method would err by ignoring the tax inefficiency of dividends, which are taxed in the year paid while capital gains go untaxed until realized, and err further by utterly ignoring the time value of money – that is, the difference in value of having a dollar of liquid return today versus having it paid to you in three years. Instead, what The Motley Fool claims it does is much worse: it subtracts dividends from users' basis. Confusing things further, The Motley Fool avoids negative basis by applying an undisclosed method to avoid ever hitting zero. According to the site, "The adjustment will be a fractional deduction, and not a flat dollar reduction. This prevents the cost-basis from ever reaching zero." The method also prevents anything like accuracy, or even duplication by third parties.

For purposes of example, and to show the absurdity of The Motley Fool's method by looking at a dividend stock, The Jaded Consumer will look at American Capital Agency Corp. (AGNC), which has been written about here on numerous occasions (mostly because it is managed by ACAS, about which much is also written here).

Let's have a look at a user who picked AGNC as a "buy" at The Motley Fool. The "buy" pick for this user was made on Thursday, September 4, 2008 – a day in which AGNC traded between $18.25 and $18.69. To give The Motley Fool the best possible case of accuracy, we will assume that the user made the pick at the exact time of day needed to nail the day low of $18.25. Given today's closing price of $$28.11, the user would (if the user had made a real buy, and held) enjoy an unrealized (and untaxed!) gain of $9.86 – for a not-too-shabby 54%. (By comparison, the SPDR S&P 500 ETF Trust – designed to mimic the performance of the S&P 500 – which traded at a low of $123.96 on 9/4/08, closed at $129.15 today, thus yielding a rather lower return even after considering several years of its single-digit dividend yield.) Holding for all this time would have entitled a user to some dividends, the history of which is readily available from the NASDAQ web site. Holding from 9/4/08 through the 1/27/2012 payment date would have entitled an investor to a $1.00 dividend, a $1.20 dividend, a dividend of $0.85, a dividend of $1.50, and for the last ten quarters a dividend of $1.40 apiece. This totals $18.55, which (ignoring time-value-of-money considerations) would amount to 101.6% of a the hypothetical $18.25 purchase price. Adding the capital gains and dividend returns would yield at best (ignoring time value of money considerations) a gain of $28.41, or 155.6%.

Yet, the CAPS participant we're looking at, having given the thumbs-up and a 3-year investment horizon to ACAS on 9/4/08, is credited with having already bagged a whopping return of 212.93%, even though the results at The Motley Fool cannot yet reflect the 1/27/2012 dividend (which hasn't yet been paid and won't be owed a shareholder until the ex-dividend date passes):

The real mystery is the purported Start Price. AGNC never traded for $9, ever. And this user's happy return is not really greater than a total return of 300% (yet) as suggested by the 212+% gain claimed at The Motley Fool.

The Motley Fool CAPS system that produces these bogus returns is not the only place one can get confusing results. The Motley Fool has a portfolio-tracker that will help calculate an annualized return that can be compared to that of the S&P, but that tool ignores dividends altogether. An investment in AGNC over the last year doesn't look like it's enjoyed a double-digit return, it looks flat.

For a site dedicated to helping users understand investment returns, The Motley Fool has a few things to straighten out – particularly with respect to making sense of the return obtained from dividend investments.

MTGE Likely Better Than Its Dividend

2012-01-11T20:11:00.001-06:00

The Jaded Consumer has a new article at Seeking Alpha.

Enjoy!

MSFT Imperils Ford's Quality Reputation

2012-01-05T10:22:00.002-06:00

Ford's decision to use a Microsoft platform to power its user-facing electronic controls includes a price paid in lost quality reputation. Of two quality issues that drove Ford from the #10 spot to the #20 spot in automotive brand survey rankings, one is the unstable and user-baffling MyFord Sync. Where "Quality is Job One", Ford's Sync system was outsourced to Microsoft.

Ford can do better. Maybe not Microsoft, but definitely Ford.

ACAS Repurchases Raise NAV

2012-01-05T08:36:00.004-06:00

Share buybacks at ACAS were new in 2011, but there's some background the investor should be aware of, in order to understand the limited time-frame in which share buybacks are likely and the specific effect of share buybacks on an investment company trading below its net asset value.

The Old Days
In the halycon days in which American Capital Ltd. (formerly "American Capital Strategies") traded in the $30s and $40s, stock repurchase made no sense for the company. ACAS' BDC status required it to pay as dividends at least 90% of its taxable earnings, leaving ACAS little opportunity to plow cash into share buybacks without reducing its deployed capital. And here's the kicker: because ACAS' debt covenants included net worth terms requiring ACAS to maintain a certain level of net assets, ACAS couldn't risk reducing its deployed capital. Share buybacks would require shrinking the company, and – even ignoring the above considerations – management made it clear on several conference calls that it wanted to grow the company and grow the breadth of share ownership. Apparently, management wanted to grow American Capital as a brand for individual participation in the private equity market. Share buybacks were anathema to this mission.

Worse: on occasions when ACAS traded above its net asset value, buybacks actually diluted value per share. That is, if ACAS were to have paid $40 on the open market for shares backed with $38 per share in net assets, ACAS would in effect have lost $2 per repurchased share – the benefit of the $2 would flow to selling shareholders rather than ACAS or shareholders who elected to hold.

How The World Turns
Share buyback has been discussed by investors since the crash because ACAS' share value has been notably in the toilet. Last year the Jaded Consumer summed the situation thusly:

ACAS' management made it very clear that it didn't think its existing cost of borrowing was attractive: ACAS prefers to borrow at AAA rates, and will repay debt to get there. Share buyback, by contrast, constitutes a leverage-increasing transaction that impairs liquidity without improving the balance sheet: don't expect share buyback soon.
On ACAS' 4Q2010 and full-year 2010

By 2010, American Capital's debt restructuring eliminated its net asset covenants. By mid-2011, a deliberately failed RIC test eliminated ACAS' dividend-paying requirement (not to avoid dividends, but for a tax purpose: this allows ACAS to roll forward operating losses from the crash era so that taxes can be avoided on more future earnings). ACAS is therefore not obligated to shed any of its earnings, and has no special incentive to maintain a specified amount of deployed capital. Under the new debt agreements, ACAS' lenders are secured by ACAS' investment holdings (look at the 10-K; the superscript numbers offer a guide to each portfolio company's situation), but have no claim on cash ACAS generates form its portfolio companies.

And instead of being required to distribute cash, ACAS is able (due to its loss carryforwards, which for the time being prevent it from having a tax payment obligation) to retain everything it makes and invest it as it pleases, without concern for enterprise value. With shares trading at something like 0.6x the last-published NAV, ACAS has an interesting investment opportunity that previously was unavailable. Sure, ACAS purchased publicly-traded ACAS debt for below face value when sentiment against ACAS was at its lowest and the debt was especially cheap (buying a $1 obligation for $0.60 causes an immediate risk-free gain of $0.40, for example). But as described above, ACAS had been loathe to buy shares. And with a debt:equity ratio currently reported to be 0.41:1, ACAS has little fear that buying shares will threaten its leverage discipline (or its 1:1 BDC limit).

The New Deal
When ACAS first announced its plan to repurchase shares on the open market, it announced a $75m purchase of 9.1 million shares. As described earlier, the impact of the transaction was to raise ACAS' NAV by 18¢ without any tax consequence. In other words, a company paying 35% taxes would have had to earn 28.25¢ to get the same after-tax impact –a feat ACAS accomplished without consuming any of the valuable loss carryforward that drove it to abandon its BDC tax status. Due to the market's sharply downward action in 3Q2011, this 18¢ was swamped by the downward pressure on all the stocks whose values are used as comparables in the calculation of the fair values of the holdings that comprise ACAS' investment portfolio.

We don't yet know what the NAV was at the end of the quarter ended December 31, 2011, but based on the 3Q2011 NAV of $11.92 per share, ACAS' repurchases during the quarter at an average price of $6.97 per share had an impact on ACAS' net asset value of $4.95 per retired share. Since ACAS retired 8.4 million shares over 4Q2011 (at a cost of $58.7 million), the value ACAS added through underpriced share retirement is $41,580,000. Working from the 344,800,000 shares outstanding at the end of 3Q2011, ACAS at the end of 4Q2011 would have had no more than 336,400,000 shares (less, if ACAS repurchased shares during 4Q2011 prior to November). This implies an immediate tax-free impact on NAV of about 12.4¢ per share.

There is another way to measure the impact of share buybacks than to think of the repurchase's impact in terms of the pennies per share it is worth in the quarter in which it occurs – which is tricky anyway, given the movement of NAV over a quarter due to the impact of price changes among the portfolio's known-priced comparables. One can instead look at the percent increase of the company's earnings and NAV gains the buybacks will cause as earnings and net assets are distributed across fewer outstanding shares. The 336.4 million shares ACAS seems to have had at the end of 2011 is 18.3 million fewer shares than ACAS held at the end of 2Q2011. Share buybacks haven't just improved NAV performance per share, but have had an anti-dilutive effect of more than 5%. That's 5% better performance per share, without having to reinvest dividends on which investors would have paid taxes. Share buyback is, in effect, a tax-free DRIP.

Given that Net Operating Income at ACAS has been in the neighborhood of 20¢ per quarter (in 2011's Q1, Q2, and Q3), a 5% concentration would seem to add 1¢ of NOI per share per quarter. This is a performance improvement superior to ACAS' fee income from capital managed under a 28,000,000-share issuance at AGNC, which yielded approximately 0.7¢/sh/q. Moreover, the concentration of ownership means that as markets rebound, yields will also be magnified by the 5% reduction in share count. Factoring in ACAS' leverage, the concentration should be good for those who continue to hold shares.

The Status Quo
ACAS currently trades at $7.25. Since ACAS' 4Q2011 report (and per-share NAV at the end of the period) has yet to be published, it's not clear just what discount $7.25 per share is to ACAS' current NAV. However, since ACAS' diverse collection of portfolio companies move in value with the broader market's collection of comparables (from which ACAS' portfolio companies' value is estimated from quarter to quarter), and since ACAS is leveraged, it follows that the broad gains in the market lately have buoyed ACAS above the $11.92 per share NAV that existed at the close of 3Q2011 and that current prices result in a NAV discount greater than 39% or $4.67 per share. Buying a profitable investment at a discount greater than 40% is exciting stuff for a value investor.

ACAS suffered a massive flight when its investors – attracted by BDC dividends and ACAS' track record of increasing dividends – bolted following ACAS' dividend cessation. When ACAS finishes consuming its loss carryforwards, and resumes meeting RIC tests, ACAS will once more be obliged to pay dividends. The NAV discount should begin to evaporate as that occurs; though the continuance of the discount would be favorable to DRIP investors eager to add shares of a company managing an internally-diversified and leveraged portfolio whose contents are artificially depressed in price because FAS 157 requires illiquidity discounts and other factors to be applied to NAV – yet which produce a return based on their actual intrinsic value.

Another note about the status quo: a dividend that changes over time raises worries from observers who could conclude that a lowered dividend is a sign of financial weakness. ACAS, by implementing a share buyback program rather than a dividend, avoids this sort of criticism while offering shareholders a tax-efficient way to enjoy management's willingness to return money to remaining shareholders. The fact that ACAS has been able to pay more than $50m per quarter the last few quarters in share buybacks is interesting, but should not be mistaken for a guarantee of its initial dividend. ACAS' share buybacks have generated NAV improvement of nearly $5 per retired share, which makes them an investment. Dividends are not an investment, do not raise NAV, and are not tax-efficient except where the BDC rules make them a condition of corporate tax avoidance. Since many investors' tax rates are less than the corporate rate of 35%, dividends under that circumstance are definitely efficient with comparison to the alternative (corporate rates, and if combined with a dividend, double-taxation). The current situation will likely endure as long as ACAS is required to fail RIC tests to avoid losing loss carryforwards.

The Future
ACAS has already moved from making only limited follow-on investments in existing portfolio companies to participating in genuinely new investments again. ACAS is a $10m participant in RBC Capital Market Corp's financing of Permira Advisors' purchase of Rennaisance Learning Inc., and a $15m participant in BMO Capital Markets' financing of Teachers' Private Capital's purchase of most of Flexera Software Inc. ACAS' follow-on investments have grown in scope: in the second half of 2011, it invested $50m in the mezzanine financing of the merger of Survey Sampling International and its existing client Opinionology Inc. ACAS is now no longer treading water, but apparently back in business. Its aggressive shedding of debt has put it in a position to retire shares without impairing its ability to enter new investments, and offers ACAS flexibility in determining the terms with which it may more favorably restructure its debt.

ACAS looks like it's heading in a productive direction. I'm still wondering what the "special situations group" has been doing while the markets have been in turmoil: haven't they spotted a "special situation" in which to invest? Ahh, well. Things are looking good for the present and foreseeable future. Wondering about the fish that got away never profited anyone.

MTGE: On the First Full Quarter's Dividend

2011-12-21T17:55:00.003-06:00

Previously, the Jaded Consumer wrote about American Capital Mortgage Investment Corp.'s $0.20 stub-quarter dividend. Now, MTGE has announced its first full-quarter dividend of $0.80. What could have happened to quadruple MTGE's dividend?

Looking at MTGE's quarterly announcement following its stub quarter, we can see that MTGE moved from an average leverage of 4.7x during the stub period to 7.8x leverage, to turn its $200 million in IPO proceeds (counting ACAS' direct investment as IPO proceeds here) into a $1.7 billion investment portfolio. Annualized net interest rate spread moved from 2.13% during the stub period to 2.41% as of September 30, 2011. At 7.8x leverage, the 2.41% spread suggests a return at quarter-end of 18.8% (less management fees of 1.5%, paid monthly). On an estimated post-IPO-costs NAV of $19.90, this suggests annual returns on the order of $3.44 (considering the 1.5% management fee paid to American Capital Ltd.), or a quarterly earnings number of about 86¢.

But the recent dividend announcement was just 80¢, right? Right.

Looking back to MTGE's sister AGNC, which began its dividend payments with a 27-day stub-period dividend of 31¢, we can draw some parallels. The stub-period dividend at AGNC didn't represent all AGNC's economic benefit; the company actually earned 37¢ in its stub period, or nearly 20% more than paid. The resulting increases in NAV lead to increases in per-share earnings and thus per-share dividends. The dividend history of AGNC from 31¢/share/quarter to $1.40/share/quarter – not the exact progression one expects repeated; AGNC had some windfall derivatives gains during the economic panic that might not be readily replicated – is something management surely hopes to repeat.

And it's on the road to do so. MTGE's 20¢ stub-quarter dividend was backed with 25¢ in earnings, 25% more than paid. The $0.80 declared as the next quarterly payment is $0.06 below the Jaded Consumer's calculated expected earnings (assuming the stability of the financial situation obtaining at MTGE at the end of the stub quarter). This means that MTGE should add over 20¢ to NAV while making payouts exceeding 17%. Mind you, this neglects the benefit ACAS (as MTGE's manager) can bring MTGE from the reinvested nickels, and assumes pricing that remains stable at about $18.50. The fact is, MTGE's been volatile and to date I've never paid more than $17.50 for a share. Most of the shares held here were picked up at $16.75. From where I stand, dividend yield looks to stand north of 19%. Since I've enrolled all my shares in dividend-reinvestment, the basis will definitely creep up – but assuming pricing returns to the $20 level last seen on the day of the IPO, dividends will reinvest at about 16% while NAV continues to be be pushed up over a nickel a quarter. Adding the expected but unpaid $0.06 in earnings – a benefit that accrues to the DRIP investor in the form of share price rather than share count – a $20 share price would leave a yield north of 17%. At present prices (last traded at $18.63), that's a yield of 18.5%. On the other hand, that's also based on current dividends.

Like AGNC, which was priced below NAV for some time before the market recognized what it was doing, MTGE is likely to continue retaining gains on which to build the assets under management that drive ACAS' management fees (and shareholders' earnings). While MTGE's partial-year results and stub-quarter performance continue to be reported as full-year results (as happened for a while in AGNC), we should expect to find below-NAV share pricing (DRIP opportunity!) and to enjoy NAV increases based on dividends that leave room for reinvestment. The long-term benefit of MTGE is that while management can pursue the winning strategy used at AGNC, it has the freedom to pick up non-Agency mortgage products when the price is right. When is the price right? Some mortgage bundle – perhaps with an insurer's guarantee instead of the government's – may have characteristics that lead ACAS (MTGE's manager and AGNC's) to expect a payout of 83¢ on the dollar, will be hated by the market for its lack of government guarantee and its ugly (but discoverable) default rate, and could sell for 50¢ on the dollar. An ugly duckling like that can contain mortgages reflecting ugly levels of prepayment and default and – because it was underpriced – return much more than was invested. This kind of underpricing is not going to overwhelm MTGE's portfolio – indeed, the use of its portfolio as collateral likely depends on this kind of product being a minority among MTGE's holdings – but it offers a yield boost simply not available to AGNC.

My initial thesis in investing in MTGE was that it was trading below NAV and should be expected to perform along the lines of AGNC. While MTGE continues to trade below NAV, it's an extremely attractive alternative to AGNC as a subject of dividend reinvestment. Like AGNC, MTGE makes its money by investing largely borrowed funds in a portfolio of largely government-backed securities. MTGE (like AGNC) must manage prepayment risk (if principal is returned early, money paid for government guarantees of interest aren't worth much and premiums to face value are lost) and risks related to interest-rate spread. With yields as low as they are now, it's not easy to believe that MTGE's investment targets would drop in yield much, but factors affecting MTGE's borrowing rates would impair the spread – the profit potential between MTGE's borrowing rate and its rate of return on its own holdings – are of material concern to MTGE. Given the leverage with which MTGE operates, small changes in yield spread are magnified – for good or ill – into big changes in performance.

AGNC has shown that ACAS can manage this risk toward a stable dividend, while growing NAV. While the jury is out on how significant a factor the ability to buy non-agency MBS will be for MTGE, my favorable experience with AGNC leaves me completely willing to pay ACAS a management fee to find out.

Self Defense Still Works

2011-12-07T20:43:00.003-06:00

After hearing for so long about the horrible things criminals do to others, it so good to hear about horrible things being done to criminals. Some of my best self-defense anecdotes haven't got supporting links, but this one is a gem.

In short: the bruised and battered face in the picture is the would-be carjacker/countervictim of a 150# MMA fighter who wasn't inclined to surrender his vehicle. The punch line? After the beat-down, he managed to shoot his own ankle.

Who says Colt made all men equal?

Trust eHow? No how!

2011-12-07T16:45:00.002-06:00

Whilst Googling the Internet for information about a problem faced by some folks I care about, I saw eHow's page on sealing divorce records in Texas.

There are two readily-identifiable problems with it.

The novice will not immediately notice that the References section, which contains but one reference, contains a link to Rule 76A of the Texas Rules of Civil Procedure (though the eHow link erroneously denotes the rule as "76(a)" rather than the correct "76a"). The first is that filing "a copy" of a notice with a couple of court clerks is not the same thing as filing "a verified copy" as required by Tex. R. Civ. Proc. Rule 76A, which is referenced in the article. Filing "a copy" of the notice won't satisfy the rule if it's not "a verified copy." The instructions will lead the ordinary reader to failure. The instructions get an F.

The next problem is that Rule 76a's definition of the "court records" that are subject to Rule 76a(2)(a)(3) expressly excludes "documents filed in an action originally arising under the Family Code" – including every divorce action filed in Texas. In other words, if you want information about sealing divorce records in Texas, you need some other rule to guide you than Rule 76a.

Like Indiana Jones said, "They're digging in the wrong place!"

Tough Regulation Is Tough On Business

2011-12-01T12:49:00.004-06:00

The Federal Aviation Administration's $900,000 administrative penalty levied against American Airlines for delaying passengers on the tarmac doesn't seem to have increased timeliness, just bankruptcy filings.

In Europe and other parts of the world, delays result in compensation to passengers, not regulators unsuccessful in preventing delays.

Result? American Airlines' Chapter 11 proceeding will facilitate tougher bargaining with employees and their unions, airports and their support infrastructure, and general creditors like the FAA with its new claim for administrative penalties. Passengers are likely to see little change.

Comparing Platform Revenue at Apple and Microsoft

2011-11-29T08:22:00.006-06:00

Mactrast's graphs illustrate the revenue by business segment for both Apple and Microsoft. Apple's business shows distinct seasonality in the iPod business during the holiday quarter over the period depicted, but little other seasonality. Both Apple and Microsoft show some product-launch effects, though Apple has more product launches: Microsoft doesn't release Windows 7 very often. The graphs are educational.

However, the conclusion Mactrast draws from the graphs – that Apple's Mac business (a largely-consumer-facing hardware business) is larger than Microsoft's Windows business (a generally OEM-facing software licensing program) – seems at first blush to be an irrelevant, apples-to-oranges comparison. Is it?

Microsoft's Windows business is a software business with software margins and software capital requirements. This has historically been great for Microsoft: it forces third parties to handle potentially troubling hardware manufacturing and fulfillment issues, while reaping profit on every unit regardless who sells the units. The result has been a market in which PCs are scarcely-differentiated commodities; Microsoft cares not who wins, so long as the unit volume in the entire marketplace carries enough licenses to support MSFT's bottom line numbers. MSFT's only pricing concern is that consumers pay enough for the machines that OEMs can afford to pay MSFT's demanded licensing fees. Toward that end, MSFT has segmented its OS lineup into a dazzling array of versions with different features enabled or disabled, ranging from "home" editions to enterprise-directed and high-end gaming versions, each at a different price to accommodate the margins on the hardware sold to various buyers.

Part of Microsoft's product segmentation in its Windows business has been its OS segmentation between its client-licensed operating system and its server-licensed operating system. Considering that Microsoft's Windows revenue includes high-dollar multi-user licenses for MS-Windows installations supporting enterprise Outlook, multi-CPU web servers, web servers backed by database applications – all revenue that Microsoft gathers under its "Server and Tools Business" segment – the direct comparison of Macs to the "Windows and Windows Live Division" is deceptive. Moreover, Microsoft's platform business – the OS licensing scheme – is so interrelated to Microsoft's software tools business (how else will people compile applications designed to exploit the APIs with which MSFT distinguishes its OS products from DOS, Unix, Plan 9, MacOS 9, MacOS X, etc.?) that the whole of Microsoft's "Server and Tools Business" has to be thought of as part of Microsoft's Windows business. Without servers that require MSFT's client software (Outlook, anyone?), Microsoft would not enjoy the enterprise lock-in it has acquired and maintains. The only reason Apple gives away developer tools for free is that when Apple announced the death of MacOS 9, it had to make migration to MacOS X tolerable to developers or the whole thing would fizzle: no apps on a computer, no point in buying the computer. Tools are an essential part of the platform ecosystem, and Apple's are free because Apple's revenue is based (historically) on hardware sales rather than (chiefly) on software licensing.

Then, one has to ask one's self whether it is seriously reasonable to separate Office from MSFT's Windows platform business, since Office is sold for no other platform and in effect is an upsell of the Windows platform itself? (E.g., to get uncrippled mail and calendars, one buys Outlook with the rest of Office, which one needs to exchange documents with everyone else on MSFT's Windows platform; Apple includes its calendar and mail client with every OS installation so the platform appears to have value – that is, utility – right out of the box, to differentiate it from cut-down no-frills PC offerings. Had Apple the market power of Microsoft, Apple would likely charge for these things as it does for iWork.)

Apple's Mac business generates a lot of revenue that doesn't flow straight to the bottom line because it flows to the likes of Intel, nVidia, Samsung, and a host of lesser-known suppliers whose wares are less known to the public than CPUs, GPUs, and LCDs. To match Microsoft's profit in its Windows business, Apple would need a lot more revenue. True, Apple is selling more and more Macs. And Apple did eclipse Microsoft in quarterly profit, but after rather than before passing it in revenue. Apple hasn't acquired such market power that it can charge developers for compilers and other MacOS X tools, though it does charge for higher levels of Apple Developer Connection that include additional software, support incidents, hardware discounts, etc.

I have high hopes for Apple's Mac business. Apple's Mac business is probably already larger than Microsoft's consumer-driven OS licensing business. However, Microsoft's enormous platform ecosystem dwarfs Apple's Mac business, despite Apple's Mac business including hardware sales.

This is not in itself a bad thing for Apple: it means that the opportunity to take share is dramatically larger than the revenue Microsoft currently milks from its huge platform base. With Tim Cook at the helm, Apple may even be capable of developing enterprise-friendly infrastructure products to enable direct competition with some of Microsoft's most profitable customers. Under Jobs, such thinking was mere fantasy.

On the other hand, adding iOS platform revenues (e.g., iPhone, iPod Touch, mobile apps) to MacOS X platform revenues makes a certain sense, because they share the same Mach-derived multithreaded kernel optimized for multi-CPU environments and use the same set of developer tools and the same APIs for programming applications. Both iOS and MacOS X have the same advantages in languages and localization and single-image installation, and derive from a common infrastructure investment in exactly the same way as MSFT's client and server operating systems. Adding iOS to MacOS X to guage the size of Apple's platform moves things a bit, because Apple crushes Microsoft in mobile. Asymco's graphs start to paint the picture, but make the same assumption as Mactrast that Apple's Windows business is captured entirely in the "Windows and Windows Live Division", when high-margin server OS licensing is captured among the Server and Tools Division's numbers.

Excluding servers from MSFT's platform business is as arbitrary as excluding mobile devices from Apple's, and either exclusion would omit the crown jewel from each business. They must be considered together. Whether Apple eats MSFT's lunch or co-exists peacefully will ultimately depend on Apple's inclination to deliver a server back-end that offers to enterprise things like Microsoft's back-end offerings to support Outlook. Well, maybe "peacefuly" is stretching it a bit: Microsoft keeps trying to do mobile phones and notebooks, which are Apple's bread and butter. Expect the competition to continue, and delightful declarations by Steve Ballmer to continue unabated.

Apple's Cash Creates Opportunity

2011-11-26T16:39:00.005-06:00

How often have we seen calls for Apple to turn its massive cash hoard into a big dividend? Big mistake. The Jaded Consumer regards ready access to massive capital as an asset to Apple as much as it is to Berkshire Hathaway.

The latest example is Apple's billion-dollar (that's billion, with a "b") investment in a cutting-edge Sharp LCD plant. Many years ago, when CRTs dominated the computer landscape, Apple ensured its supply of quality LCDs by making a $100 million investment in Samsung, to avoid parts and quality issues in its not-yet-shipping iBook portable. The payoff? When Apple wanted to make sure it didn't lose sales of MacBooks or iBook G3 units (remember those?) to production-related fulfillment delays, it guaranteed supply by funding the production in advance. The hundred million looked like a lot of money. Structured as a 3-year unsecured convertible note with a 2% yield, the investment was eventually sold back to Samsung in 2001 for $117 million. What did Apple get for tying up $100m from 4Q1999 to 2Q2001? For starters, Apple avoided LCD shortages that threatened the industry just as monitors were transitioning from desktop CRTs to LCDs. Apple's migration to an all-LCD lineup created significant exposure to LCD availability problems, which Apple cured with its Samsung deal. The $100m investment was a hedge against the risks of bidding in an open market for key parts.

A conservative strategy, perhaps – and effective at protecting high-margin production. What's different now? Apple isn't struggling toward averaging a million total devices sold a quarter while netting just over a half-billion in profit, it is selling tens of millions of LCD-based products per quarter at over $100 billion per year to earn over $25 billion a year. Apple's desire for premium displays isn't a matter of building LCD notebooks in a world of CRT desktops, it's a matter of filling an LCD lineup from iPod Touch, three different iPhone models (3GS, 4, 4S), two classes of notebook computers, the all-LCD iMac desktop line, and the stand-alone displays sold for users of every type of computer Apple sells – while maintaining a quality edge intended to support Apple's traditionally high-margin hardware.

In other words, the order-of-magnitude increase in Apple's LCD infrastructure investment reflects Apple's greater-than-an-order-of-magnitude increase in LCD consumption. A billion bucks – to buy entry into Apple's next-generation supply contract with Sharp – is just the increase in ticket price Apple faces as it seeks to maintain its supply-chain strategy in a world that can hardly supply its needs. And Apple gains a significant benefit from its supply chain management. By making capital investments in key suppliers, Apple ensures that it is supplied first rather than last as manufacturers line up for parts when supplies tighten. Being able to ship products is a necessary prerequisite to closing sales – and Apple doesn't want to risk being the one waiting for parts.

But let's think about Apple's strategy. Steve Jobs made it clear that Apple preferred to own the intellectual property behind all its products, yet it depends on third parties for absolutely critical elements such as LCD panels, wear-resistant glass, and so on. Apple is the planet's single largest buyer of Flash memory. To secure Flash supplies in a market subject to pricing variation and shortages, Apple has done things like pre-pay 10-figure sums for its expected Flash supplies. Supply risk isn't merely theoretical. Apple's consumption has been blamed for causing Flash memory shortages on a worldwide basis for years. In 2005, Creative blamed Apple's supply-chain management for Creative's inability to build MP3 players. Gartner predicted iPod-related Flash shortages in 2006. The supply/demand ratio for Flash parts remained unfavorable to buyers through 2009, with Apple's consumption for mobile devices expressly named as the culprit. In 2010, the shortage was being blamed on the iPhone rather than the iPod, but Apple was still being seen as the responsible party. Apple needs to deploy substantial capital to ensure its own supplies are met.

Yet, Apple doesn't want to create a free-rider opportunity for competitors. If Apple simply coughed up money to competitors by investing in their common suppliers as it did over a decade ago with Samsung, Apple would enable these suppliers to develop techniques and machinery they could deploy in their effort to supply any customer, not just Apple. Apple would, in effect, be funding the R&D of its competitors by enabling their suppliers to produce more products better for less money, on exactly the same terms available to Apple. Ick! What could Apple do to ensure that machinery it funded didn't lower the cost of production to competitors?

For that insight, let's look at Jobs' comments at the D5 interview in which he and Bill fielded questions.

Q: What did you learn about running your own business that you wished you had thought of sooner or thought of first by watching the other guy?

Jobs: You know, because Woz and I started the company based on doing the whole banana, we weren’t so good at partnering with people. . . . And we weren’t so good at that, where Bill and Microsoft . . . learned how to partner with people really well.
And I think if Apple could have had a little more of that in its DNA, it would have served it extremely well. And I don’t think Apple learned that until, you know, a few decades later.

Now let's think about what "partnering" has meant in connection with Microsoft. After Microsoft "partnered" with Apple to write applications for Apple's hardware, Microsoft earned more profit on MS-Office for Macs than Apple earned selling Macs themselves. PC vendors who facilitate Microsoft's OEM operating system licensing program have been reduced to mere commodity vendors, while Microsoft enjoys monopoly pricing (and profits) on its operating system. Vendors seeking to supply Microsoft with technology have been crushed. "Partnering" in this context is a sophisticated form of competitive positioning in which vertical integration is achieved not by owning the entire production column, but by arranging that non-owned portions of the column lack profit, differentiation, or competitive positioning.

This kind of "partnering" is what Apple learned from Microsoft. However, Apple has gone a step further: rather than license software under conditions that eliminate hardware differentiation (either by eliminating the profit motive for investing in it, or by making it impractical due to the limitations of the software ecosystem), Apple has used its supply-chain expertise to enhance its hardware differentiation. As described above and elsewhere, Apple contracted by using large advance payments to guarantee its components supply under conditions that leave competitors scrambling to find parts with which to build competing devices. But Apple has apparently gone far beyond that. When Apple bought all the production of key manufacturing tool maker, it didn't just deprive competitors of the ability to buy the same drills as quickly. As described at asymco in the article "How much do Apple's factories cost?", Apple isn't just ordering manufacturing equipment for use by its contractors. Apple is buying the manufacturing equipment and owning it itself. Apple has to own scads of capital-intensive manufacturing equipment, because it's got so much of it on its own balance sheets.

Think about this. Apple doesn't have to enter anticompetitive contracts with its own vendors, it only has to make clear that Apple's production equipment is for making products for Apple. In one swoop, Apple takes whole plants out of availability for competitors. Why? They're full of Apple property available only for use in Apple products. This sort of production partnering – Apple takes the capital investment risk because it can afford the capital and is willing to bet on its own products, but doesn't want to have to duplicate high-volume manufacturing expertise that can be provided more efficiently by production partners – allows Apple to negotiate for pricing much closer to the marginal cost of production than its competitors, who don't take the capital risk and have to pay for amortization of production facilities that the manufacturers and assemblers have had to take the risk to build. Apple-risk facilities are just for Apple-benefiting production, boys. If an Apple joint-venture factility were used to produce something for a competitor, of course, Apple would (as a joint venturer) share in the profit: competitors would in effect pay Apple to have their parts built.

Apple can do this with LCDs, NAND storage, microchip fabrication tools (it's designed its own mobile CPUs, which now include both the A4 and the A5, and has someone building these for it), hardware cases (this page offers some video of Apple-developed manufacturing tech, including a technique for machining the unibody Mac notebook chassis from a solid block of aluminum – no doubt in use by a contractor), batteries – everything that might possibly differentiate an Apple product from a competitor vending Wintel boxes or MP3 players or ARM-powered phones. Every time Apple gets a pricing advantage with its capacity to fund the manufacturing investment required to fulfill its orders, Apple puts competitors in a position of fighting just that much further uphill just to stay even.

Billion-dollar parts prepayments aren't normal except for Apple. Next-gen LCD development investments in the ten-figure range aren't normal except for Apple. The only thing that makes capital risk of this magnitude a safe activity for apple is that with so many tens of billions of dollars available, a mistake won't impact Apple's ability to execute on the rest of its operational requirements. The $80B is not some kind of retirement nest egg, it's a license to invest in the future and a ticket to the front of the line for parts and an AARP discount all rolled into one.

A day may come when Apple can't imagine anything it might want to do with all its cash, but that day isn't here yet. Let's not hear demands for dividends when we could be hearing demands for more insanely great products at prices competitors can't profitably match.

Foolish Newsletter Subscriptions?

2011-11-17T19:46:00.010-06:00

The Motley Fool has been an interesting experience.

(In 2007, I became interested in diversifying my portfolio, which had come to be utterly dominated by my ballooning holdings in Apple. I started looking for other good ideas, and it was hard to find ideas as good as Apple. But I was committed to "diversifying" and tried. Oops. I'm sharing here some of what I learned after the crash of 2008 about getting advice on how to diversify.)

Over ten years ago, I heard David and Tom pitching a "Dogs of the Dow" strategy: in less than fifteen minutes every year, you could manage a portfolio mechanically by rebalancing a portfolio into some of the highest-yielding companies in among the Dow Jones Industrial Average's industrial stalworts. The strategy promised the security of buying only brand-name companies, the certainty of crystal-clear buy/sell signals that offered no room for judgment one could doubt, and a speed that would allow anyone to manage a portfolio that (the strategy proclaimed) would crush the market in just fifteen minutes a year.

Among the advantages of this system are (purportedly): (a) you don't lose built-in management fees to advisors, which sadly is the case with funds – including ETFs – because they typically siphon off about 1% of assets or more each year, whether they make you any money or not ... and TMF is fond of pointing out that this management fee becomes a big deal as one considers compounding; (b) advisors don't do particularly well, and you can do better yourself, champ! And sleep better! Because the system works! Besides, (c) investment professionals are dishonest scum. These points are made across the Fool web site and in the Foolish Four book to varying degrees. But the impact is the same: you can do better yourself, the pros aren't good, and the pros cost too damn much money.

In contrast to the mechanical investing thesis but in synch with the do-it-yourself meme, the Motley Fool web site offers a bunch of support to individual investors. The thesis is that like Warren Buffett, its readership should be able to spot undervalued investments and, by cherry-picking the best of the bunch, glean outsized returns without paying fund-manager fatcats premium fees year in and year out whether they earned or lost on the money entrusted to them. The Motley Fool web site was chock full of discussion about individual stock picking, and began vending newsletters to aid investors hoping to cherry-pick stocks, or small-cap stocks, or dividend stocks, or options plays . . . the list seems to be growing. These newsletters are available by subscription. They cost money. The good news? The subscription doesn't scale with your investments; if you have infinite capital, your transaction costs associated with any given subscription approaches 0%.

But investing based on the no-charge site involves work and it involves judgment. These are diametrically opposed to the mechanical investing thesis blessed by the Motley Fool in The Foolish Four. They invite homework, open-ended analysis, judgment . . . in short, a mess.

The subscriptions aren't much help in that regard, whatever their cover price. They recommend such a huge variety of stocks – especially in the aggregate – that no investor would plausibly pursue them all. One would need to be involved in so many positions that there was no possible way way to stay informed about them all, unless it was full-time work. Unless one chose to buy everything advocated by one of the newsletters without the exercise of judgment, one would drown in homework staying abreast of a portfolio. Unfortunately, the list of stocks that are "active" as recommendations of its flagship newsletter – Stock Advisor – has over a hundred and five (that's 105) different issues listed. Just counting them is a trick, though: every time David or Tom "recommends" a stock, it gets a new line and is tracked as a new recommendation. When calculating the newsletter's "performance", Stock Advisor's management count each recommendation from inception to close date. So the "active" list has over 140 entries, and much of the newsletter's "market-crushing performance" consists of re-recommendations of the same good idea.

What's a subscriber do to mirror the newsletter's "performance" – re-purchase Apple or Disney each time it's (re)recommended? Is that even plausible? The newsletter identifies a group of "core" stocks, but doesn't really tell new subscribers at what price they should consider stocks off the list. There's a list of "best buy now" stocks, but the newsletter's management doesn't help investors figure out what off the "best buy now" list is worth getting into immediately. In what proportion does one invest?

And the newsletter can be slow to react to reality. GameStop – which evolved into a sort of Blockbuster for computer games sold on physical media, and you can see how Blockbuster is doing by following how Blockbuster in bankruptcy (OTC:BLOAQ) converted into BB Liquidating Inc. (PK:BLOAQ), which has negative earnings – was listed as a "hold" (what does that mean, anyway?) for a couple of months before finally calling it a sell in 1Q2010. That company was in (what I concluded was) an obviously-dying business for a long time, folks. Yes, it was still up from its two recommendation dates at the end of 2005 and the third quarter of 2006, but let's look at the graph:

Until December of 2009, GameStop was still an active recommendation. (Well, it was "active" until the March issue of 2010, but on "hold" – whatever that means.) So subscribers were led from 4Q2007 (for example) until 4Q2010 to think it was a Stock Advisor pick, and encouraged that it was the dominant game retailer in a world awash in video games, and one of Stock Advisor's picks for crushing the market. Maybe you'd beat the market trading on the dates of the recommendations – which might be hard, if you read it when it arrived in the mail; the sell rec is in the March issue but bears a sell-rec date of Feb 18 – but investors are given no advice what to do between recommendations if they show up mid-movie, so to speak. And with 100+ recommendations, it's hard for investors to figure out what on Earth to do with them all.

Since the Motley Fool offers a nice tool for working out weighted, annualized rates of return on your self-reported portfolios, I can report this about my post-2008 investments:

In case it's hard to read, it says that the Stock Advisor recommendation Dreamworks Animation is my worst-performing investment entered since the last market crash, whereas my decision to nearly double up on American Capital Ltd. at $1.80 in early 2009 has more than quadrupled my money (while my overall performance of an annualized 23.7% in post-crash purchases has to date outperformed the S&P by 9.6% on an annualized basis). ACAS has, over time, dropped from a 5-star ranking at the Motley Fool to a four -star ranking, and it's never appeared in Stock Advisor.

I was going to write that I have no idea what the publishers thought about entering a position in Dreamworks in the first half of 2010, and that if they had any reservations I was unable to find evidence they shared it with subscribers. However, this is not true. I've been reminded that in May of 2010, Dreamworks was re-recommended at $34.87, making it a loser – even for the Stock Advisor – in excess of 50% of the stock's value. Of course, you can't win them all. And it's not over until the fat lady sings, and all that.

But down 50+% is a painful start, because recovery to your starting point requires going up more than 100%. Apple gave me a few -50% days while I held it, but I first bought Apple at $20.35 per stub, after which it then split 2:1 twice, so losing from $100 to $50 wasn't so hard, particularly not with the perspective of $380 AAPL (after it's received a "haircut"). From the Stock Advisor commentary, I sense the editors are hoping someone acquires Dreamworks. I don't see the market-crushing behavior (I'm ignoring the stock price here, and looking at the company's performance in competition with its peer) the Motley Fool discusses in its sales materials for the Stock Advisor. DreamWorks isn't a Rule Breaker, it's a Pixar imitator which – until I saw How to Train Your Dragon – was failing to make movies anything like Pixar. (I discussed what I viewed as Dreamworks' evolution from a "me too" to a "real me" in this post.)

General Electric, which the Fool's performance-analysis tool cheered as a "two-bagger" (and here I sigh, because I read Peter Lynch's book in hardcover when it was first published, in which he lamented buying a washing machine instead of Berkshire shares in the 1960s, before there were any B-class shares to buy), wasn't a Stock Advisor recommendation, either. It was a Peter Lynch inspiration: I was familiar with some of its outstanding products, and realized that the stock was hated simply because nitwits thought GE Capital made GE a financial and after 2008 nobody wanted to own a financial so it was beaten like a red-headed stepchild. I looked at its historic dividends and glanced at its financials and said "of course!" This was while it was below $7. And that reminds me: the Fool's performance analysis tool won't give you your annualized yield on anything but the equity itself; it ignores dividends. GE pays a dividend, so my return is better than the Fool relates.

The Fool's return calculator's dividend-ignoring behavior stands at odds with the Fool's apparently normal practice (at least, in other places on Fool.com) of subtracting dividends from basis to calculate returns. This is crazy, of course: a stock held for ten years doesn't cost less in year 1 just because you later held for dividends. This only makes sense in a tax-deferred account with dividend-reinvestment engaged – but that's not what the Fool assumes, as it doesn't increment your share count, it decrements your basis. The Fool tool would treat each reinvestment purchase as a new investment, each with a declining basis. So folks who recommend big dividend stocks in the Motley Fool's CAPS system (the Fool's community-rating system) should appear to crush the S&P just by holding on until their basis approaches zero, no? Check out this player's recommendation of American Capital Agency – the Fool claims the player's basis in June of 2008 was less than $9, so of course he's crushing the S&P 500 now that AGNC is flirting with $30. The lowest I was ever able to pick up shares was $15, though it dipped a little below that. But AGNC never traded at $9, ever.

But ProEdgeBiker is up 213.33% on his AGNC recommendation! Yeah, right. I know this guy selling a bridge .... CAPS scores are flawed, and if you want to game them pick a dividend stock, yo.

The confusion generated by the dizzying array of stock recommendations and the drinking-from-the-fire-hydrant problem of trolling CAPS for ideas seems to be the chief selling point of the Motley Fool's costlier service, Million Dollar Portfolio (MDP). Entry is $1k/y, with a discount for new members. (There's a money-back guarantee, I'm just checking it out, though if impressed I'll naturally renew. But read on.) MDP invests a real-money portfolio that begain with $1m. MDP's deliverable is based on all the Fool's subscriptions, making it something of a best-of aggregator, but it does not include either all the newsletters or a list of all the recommendations. The managers have access to this, not you.

MDP gives concrete instructions to subscribers before each trade: not just the name of the stock, but the percentage of the portfolio that has been assigned to it so you can follow along at home. In advance, even. And for new subscribers, MDP offers "catch-up" plans, advising you what to pick up and when, to bring your portfolio in line with the MDP. If that's not fast enough for you, the portfolio lists "buy around" prices for each pick, so you can make your mind up as prices change. And some of the stocks are nice picks I myself have loved for years: Berkshire Hathaway and Markel, for example. Unfortnately, despite my Berkshire shares having more profit in them than MDP's (I bought before MDP picked it), both I and MDP have done worse than the S&P 500 in our BRK.B investments. And I read that for a while last year, the MDP pulled out of its picks and bought an index fund. True? If so: Would Buffett pull a move like that?

You either have a sound investing thesis (and damn the torpedoes! – until real information impacts your analysis) or you are a lemming. Period. If your own decision isn't so rock-solid that it withstands a criticizing public, you don't even believe in your ability to pick promising companies from the dregs that haven't yet been ejected from the S&P 500. Of course you can pick a few losers! Right? If not, why are you managing others' money?

MDP was down something like 10% last year. Since inception, the tale of the tape is:

This is at least honest. It might not be something I'd want to admit while selling a stock-picking service, but it's honest. The portfolio's first purchase was a symbolic one-share purchase of Berkshire Hathaway (a pre-split B share, $4,256 a stub) made four years ago in October of 2007. Losing only ~13% in the crazy time between October 2007 and the present is something to be proud of, but it takes some perspective to perceive it. I have to think carefully about my own performance to realize what a positive statement -13% really is over that time period. And they did beat the S&P by about 5%, which in a big enough portfolio might even be worth the annual fee. And let's think about that a moment. Berkshire Hathaway's 2008 result was a 9.6% decrease in book value per share, which beat the S&P by 27.4%. At $1k/y, MDP's charge represents a 1% management fee on a $100k portfolio, for what turns out to be a 5% advantage. Over what period? Is this a deal? Wasn't avoiding recurring management fees such a big part of the Fool's pitch?

And did they really allocate 80% of the portfolio into SPY in 2007 while they waited to figure out what to buy? While SPY charged a management fee? (The note says "Plus it has a really cool, James Bond-like ticker symbol." Thank goodness for that!)

But back to the cheaper subscription services for a moment. You can't use Stock Advisor as a substitute for judgment, because you'll end up with 100+ stocks and can't be assured that you will get advice to sell that's worth a nickel. In fact, you can't be sure the advice even makes sense. Check this out: in its latest issue, in discussing Stock Advisor picks that don't pay dividends, the Motley Fool wrote of Berkshire Hathaway:

a recent offer to start buying back shares has us thinking a new dividend may also be in the offing. Among our Core non-payers, Berkshire's our most likely candidate to start.

This is, of course, utter nonsense. Berkshire is doing a stock buyback in lieu of a dividend because of the double-taxation problem inherent in C-corp dividend payers. (A REIT like AGNC is a tax pass-through, so there is just one tax, levied on the dividend recipient; earnings retained by the REIT are limited if it is to retain its tax status, and subject to excise taxes.) Imagine you are a multibillionaire with the power to declare yourself millions a year in dividends, on which you will pay 35% taxes; or you could sell a couple of extra shares, raising the same amount of cash, and pay 15% taxes. Which would you pick? And if you don't for sure need the money this year, why would you subject the money to a personal income tax at all? Why not let it continue to enjoy reinvestment within the corporation that's already paid taxes on it once?

The third option is a share buyback. If management is right, and Berkshire's announced strategy of making purchases at a premium of 10% to book value (which is based on things like the carrying value of land that is being depreciated, and may bear no connection at all to the market value of any of the company's holdings) will lead to a purchase at less than intrinsic value (which presumably would be based on the company's expected present value of its entire stream of future cash flows), then buying shares on the open market will reduce the outstanding share count, concentrating the company's post-purchase assets in a smaller number of shares. As long as the purchase price is less than the real value of the company per share (whatever that speculative number may be), the remaining shareholders enjoy an increase in value per share. This has the same impact of AGNC's strategy, which is the same thing in reverse: by selling new shares above the net asset value per share of prior shareholders, the original shareholders end up with shares backed by more assets than before the issuance. The reason this is better for Warren Buffett than a dividend is that only the selling shareholders face any risk of a tax impact: remaining shareholders get this benefit tax-free until disposition. Since Warren Buffett has announced he's giving his wealth to charity, none of his shares should be expected to be subject to income tax. Nice trick, eh?

Warren Buffett has no reason to issue a (taxable) dividend to individuals in the hope they know what to do with the money, if he knows full well that he can invest it somewhere safe and undervalued like his own company. A dividend prediction like this is nonsense. Paying dividends also ties Berkshire's hands in the event it finds great opportunities: it either won't have the cash, or will have to worry about "confidence" issues associated with halting a dividend, or will have to think about liquidity in case a risk matures into a loss on one of its multibillion-dollar-premium reinsurance contracts. The only safe thing for Berkshire to do – and the only sensible thing from a tax perspective – is to hold the money patiently awaiting good buys, including good buys in Berkshire's own stock.

The other thing I noticed is that the Fool – despite having long railed against paid money managers – not only sells a subscription specifically to alleviate your need to exercise judgment as to capital allocation but also runs an actual, honest-to-goodness, publicly-traded fund. Launched in June 16, 2009, FOOLX (an open-ended fund; we don't know how long it's had the capital it's currently deploying, or how much of it is new) is worth $13.88 at the time of writing. After the advisory fee, which my broker informs me is 0.95%, and the fund has an expense ratio of 2.2% (which offsets the lack of transaction fees, though there is up to 2% redemption fee), FOOLX has returned (according to my broker's metrics) 17.04%, which beats the S&P's 10.04% by 10%. If the 17.04% total return is accurate, its annualized yield – the fund has been in existence a bit over two years – is less than 8%. Other than the fund's holdings in a cash reserve fund, its largest holding is (according to Google) the POSCO ADR (PKX) – a Korean steel producer I've never heard of. An unknown is a great place to look for underfollowed, unnoticed, and mispriced opportunity. It'd be nice if I'd heard about this opportunity in one of the Fool's paid-for services, if it's so compelling that it's the largest equity in its namesake fund.

Conclusion
The Motley Fool provides a diverse array of conflicting advice: mechanical investing so you have simplicity and certainty; do-it-yourself because individuals can beat institutions; paid-for services because you haven't the time to find stocks; super-premium paid-for services because you can't tell which of our recommendations to buy, or in what amounts, and you're tired of standing like a deer in the headlights while your subscription ticks by; publicly-traded funds because you don't really believe that with all the brainpower at The Motley Fool there isn't an institution that can beat the markets, and you don't believe The Motley Fool when it says professionals' fees will sap your returns, and you just want to pay someone to take the responsibility off your hands. The Motley Fool does this while stuffing your email box with advertisements for its many services, using pitches that run absolutely counter to its Buffett-style patiently-investing-forever party line (e.g., click to see free report on hot stocks about to take off; act now before it's too late! Entry to this premium opportunity will close quickly so act now before you miss out!). Worse, they sell your email address to third parties who send you the same drivel – except for more complicated schemes costing even more money, that you have even less inclination to actually perform as recommended by the service, though it's hard to click the stop button while they discuss their slick ideas for enriching you ... which, if they worked so well, they'd hog to themselves instead of poisoning with a bunch of traders who'd play it out.

I'll continue to read the material – The Motley Fool is certainly one place to get ideas – but I have sincere doubt that I'll be maintaining any of these subscriptions (even at the newbie discounts). The quality of the analysis in the areas with which I'm familiar makes me deeply concerned with the quality of the analysis in areas in which I am not familiar. Thus, knowing nothing about Dreamworks except the quality of its latest product and its track record for turning merde into gold, I was made susceptible to buying the worst investment I've made since the crash – because I assumed they'd checked out the fundamentals. As I better appreciate the depth of the analysis (or lack thereof) behind the recommendations made in The Motley Fool's flagship Stock Advisor product, the less confident I am about the content of the paper or the homework that may (or may not) lie behind the short paragraphs pitching the companies. Whether I re-up will turn entirely on the quality of the investment ideas I actually get from the services. And this soon in, it's far too early to tell.

But here's this to think about. If subscribers have to do their own due diligence after reading The Motley Fool's flagship advisory products and their premium subscriptions, what is it exactly they are being sold? If all the customers want are ideas, they should be aware that trolling CAPS for pitches and/or combing the markets with free screeners is, well . . . free.

Examining Apple

2011-11-17T09:07:00.007-06:00

David Nelson writes that Apple is doomed to slower growth and that Apple investors are living in denial.

Really?

As a longtime advocate of Apple as an investment, the Jaded Consumer was immediately intrigued. Several years ago on this very site, one could read about significant concerns arising out of the lightning-not-striking-twice problem facing Apple as an investment:

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 mobile 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.

The link at the end of that paragraph is to a piece that includes this pearl:

The Future Is Not The Past
Apple's miraculous movement from 1997 to the present involved a movement from non-profitability to profitability. Margins improved by an order of magnitude. These are changes that can't happen twice.

So, the "news" that Apple can't repeat some of the most significant elements of its meteoric rise – the ranking increase of its world-recognized brand into the very top tier, for example – is not news at all. And everybody knows that doubling a $300B company is a different problem than doubling a $300M company. What's wrong with the easy conclusion that Apple's goose is cooked?

Apple has a margins advantage other manufacturers won't readily duplicate. Despite price declines in products, Apple is not a commodity vendor competing on price, but dominates its markets' capture of profit. Long garnering an outsized share of mobile profits, Apple now exceeds the handset profit made by all other handset makers combined (and has room to grow in units and in share). As Apple grows in its power to reach larger and larger addressable markets, its enormous advantages of scale will only increase its competitive advantage. Consider the difference in the effect of large volumes on the businesses of Dell and Wal-Mart: instead of paying for share like Dell (which must cut costs to move units against its competitors), Wal-Mart gets advantage from its scale. Apple's premier position promises to mature into a Wal-Mart like cash cow rather than a Dell-style yawnfest. Not that Apple's businesses are all headed from growth to stable maturity overnight – far from it. Apple has only just entered the top 5 PC vendors in Western Europe, for example.

And China has only a couple of Apple Stores. And South America hasn't been cracked yet. Russia? India? To claim Apple is done when it's just hit double-digit PC share in the US and hasn't yet done so worldwide is short-sighted, to say the least.

Conclusion
The end of the old piece on whether Apple had a safety net remains relevant:

The next ten years won't be the last ten years. They will, however, involve competition against some of the same players -- players Apple has apparently mastered fighting. They will be ten years of new hardware, new markets, and increasing price per unit of performance of component parts. Apple's addressable market will grow, and with it Apple's opportunities to reach out with sales opportunities.

If Apple's price becomes really crazy this suggests an excellent long-term buy. The question is: at what price have the shares become crazy enough?

On the other hand, in this fearful market and facing the liquidity concerns that it poses, there is no safe price for someone unable to tolerate short-term price collapses. The opportunities presented by this market are most attractive, I believe, to solvent investors who will remain without a need to liquidate positions for the foreseeable future.

Between then and now it's become clear that Apple's competitors include its former information services partner Google, and every handset and tablet manufacturer on the planet. Not just the smartphones; anyone listening to Tim Cook on the last call sees that Apple is aiming long-term at the entire mobile phone market. Looking at the evolution of the iPod ($499 at 5GB and fits into a pocket) to the iPod Nano ($129 at 8GB and clips to your sleeve), I don't doubt Apple has a plan to reach Everyman with an iPhone product. In fact, Apple was derided at the iPhone launch both by naysayers who declared phones were too difficult for Apple to master, and by competitors who laughed at the outrageous subsidized price of $499 – and it was a hit. Now – for the first time ever – Apple is selling an iPhone at a subsidized price of $0. That is the sort of change that dramatically alters the accessibility of the product, and grows its addressable market tremendously. Remember how Apple's quick iPhone price drop from $599 to $399 drove sales like wildfire into the holidays? Apple's iPhone 3GS and iPhone 4 models are still topping sales charts, not because they are new (they're old) but because their price is right. Imagine $0.

And in the meantime, Apple has launched a tablet product that has actually made the tablet market meaningful for the first time, and is the sole curator of the world's largest software store. Apple's huge transaction volume in its music, software, and hardware stores put it in an interesting position to become a major transaction processor itself (don't laugh, Apple considered becoming a telecom carrier in order to control the whole stack) – an important step in becoming a major conduit for RFI-enabled transactions based on Apple devices linked to iCloud accounts. Mastercard has a market cap of $46B, and Apple has better global brand recognition. Visa's market cap is about $75B. Suppose you didn't need to carry a wallet, just your phone? Making things simpler is part of the genius of Apple's broader pitch, and this fits right in.

Processing small charge transactions is a capability that – combined with Apple's demonstrated ability to offer $0 subsidized phones – places Apple in a position to become a fully-integrated payment system in developing countries where vendors have no infrastructure investment in traditional credit cards. I can imagine some markets in which Apple's capabilities could turn into enormous market advantage. And with $80+B in cash, Apple can create the banking back-end to ensure everyone is paid on time, all around the world.

Strategic investment, indeed!

Given Apple's enormous advantages of scale, its desire to improve both efficiency and control through integration of all the elements of the customer's experience, and the enormous fractions of the PC and mobile handset markets that remain open, it seems premature to conclude that Apple's growth is done. Rather, it's reasonable to conclude that Apple has found substantial room for growth and is exploiting that opportunity with the same quality of execution Tim Cook exercised before he became CEO.

UPDATE: The three major US carriers are struggling to fill customer orders. In the first three days of sales, Apple sold some four million iPhone 4S units in seven countries. Seventy countries will have access to the phone by year-end. The quarter's sales are likely to be brisk in comparison to the prior quarter: whereas the entire prior quarter saw Apple moving 17m units, Apple moved 4m in three days this quarter and is now rationing iPhone 4S units to retailers; Apple is still selling them by reservation before they arrive. Given the apparent shortages in evidence before the 70-nation availability has arrived, it's clear that even Apple's outstanding supply chain can't meet demand. Nice problem, eh? And this holiday, it appears Santa may be particularly good to Apple.

Reverse Barometer Prediction: Windows Era Forever!

2011-11-15T19:48:00.004-06:00

Steve Ballmer, previously described here as a reverse barometer, has once again made a major public prognostication. This one, in response to a question about his agreement or disagreement with Jobs' description of today's world as a post-PC era, is a whopper: "We are in the Windows era -- we were, we are, and will always be."

Not that the Jaded Consumer would stoop to comparing such a Ballmer pronouncement to a declaration that the newest Reich will last a thousand years, but . . . imagine that declaration from the depths of a bunker . . . within earshot of Soviet artillery . . . . I'm just sayin'. It's an image.

At any rate, the presentation (as recounted by Electronista) included classic Ballmer unintentional poetry such as Ballmer's answering a question about why no good Windows tablets can be bought by holding up a developer's preview tablet from Samsung that is not available in stores and can only be had through attendance at Microsoft's build conference, and which runs a Microsoft operating system that has not yet been released. Not quite an answer, is it?

Similarly, Ballmer claimed that post-PC devices like cellphones and tablets were, in fact, good for Microsoft – notwithstanding that Microsoft's share of the phone OS market plummeted past 2% in the year immediately preceding his claim, and that tablets crushed the market for netbooks running MS-Windows. This, after saying last year that figuring out how to compete with iPads is "job one urgency", isn't particularly persuasive – especially after utterly failing to deliver for over a year. (Which has led to a drive to port MS-Windows to ARM, because the hardware for which MS-Windows has been compiled in the past just can't cut the mustard in the mobile space. Naturally, despite earlier representations, the ARM port will break legacy apps – including all x86 apps, which could be a problem for the effort to convince consumers that all they need to know about is "Windows compatibility", and a chore for developers with substantial code bases using any of the multiple APIs sold to them by Microsoft over the years – including Win32, the NT "Native API", Silverlight, and/or dotNET. Code to Metro, or go home.)

Mobile Platform Wars

2011-11-15T10:47:00.006-06:00

According to Electronista, Gartner (whose direct link I didn't find; help welcome on this) reports that the 3Q2011 unit sales in worldwide mobile devices totaled some 440.5M units, of which 115M were smartphones.

Mobile device sales share by vendor looked like this:
23.9% Nokia
17.8% Samsung
4.8% LG Electronics
3.9% Apple
3.2% ZTE
2.9% RIMM
2.7% HTC
2.5% Motorola
2.4% Huawei Device
1.9% Sony Ericsson
33.8% Others

Considering that Apple's stated objective at iPhone's launch was 1% of the global share, this is quite a result. (Apple's 17m unit volume result was down sequentially from the prior quarter, presumably in anticipation of the imminent release of its new iPhone model, which at launch sold 4m units in three days before the rationing started.) Apple has increased its reach into numerous countries and has made a recent effort to focus on China, where the 300m+ middle class is a growing population. The whole list is included so that the just-over-a-third-of-the-market chunk that represents other smaller manufacturers is put into proper perspective. There are lots of handset vendors, and a big chunk of the phone space appears open to competition by small vendors with no particular advantage in scale or platform advantage.

Gartner reputedly reported that smartphone unit share, broken down by operating system, stood as follows:
52.5% Android (Google)
16.9% Symbian (maintained by Accenture, but appearing largely in Nokia devices)
15.0% iOS (Apple)
11.0% Blackberry (RIMM)
2.2% Bada (Samsung)
1.5% Windows Phone (Microsoft)
0.9% All Others

The story in platform is very different than in handset hardware. Only four vendors have double-digit share, and one of them appears on only one line of phones. Nearly the entire rest of the non-Apple segment of the market – 85% of smartphones – appears to use one of a few large-volume multi-phone operating systems. Leading among them is Android, which is a free Linux-derived operating system running WebKit and V8 and other no-charge open-source software. That it is free is certainly a reason OEMs would prefer it to a per-unit licensing fee as required to join Microsoft's tiny (by unit volume; I'm sure its enormous by code size) mobile ecosystem. Microsoft's 1.5% result was a drop from the 2.7% it had held of the phone platform share in the
year-ago quarter. The Nokia deal has apparently not yet paid off with a large volume of unit sales. Unless Nokia's fortunes reverse it will have little power to lift Microsoft's mobile share over the long run; if Nokia thought it was winning, it wouldn't have needed to abandon its own OS to partner with Microsoft, no? Since Nokia's >16% share of the smartphone platform sales gleans it just 4% of the operating profit in the mobile space, it's clear Nokia hasn't isn't sharing with Microsoft a yummy peach of a market segment; it's sharing a hatful of picked-over apple cores.

Research in Motion also suffered a nasty drop from the year ago quarter – from 15.4% of the market to 11% – and its effort to maintain relevance will be aided by enterprise relationships, which will buoy it somewhat as it heads past your window toward the parking lot below. Whether it will survive the fall is for another post.

On the other hand, the biggest share-loser over the year has been the Symbian platform, which plummeted from over a third of the smartphone market (36.3%) to 16.9%. Although 16.9% is still good enough to turn in a second-place finish, the trajectories of the share of Symbian and Blackberry don't suggest good things against Android and iOS, whose trajectories are plainly skyward. Symbian appears to be running out of momentum as a platform, especially since Nokia has announced a deal with Microsoft that seemingly spells the end of Symbian as a Nokia platform.

Conclusion:
Smartphone unit sales are increasingly concentrating in a small number of OSses. Budget vendors operating in the commodity space have a strong incentive to choose the only available free contender, which is Android. Android should, over time, accumulate most of the OEM business available from smaller commodity vendors, and there is little reason for larger competitors not to use it as well. Microsoft, which hasn't had success selling phone handsets, should have trouble unless through strategic partnership with larger vendors – but how many larger vendors will be willing to do business with Microsoft while its business model remains per-unit licensing fees?

Microsoft's mobile flop won't likely cost it anything noticeable on the bottom line – the billions it gleans from its cash-cow legacy businesses in operating systems and office software utterly swamp anything it could be spending on its mobile team – but things look grim in the mobile space for the company in light of its current strategies. Sure, some radical new idea could take hold – but radical new ideas haven't exactly had a track record of survival in Redmond, so I'll venture to say that until Microsoft's culture changes, the window-dressing won't have long-term impact on its mobile performance.

This seems to leave iOS and Android. Google's software-only contribution to most Android devices means that, like Microsoft, it need not profit on hardware. Being the magnet for vendors fighting over the sea of Android users – and all OEMs seeking to avoid per-unit licensing fees – will cause the Android segment to draw a significant fraction of the commodity hardware competing with similar technology on the basis of price (for which discussion, see here). Android will represent the larger mobile device share by unit volume, while – at least for the next several years – Apple will remain the vendor with the largest share of the mobile device profit (as it is in PC profit). (UPDATE: Apple's phone handset profit now exceeds that of all other handset manufacturers combined.)

In this view, Google will succeed in chasing the revenue it expects users to generate using Google's services on a growing population of devices capable of accessing them, and Apple will succeed in earning the profit to be had on handsets, and enjoying the post-sale revenues deriving from use of its App Store, Music Store, and so on. Neither must currently destroy the other to achieve their objectives, because their objectives are currently orthogonal.

This leaves the question whether Apple will succeed in developing a post-sale profit that derives from non-purchase transactions, as Google does. For example, via Siri-accessible services. Anyone care to venture a guess whether Apple reaches a point at which handset profits are dwarfed by post-sale revenue and Apple directs its economies of scale to making low-cost devices to grow user base? Is that where older devices such as iPhone 3GS are headed over time? Any thoughts?

Apple Bucks Declining PC Sales in Europe To Enter Top 5 Vendors

2011-11-14T15:45:00.003-06:00

According to Gartner, Apple's nearly 20% rate of unit sales growth rate over the year-ago-quarter helped to push Apple into the top 5 vendors (by unit volume) in Europe. Apple now stands at #5 in unit sales. Over the same period, three of the top five vendors (HP -7.5% to 21.8%, Acer -45.1% to 24.5%, Dell -10.0% to 9.6%) experienced an absolute decline in unit sales. Only Apple (having sold 5.7% share of units sold in Western Europe) and ASUS (at 7.8% unit share) enjoyed gains, each about 20% over the period.

In the UK, Apple is a top-5 vendor (ranking #4, at 7.8% of unit share) by volume; in Germany and France, Apple is not ranked. Western Europe bought about 14.8 million PCs in 3Q2011, and there's quite a bit of that market Apple hasn't snagged.

This market doesn't include the tablet market in which Apple's iPad competes.

Of course, unit share isn't profit share. Apple doesn't sell an undifferentiated commodity box; it competes in a high-margin segment of the PC market. Apple's gains in PC share represent even greater gains in the share of the profit to be had in the PC business in a given market. And as the Western Europe numbers demonstrate, Apple has opportunities for future growth in the PC business.

Security Researcher Misjudges How To Demo Exploit

2011-11-10T13:41:00.004-06:00

Forbes' Andy Greenberg interviewed Charlie Miller ahead of Miller's SysCan presentation on an iOS 5 bug that can be exploited to permit developers to have unsigned code downloaded to and run on an iPhone.

Code signing is Apple's technique to ensure that hostile programs aren't used to replace trusted ones, and to ensure that only trusted code is permitted to run on users' iOS devices. Apple's code-signing policy is a major differentiator of Apple's devices from those running Google's mobile operating system. Apple's relatively superior security record with respect to Trojans and viruses results directly from Apple's platform's refusal to run software not bearing a valid signature from an Apple-authenticated developer (available only through the App Store).

In order to demonstrate this flaw to Greenberg, Miller didn't show him an iPhone side-loaded with a developer demo app to prove it worked. Miller never explained why he didn't use his development tools to make a non-distributable demo. Other developers use this to test apps prior to submission, to ensure they perform as expected on actual running hardware. It's a natural fit for this kind of display: it's a test, and doesn't require making a known security risk available for public download.

What Miller did was to submit to Apple an app that pretended to be a garden-variety stock tracking app, but which surreptitiously phoned Miller's server to see if Miller had any unapproved code Miller wanted to run on the phone. Miller's server was set to "innocuous" mode when the app was approved, and he cheerfully set it to malicious mode and took remote control over the phone during the Greenberg interview. Greenberg's article was published November 7 at 2:38 PM. At 8:15 PM the same day, Greenberg was already publishing that Miller's app had been removed from the App Store and Miller removed from Apple's developer program for violating the developer program license agreement through a scheme to "hide, misrepresent, or obscure" material features of the fake stock ticker program.

Apple has already released an update resolving the code-signing workaround.

Since Miller didn't deploy the app using a non-distributable signature generated by a dev testing key, but actually persuaded Apple to approve an app that allowed Miller to take remote control of strangers' iOS devices, Apple didn't have much of a choice in how to handle Miller. Miller did exhibit a certain amount of humor: “I miss Steve Jobs,” he says. “He never kicked me out of anything.” Perplexingly, Greenberg seems to miss the critical difference between Miller's conduct and that of security crackers with whom Apple has extended friendlier treatment (to crackers whose work is expressly permitted by regulations promulgated by the Librarian of Congress under the authority of the DMCA).

The rule seems pretty easy: don't lie to anyone who relies on your code. Like, say ... Apple.

This leaves us with two questions --
(1) What will Miller demo at SysCan?
(2) What will Miller have ready when he's allowed to re-enter the developer program next November?

End Of The Mobile War Over Flash Player

2011-11-09T15:37:00.003-06:00

The long-running account of the jabs and counter-punches exchanged between Apple and Adobe over Flash Player and its suitability for mobile devices seems to have wrapped up at last. ZD Net first reported that Adobe's Flash player will not be developed for new mobile devices, mobile browsers, or mobile OSes or even their future OS versions.

All Things D notes that Adobe recently announced a 750-FTE job cut, which may be related to its lack of stomach for a platform war that, as chronicled right here (from its inception or shortly afterward through a number of pieces of evidence suggesting the ultimate outcome), Adobe was plainly losing.

Will anybody miss mobile Flash?

Will anybody see a reason to maintain desktop Flash? If it eats cycles (i.e., electricity), weakens security, is unnecessary (or mobile devices wouldn't work), and messes up accessibility on users' diverse platforms, what will the basis be for deploying content that requires Flash players on any platform?

Earnings Obfuscation Under FAS 157

2011-11-07T16:35:00.007-06:00

The Jaded Consumer has previously discussed how FAS 157 impacts American Capital Ltd. (ACAS), but this only scratches the surface of the pricing errors one can find in the wake of SEC filings whose earnings reports are poisoned by FAS 157. Watch this explanation of how –

"What's that?" you say. "Poisoned?"

Yes, my friend. Poisoned. You see, the Securities Exchange Commission is supposed to require filings with representations about earnings and performance so that the public is informed. When Joe Public reads a number like quarterly earnings, Joe wants to know if it's better than last quarter or the quarter that occurred the same time last year, and wants to understand whether the company is gaining or losing money and whether that gain/loss is slowing or accelerating. Joe Public may be using stock screening tools to identify in batches companies with improving profits (or exclude companies without them), and he may have little depth of knowledge about the particular companies whose headlining numbers he's reading. Goodness knows, Joe Public may be buying on a friend's stock tips or the raucous exhortations of a television personality.

So let's look at a company that's not speculative at all, for the purpose of identifying to the reader how FAS 157 confuses the public about a company's earnings and creates opportunities to catch utterly rock-solid and well-known companies being mispriced in the public markets.

So-Called Efficiency
Yeah, the markets that are supposed to be "efficient" so that all information is reflected in the prices – those markets. Markets that are so indundated with information of varying degrees of kind and quality that no participant can plausibly comprehend it all. Markets whose participants frequently have full-time work doing things so totally unrelated to the markets that they are inclined to buy or sell or invest or withhold investment on the basis of trust in third parties who themselves almost certainly arrived at a decision on the basis of incomplete information. Markets whose prices are not fixed by an arbiter of fairness, but on the purely mechanical conditions of the number of buyers, the size of their orders, and the prices at which their brokers will admit they are willing to pay for the size of order the brokers are willing to admit their clients are interested to obtain – and the number of sellers whose brokers are equally opaque with respect to the intentions of their clients. If you want the price of a thinly-traded stock to go down, simply enter a sell order and watch the numbers drop (which is a major reason to be skeptical of many pink-sheets listings). Or, as Cramer has described, wait until just after lunch when trading in all the issues is thinner and – by using the leverage inherent in standard options contracts – push even major issues one direction or another (I recall Cramer describing this technique as also involving a bogus rumor, which though poor-quality news – and easily exposed after time – still drives people into fear-based or greed-based moves, their confidence in which is increased by the "real" position taken by the manipulator to make the rumor look like it has substance). One can create or desrtoy quite a lot of market cap – utterly out of proportion to the capital at risk – or at least appear to.

But I don't have personal experience manipulating stock prices, except by accident while attempting to enter or leave a thinly-traded equity position. And in that case, I was accidentally manipulating the price against my own interest, which – lemme tell ya – is sorta a drag. Look carefully at trading volumes before buying thinly-traded issues; if your position is bigger than daily trading volume, how do you plan to exit? Even a big fraction of daily volume is frightening to think about planning an exit.

FAS 157 In Action
So what's accidental manipulation got to do with buying mispriced stocks after an earnings release that's impacted by FAS 157? Simple. When the earnings report comes out with a number that is heavily influenced by FAS 157, some people will look at the number – which is a good number so far as SEC compliance is concerned – and confuse it with an earnings number that one might take to the IRS. Depending which way that error runs, people may confuse the company with one that is unexpectedly profitable – or conclude that it's suffered a terrible hit that has, in fact, not occurred.

I promised a safe, stable, low-risk example. So, I give you Berkshire Hathaway. Berkshire Hathaway (BRK.A, BRK.B; after the 50:1 split that took place at the time of the Burlington Northern acquisition in 2010, BRK.B represents 1/1500 the equity interest of a BRK.A) is a holding company that includes retail insurers like GEICO, a reinsurance business so big that it was about the only place in which Lloyds could offload Equitas, which held the long-tail risk of its asbestos liability overhang (and where AIG just did the same thing), and a whole slew of portfolio companies in which Berkshire Hathaway invests money received from its insurance business in order to make money while waiting to see what long-term risks materialize. If you haven't read a Berkshire Hathaway annual report, you haven't seen how an annual report should spell out business to investors.

Berkshire Hathaway's earnings derive primarily from the consolidation of portfolio company earnings into its own balance sheet. Those earnings result from a diverse array of businesses (in no special order): GEICO, Dairy Queen, Sees Candies, Star Furniture, Burlington Northern Railroad, ISCAR Cutting Tools ... I could go on, but you can read the annual reports yourself. Berkshire also receives dividends from Bank of America, Coco-Cola, American Express, and so on. All good earnings. All pretty easy to understand. What's not to like?

Indeed. Berkshire's broad-based and powerful cash-generation is greatly to be admired. It's the kind of thing that, in the hands of investor-friendly and transparent operators such as Berkshire Hathaway's present management, inspires immense confidence. You see the earnings number, and you know there's no accounting game: you can take it to the bank.

And, yet ... FAS 157.

FAS 157 is an accounting standard. FAS 157 requires booking changes in values of derivatives (among other things) as income or loss in the period in which the value change occurs, without regard to the realization of that gain or loss. In other words, a company that reports that its book value has increased because its holdings are more valuable also reports that its income is up by the same amount, despite that no realization has occurred (and, due to market conditions, may never occur). This has the impact of causing unrealized gains and losses to be counted twice: first, against book value (which one would expect), and second, against earnings. It's that second application that's unexpected. Reported earnings are going to be understood by the public as earnings, not holdings. Reactions are sure to follow the headline number (earnings up!) rather than the number you or I would work out using the tax accounting with which we are more familiar – but investors will treat the headline number as if it were a taxable income number.

When The New York Times publishes an article titled "Derivatives Cut Into Berkshire Hathaway's Profit" there's no asterisk to indicate that the "profit" described in the title isn't taxable profit, or even realized profit, but a number that reflects an accounting principle no investor would ever apply to his own bookkeeping. Readers assume the New York Times is being accurate when its lead paragraph proclaims that Berkshire's profit declined "after losing more than $2 billion on derivatives related to stock market performance." Then, the lead of ¶2: "That was nearly three times what Berkshire lost on the same instruments a year ago." Readers' conclusion is obvious: Berkshire has no idea what it's doing with dangerous derivatives. Quotes form Buffett on derivatives' risk buttress the view of their danger, and suggest the company's leadership is unable to implement its publicly-proclaimed beliefs. The New York Times isn't some kind of outlier in describing earnings reports impacted by FAS 157. Bloomberg's headline, "Berkshire Profit Declines 24% on Buffett's Derivative Bets" is at least as lurid.

Readers value the company accordingly. Maybe readers think Warren has lost it, or that Berkshire is awash in rogue traders who imperil its good business with scary derivative-related risk. Who knows? What we do know is that Berkshire's shares are trading as if it's making a lot less money than it is.

Berkshire's Earnings and FAS 157
In the most recently-reported quarter, operating earnings of $2,309 per A-share exceeded estimates surveyed by Bloomberg (which averaged just under $1,800). Instead of publishing "Berkshire Beats Operating Earnings Estimates by 28%", Bloomberg publishes what in places reeks of character assassination. This is because Berkshire's assets (Berkshire holds investments in Coco-Cola, American Express, Bank of America, and lots of other long-term investments that it won't exit and whose price changes don't impact earnings) include some asset types subject to FAS 157, so that their change in asset value must also be reported as a change in income. In this case, it's derivatives.

In Berkshire's 2008 annual report, Warren Buffett explains how unnamed investors paid Berkshire $4.9 billion (cash Berkshire can use; there's no counterparty liability) for custom-made equity index options for which no market exists (neither party can possibly buy/sell to close the position before expiration), and which can only be exercised (if at all) on the date(s) of expiration (ranging between 2019 and 2028). In other words, market volatility can't cause early exercise; the option is either worth $0 (Berkshire hopes), or is worth more than $0, at the expiration date 15 or 20 years following issuance, and Berkshire either makes a payment under a contract (which may or may not be greater than the premium) or does not. If each of the indexes are 25% below their level at the date the options were written, Berkshire will be on the hook for about $9 billion. While there's risk of paying out more than was received in premiums, there is certainty of being able to invest the $4.9 billion for well over a decade and a very good chance that the indexes aren't so far below their value the day the options were written that Berkshire pays in 2019 (or 2028) more than it received in premiums. This is, in essence, like its insurance business: it invests a float while awaiting possible risk. This is in many ways better, because (unlike life or health or auto risk) the risk can't come due until expiration date. Berkshire has also insured some bonds, and some of that bond insurance (but not all of it) is subject to FAS 157.

It's worth pointing out that Warren Buffett's 2008 letter to shareholders makes a detailed explanation both of the risks in the derivatives, and the case to be made that the mark-to-market valuation given the equity index options systematically overstate Berkshire's risk. In the 2008 letter, he explains why, despite the apparent outrageousness of the liability overstatement, Berkshire Hathaway reported a "liability" in connection with its derivative holdings that led to a mark-to-market "loss" exceeding $5 billion. If you have any doubts about this as you read here, Buffett's letter provides delicious examples anyone can follow. Despite that the 2008 annual report listed Berkshire's derivative contract liabilities at $14.612 billion, it's worth noting that in the 3Q2011 report, Berkshire Hathaway's derivatives liability stood at $10.421 billion – not a bad move, considering what's happened to credit and equity between 2008 and the end of 3Q2011.

Berkshire Hathaway didn't exit derivatives positions in the last quarter for a realized loss of $2.443 billion, or even $2.443 million. First, neither party can exercise the 15-year and 20-year options except on the expiration date, and only then if they are in the money, and in that case the exercise only results in payment to the extent they are in the money. Second, 3Q2011 investment gains were $100 million in the insurance segment and $0 in the finance and financial products segment.

The fact that Berkshire Hathaway reported $2.278 billion in net earnings in the quarter while claiming to have "lost" $2.443 billion in unmatured derivatives suggests that Berkshire's real financial condition over the quarter amounted to (1) a real but speculatively-scaled reduction in assets associated with the unfavorable market conditions that impact the value of the illiquid derivatives that can't be exited for years, while (2) Berkshire experienced earnings of $4.721 billion.

Valuing Berkshire Hathaway Despite FAS 157
The question of how significantly the asset devaluation should impact valuation of Berkshire Hathaway is a fair question. However, to believe the impact is the equivalent to reducing Berkshire's earnings in the quarter by more than 50% is simply ridiculous. This quarter, FAS 157 caused Berkshire Hathaway's SEC-reported earnings (not its IRS-reported earnings!) to be lowered from $4.721 billion to $2.278 billion – a reduction of about 52%. What that means is that without FAS 157 to confuse people into mistaking Berkshire's unrealized gains/losses in long-term investments for income, its 3Q2011 earnings would have been higher than actually reported – 107% higher.

Yet, that's what FAS 157 requires: if bond insurance transactions are structured as a derivative rather than as an insurance product, it is subject to mark-to-market rules and impacts "earnings" every quarter regardless of actual realizations; yet if the same transaction is structured as an insurance product volatility becomes unimportant and earnings isn't impacted unless actual and anticipated payouts diverge. It's hard to escape the conclusion that FAS 157 causes Berkshire Hathaway's income to seemingly halve or double based on the Black-Scholes valuation of 20-year index puts (which is based on transient volatility and not the likely end-of-the-decade valuation of the equities in question, which is why the model has serious problems with long-term options without pre-maturity exercise risk).

Berkshire Hathaway's income is clearly subject to material misstatements (that are required by the SEC) on the order of 100% or so in a quarter. In the wake of earnings announcements that are based on these reports, Berkshire's price is likely to be based on dramatic misconceptions of its earnings. The tone of the Bloomberg news item in particular suggests that Berkshire is led by a doddering gambler on a long-term losing streak, which can't be good for the non-numerical evaluation of the company, either.

Since more people will read articles like those in Bloomberg and The New York Times than will read Berkshire's annual reports, it's fair to say that Berkshire's valuation is based more on Bloomberg and New York Times spin than on the sober, thoughtful, and respectful content of the reports filed by Berkshire with the SEC. A sober investor might be expected to be able to weigh the impact of current earnings against unrealized changes in asset value, but those aren't the rules we have following FAS 157. Now, we're given an "earnings" number that tries to include unrealized changes in some – but not all – asset classes. The rule leads to confusion because it makes earnings difficult to compare across industries (some transactions of identical substance are subject/not-subject to FAS 157 simply based on the form of the transaction), and because it leads to "earnings" reports that are different from the experience of investors.

FAS 157 increases the opportunity to locate mispriced securities issues.

CONCLUSION
By identifying companies with significant exposure to FAS 157-generated confusion regarding quarterly profit, it is possible to use vastly overstated/understated earnings to ride substance-free movements in stock prices. Buying on the heels of a selloff resulting from a "bad" quarter like Berkshire Hathaway's recent above-expectations quarter provides an opportunity for outsized recovery following a report with a FAS-157-induced misstatement in the other direction. Don't hate FAS 157, use it to get an information edge on the nitwits that dominate the market.

Admiring Apple's Supply Chain

2011-11-06T17:39:00.004-06:00

In a recent BusinessWeek article, Adam Satariano shows us a few examples of how the Apple that existed after Jobs returned was able to achieve such outstanding supply-chain performance.

Under Tim Cook – now Apple's CEO – Apple invested big (and early) in production and fulfillment, reaping benefits unavailable to competitors who didn't move fast enough to lock in sufficient access to scarce resources. Although the Jaded Consumer mentioned some examples of this in the past (locking up the world's supply of 1.8" hard drives following the iPod launch, and consuming so much of the LCD supply that competitors at times had to make do with Apple's leftover screens), Adam's article shows more examples of Apple foreseeing supply-chain concerns and acting quickly to solve them.

Among them was Apple's decision following Jobs' return in 1997 to buy – well in advance of the holidays – huge swaths of air shipping capacity. Instead of paying near-retail to air-ship a couple of boxes, Apple bought pallet after pallet of space so that (a) last-minute shoppers could get fulfillment by Christmas, and (b) competitors had no hope of moving material amounts of product in a hurry around the holidays. Fast-forward to 2001: Apple pioneered drop-shipping iPods to customers directly from their Chinese points of assembly. In the words quoted by one of Apple's competitor's supply-chain chief, the realization what Apple could do was "an 'Oh s----' moment[.]"

Sure, people accused Apple of "wasting" resources on air shipment when competitors used surface transit – but Apple got good value for the money: no local warehouse, decreased transit times, lower inventory overhead, and -- crucially for people meeting birthday and holiday deadlines -- quick fulfillment. Paying $50,000,000 in advance for air shipping was a ballsy move in 1997: Apple didn't have an $80,000,000,000 cash pile then.

Logistics isn't just shipping, though. Like Apple's move to absorb the world supply of 1.8" hard drives in the early days of the iPod, and Apple's ongoing activity to ensure it has ample access to flash storage (Apple is the world's largest buyer of flash), Apple's appetite for precision manufacturing tools has made it harder for competitors to buy what they would need to duplicate Apple's accomplishments. Drills. Lasers. Imagine the list growing with advancing technology. Apple's ability to buy forward supplies with multibillion-dollar advance payments simply puts it in a supply-capturing league in which there are just no apparent competitors.

Supply-chain intelligence is at work in other areas of Apple's operations. By observing in real-time the foot-traffic patterns and buying behavior in its worldwide network of retail stores, Apple can spot emerging trends and avoid, say, the next cube debacle (referenced here in connection with dire predictions against the sure-to-flop Apple tablet) – while gaining the market information needed to intervene early to head off retail product shortages that could result in missed sales.

World-class supply-chain management is an example of the sort of excellence Apple has been delivering, that under Tim Cook will continue to be delivered. Supply-chain management wasn't a traditional strength of Apple before Jobs' return, and it wasn't an area of excellence Jobs developed while at NeXT or Pixar. Tim Cook – who left IBM's North American Fulfillment to become Compaq's VP of Corporate Materials for six months before being recruited by Steve Jobs in 1998 – has been reciting to Apple employees that people don't want to buy sour milk for years; supply-chain management is an area in which he believes, and in which he has proven he can deliver. Under Tim Cook as Apple's CEO, the competitive advantage of supply-chain management will not suffer.

Apple's Siri Generates Its Own Press

2011-11-04T10:03:00.002-05:00

There's a developing ecosystem of content revolving around purported social interaction with Apple's virtual assistant Siri. As an example, the Jaded Consumer offers this song, in which Apple's product is sampled to perform a "duet" based on actual answers Siri will give to queries that attempt to treat Siri as an intelligent being.

The page has links.

When OS/2 Warp v. 4 offered "voice control" it didn't get anything like this response. IBM's solution was billed as offering recognition of a command dictionary directed at programs' predefined instructions, not a tool to make sense of things humans would say. Reaction to Siri suggests that this difference means something to people.

Apple is still able to get people to market Apple's products with resources far outstripping those Apple itself invests.

MSFT Browser Share < 50%

2011-11-03T09:09:00.003-05:00

CNN informs us that Microsoft's browser Internet Explorer no longer commands more web share than all other browsers combined. At least, not when mobile traffic is included. As of October, the no.2 browser Firefox accounted for 21.20% of the web's traffic, and Google's WebKit-based Chrome reached 16.6%. Although Apple's browser – the WebKit-based Safari – commanded 62.17% of the mobile web traffic, its overall share was 8.72%.

As described by CNN's original source NetMarketShare, desktops (a category that, based on the information on the page, seems to include notebooks) seem to drive most of the web traffic. And in access from desktop hardware, Internet Explorer holds 52.63%. Overall, IE has fallen to 49.6% of web share. With mobile devices' share of web traffic reaching 5.5%, though, and the market for both tablets and smartphones apparently outpacing that of desktops, the commanding share of Safari (on iOS) and Chrome (on Android) in mobile seems likely to further dissipate IE's top-ranked position in browser share with passing quarters.

Why does this matter? Despite the advance of web standards and developments such as Ajax and HTML5, Microsoft technologies still tie enterprise web functionality to its browser so that clients of Microsoft-vended server solutions are required to use Microsoft's browser. This, in turn, requires clients to use a Microsoft operating system. Rejection of the browser is likely to lead to trouble in the marketing department: does MSFT uncouple web apps from its browser and risk desktop migrations, or insist on controlling the browser and risk losing the servers in favor of a solution that is client-neutral? Yes, one can develop client-neutral solutions for delivery from Microsoft platforms, but I have continued to see IE-only web-delivered solutions vended in the enterprise. Movement from MSFT's browser is a movement toward standards, which is good for the quality of software available to users: if competition is on features people care about rather than on corporate linkage with a server solution, users stand a better chance at a higher-quality software product.

But back to the NetMarketShare data: As of October, Apple made 62% of the mobile devices measured on the web and holds 61.5% of the mobile browser share. Google received 91.1% of the mobile search traffic, though providing the operating system for 18.9% of the devices and providing only 18.6% of the browsers. Both Apple and Google have a browser share tightly linked to platform share. By abstracting away the search interface, Siri offers an opportunity to drive iOS search traffic from Google to sources with which Apple has a more favorable relationship. Whether or how Apple will monetize this is something of a mystery, but that's what we've got at the moment.

ACAS: 3Q2011 Results Promise Confusion

2011-11-01T16:27:00.004-05:00

At last, after an eternity waiting to understand what impact the recent financial market madness has had on the opaque internal workings of American Capital Ltd., ACAS investors have received the third-quarter results announcement.

As usual, the top items are income and assets: NOI (what ACAS earns outside the deals it makes exiting investments) and NAV (what its holdings are worth).

As this is written (November 1), shares trade for $7.20 in the after-hours market. Against that backdrop, the NAV reported for September 30 – $11.92 per share – represents a discount of about 40% to the assets ACAS is actually investing on behalf of those who buy the shares at this price. Ordinarily, a huge NAV discount would worry one that the company must be losing money hand over fist, or at least not going anywhere. In this case, ACAS' quarterly Net Operating Earnings of $6 million represent a 10% increase to the NOI of 3Q2010. ACAS' taxable income – the income on which ACAS would have to base its dividend if it hadn't dumped its tax-pass-through status in order to preserve its operating loss carryforward for the benefit of shareholders (as a non-taxpayer, ACAS wouldn't particularly be impacted, but it affects shareholders' after-tax return) – is comprised of both its operating income and its realized gains/losses. ACAS' earnings over the quarter were $98 million (an improvement of $107 million compared to 3Q2010), so the company isn't bleeding losses. Much of the $260 million of realized cash proceeds were profits. Nice.

In addition to making $163 million over the quarter, ACAS both repaid $123 million in debt and repurchased $75 million in its own shares (reducing the share count by 9.1 million shares, at the below-NAV price of $8.21).

So, business looks good. Right?

Expect a selloff.

Because ACAS is bound by FAS 157 not only to mark investments at market, but for SEC income-reporting purposes to book unrealized gains and losses in investments' value as if income (which makes its SEC-reported income utterly independent of its taxable income in a given quarter), the decrease in the financial markets' valuation of other companies (i.e., those against which ACAS' portfolio companies are compared for valuation purposes) caused ACAS to report that it lost $1.24 per share over this profitable quarter (at least, as you or I or the IRS would have measured the quarter). This is similar to the wierd bumpiness that exists in Berkshire Hathaway's earnings as a result of the long-term puts BRK wrote against the S&P index; the totally illiquid long-term can't result in a realized gain except on its maturity date years from now – but FAS 157 requires Warren Buffett to report "gains" based on a modeled value of the short put as the markets fluctuate over the life of the option (which, because it can be exercised only on its expiration date, poses no short-term risk). The difference is that unlike BRK's stable of illiquid portfolio companies that are held "forever" and aren't for sale, ACAS is required to use this accounting treatment with substantially all of ACAS' investments.

Due to the rough quarter in the markets – ACAS' NAV declined by $1.24, from $13.16 to $11.92 – ACAS' NAV isn't what it was at the end of the prior-reported quarter. Combined with the FAS 157 "loss" of $1.34, people will be expected to conclude that ACAS is in serious trouble unless they understand that the "loss" of $1.34 is a double-counting of the NAV decrease. In fact, ACAS' NAV decrease would have been worse had it not made as much money as it did. The fact that it was also repurchasing shares is an added boost.

And expect more repurchases. As the CEO explained in the earnings announcement:

In the aggregate, revenues and EBITDA of our portfolio companies continued to show growth. The positive performance of our portfolio companies, the recently released 2.5% U.S. GDP growth rate for the third quarter and the fourth quarter rebound in the capital markets has us cautiously optimistic that our portfolio companies will continue to perform well in the near future and that our earnings will return to their overall positive trend, similar to the previous eight quarters. Based on this confidence and the current price to book, we believe our shares are an excellent bargain and intend to continue the share repurchases we began in the third quarter.

Let's hope ACAS takes advantage of the predictable confusion to buy lots more shares at even greater NAV discounts than were available in the prior quarter. Retiring debt is nice, but retiring shares below NAV really has a prospect of moving the needle in the long run on ACAS' per-share returns.

Here's to the short-term confusion :-)

Apple Expects Huge iOS Growth in 2012

2011-11-01T14:27:00.002-05:00

Daring Fireball drew attention to Asymco's economic analysis of Apple's projected expenses that suggests expectation of 100% growth in iOS devices over the next fiscal year.

100% growth may sound impressive ... but apparently dropping $1B on a datacenter is designed to make Apple's products better at helping people access data than is available using Google's tools. Can Apple beat Google at its own game? Will Apple develop a revenue model based on the data access to make this kind of investment pay for itself (as Google does), or will Apple rely on hardware profits Google doesn't reap?

This is interesting stuff. Apple's acquisitions in maps, voice, search, etc. have the potential to put Apple in a much more serious collision course with Google than was initially apparent as Google began shipping a mobile device OS. Apple seems set to try to take Google's lunch money. Would you buy a ticket to see that fight?

Humorless TSA To Fire Note-Drafting Screener

2011-10-29T17:08:00.002-05:00

A TSA screener who left a friendly note for a female passenger traveling with a checked sex toy will apparently be terminated.

"Get your freak on girl!" is apparently a firing offense.

Apparently, subjecting passengers to screening isn't an offense, but trying to humanize the experience with humor is.

Go figure.

MTGE Announces First Quarter Results (3Q2011)

2011-10-27T15:29:00.004-05:00

MTGE, which announced a stub-quarter dividend of $0.20 for 3Q2011, has now revealed that it earned $0.25 in net income during its inaugural partial-quarter, and taxable income of $0.17. The other big-ticket news is that NAV at the close of the quarter was $19.96, which is up from the net MTGE would have received from its $20 IPO, after issuance-related fees were deducted.

MTGE used 4.7x average leverage during the stub period, but closed the period with 7.8x leverage (compared to 7.7x leverage at AGNC on the same date). Net interest spread in the stub quarter was 2.13%, but at quarter-close it was 2.41%. Increasing leverage and increasing spreads should mean dramatic increases in income. That is, up from 10.01% to 18.80%. MTGE hasn't got the fat investment sizes with which AGNC can manage transaction costs, but (with leverage) has $1.7B to work with.

Crazy risks?

"With book calue preservation in mind, and given the volatility and liquidity conditions in the credit markets, we have been cautious on non-agency investments. We expect to patiently develop this portfolio as compelling opportunities arise."
- Jeff Winkler, S.V.P. & Co-Chief Investment Officer

This is exactly what I was hoping for in MTGE: a portfolio that mirrors AGNC's successful formula, but keeps its eyes peeled for material mispricing in assets more susceptible to fear-based avoidance (as opposed to fundamentals-based avoidance) than the agency-backed instruments whose principal and interest, being guaranteed by the federal government, tend to assuage terror regardless the fundamentals of the asset bundle. The non-agency opportunities are thus a nice place to get capital appreciation: a mispriced asset will, in time, end up valued at its worth. (As Buffett has said, markets may be a popularity contest in the short run but in the long run they are a weighing machine.) Carefully scrutinizing opportunity rather than rushing in is exactly how I'd like to see non-agency assets approached.

The price for this opportunity in MTGE is a 0.25% increase in management fee over the fee paid by AGNC. It's described here. ACAS, which had hoped to issue a lot more shares of MTGE than actually changed hands on IPO day, may want to raise some more money in order to support big deals in really mispriced non-agency bundles – but for my money, ACAS just wants to be ready to capitalize on opportunity and hasn't got a deal it's dying to do or it'd have done it.

AGNC Pummeled Today

2011-10-27T14:42:00.003-05:00

TheStreet just today published that American Capital Agency Corp (AGNC) fell on high volume, but it doesn't seem to suggest why.

AGNC, which has a history of issuing shares above NAV to increase the equity behind its outstanding shares, announced on 10/26 that it would issue another 37m shares ("approximately" $1B gross proceeds), which comes to "approximately" just north of $27 per share. There's an over-allotment option for an additional 5.55m shares. Presumably, the proceeds received by AGNC net of fees and commissions will be "approximately" $27. The magic number to look at in evaluating this transaction isn't the trading price of the shares, but the net assets per share prior to the transaction. At the end of the third quarter of 2011, that NAV stood at $26.90 per share. Without knowing what "approximately" means, we can't know whether this is NAV-neutral, or actually raises NAV.

The fact that AGNC has maintained NAV despite worries about the twist suggests that its managers at ACAS are doing an appropriate job of managing rate-related risk. Or in the alternative: it suggests that worry about the twist failed to take into consideration the difference between the short-term rates available to financial institutions borrowing against federally-secured financial instruments, and the rates that were available to individual borrowers when they last refinanced their real-estate-backed mortgages. The spread AGNC needs to accomplish its work isn't the spread between 1-week and 10-year Treasuries, but the spread between the rate AGNC can get in the short term and the rate individual borrowers can get on their home loans.

Given the growth of this movement, it's clear the view isn't in favor of rapid decrease of home loans toward 0%. While the spread survives, so too does AGNC's business model.

With NAV seemingly free from dilution risk in the current issuance, and share prices remaining above NAV, AGNC doesn't seem to be moving in response to factors specific to the long-term prospects for the stock. The "issuance at ~$27.03" news is good for a short-term push toward $27.03, but AGNC has historically traded at a premium to NAV and – barring failure to perform in the manner so long justifying the premium – that premium is likely to return.

ACAS Moves Up

2011-10-27T14:12:00.002-05:00

ACAS has rocketed over $8 today as the market has moved broadly up on summer economic growth numbers and slightly-lower jobless claims. ACAS' portfolio companies should be expected to move in value with their publicly-traded comparables, but there's something else afoot. Zacks just added ACAS to a list of #1 Rank ("Strong Buy") stocks. The five added to this ranking yesterday include Duke Energy (DUK), Bebe Stores (BEBE), AMAG Pharmaceuticals (AMAG), and software developer Fortinet (FTNT).

Are people buying on the market, or on something as ephemeral as a ranking change?

re OWS

2011-10-27T13:45:00.003-05:00

Recently, this note was sent out-of-band:

An awesome article by Matt Taibbi, well worth the time to read. When anyone asks what the hell the Occupy Wall Street people are about, this tells it "like it is".

http://www.rollingstone.com/politics/blogs/taibblog/owss-beef-wall-street-isnt-winning-its-cheating-20111025

My reply was:

I agree that the ire against brokenness in the system is genuine, and not merely the sour grapes of jealous also-rans. My concern is that the movement, while capable of articulating its displeasure, has not seemed able to propose a remedy. I therefore fear that the movement will end up like the Tea Party, co-opted by persons capable of harnessing their energy for some orthogonal purpose. The Tea Party began as a leaderless movement of people dissatisfied with government, too -- and now look at it.

This isn't to say that nothing done under the name of the Tea Party is good, but it is no longer about restoring representation, bringing government to heel, and introducing a fiscal conservatism long denied Americans by either party. It's taken on a distinct right-wing social cast and appears aligned with extremists within the Republican Party – a party which has just destroyed its "small government" and "fiscal conservatism" branding by presiding over some of the most significant budgetary imbalances in our lifetimes while growing both the size of government and its scope of intrusion into everyday life. The injection of social conservatism strikes me as being at distinct odds with the seemingly libertarian cast the Tea Party movement had at its inception.

While the relation between Republicans in Congress and the Tea Party candidates elected into their midst on the Republican ticket may not be entirely warm and cozy, there's no question that Tea Party candidates are neither Democrats nor Independents. Elected "Tea Party" candidates seem to view their mandate as bringing a no-compromise position on issues that anger their voter base – thereby imperiling business-a-usual vote-swapping operations in Congress – but they don't seem to be proposing the sort of radical change that would be reflective of serious effort to control the problems that seem so connected to the concerns that gave rise to the Tea Party in the first place. Perhaps it is the fate of OWS to pose as a mirror to the Tea Party, sharing an anger at the establishment but supporting a more Democratic-leaning brand of uncompromising, government-skeptical extremism.

Might not be a bad thing, all in all, but it would not set the ship aright either.

The question is: what will?

My proposals all involve changes of a scale that make them politically unlikely, so I've kept their details largely to myself.

On "Occupy Wall Street"

2011-10-26T14:41:00.008-05:00

To discuss "Occupy Wall Street" without going into the details of whether private property owners must accept squatters who seek to proclaim a political message without regard to the maintenance needs of the property, or whether protesters are unduly paranoid in their interpretation of effort to vacate areas to enable maintenance and public health operations (interesting; here and here), it seems attractive to discuss it in comparison to its opponents.

About OWS Itself
"Occupy Wall Street" proponents assert that the movement represents the views of the 99% of the population whose incomes aren't in the top 1% of incomes. These proponents include some advocates who are rather more articulate than those sent to interview them. Being articulate in exposing flaws in some opponent is excellent marketing, and is wonderful for argument ad hominem, but what does it do in connection with the movement's thesis?

Does OWS have a thesis?

The OccupyWallSt.org site contains a sympathetic video that nevertheless suggests that movement participants may have no idea what they will do next, or even what result they hope to achieve through their action. (If true, how will they know it worked? Or will any subsequent development be seized as proof the movement accomplished valuable objectives? Will this end up like Crichton described junk science environmentalism, with no need for data, just a press strategy?) Many of the individual quotes accompanying photos of OWS participants reflect a theme of disappointment with existing government and a desire for an undefined "change". Some suggest hopelessness, and others a call to action to combat the apathy that enabled government to get to its current unsatisfactory state. The apparent unifying feature is disappointment with the status quo; what seems lacking is a specific proposed fix.

The lack of any articulated "condition of victory" is rather a problem in evaluating an intervention's effectiveness. While claiming to represent the 99% who aren't busy raping the land and destroying the economy for personal gain (an apparent meme of OWS), OWS doesn't seem to have expressed any solution to whatever evil it is OWS asserts the government should address. And getting the government to address some evil seems to be OWS' hope: that someone will eventually, inspired by the throngs napping on the local parks and streets, devise a solution to the ills that upset them. Claiming to represent 99% of the nation that generates the most patented inventions on the planet, these folks seem to be singularly bereft of concrete solutions.

Representativeness is a tricky thing. Revolutionaries in the late 1700s famously chafed at taxation without representation, and denied that the democratic government in London was capable of representing colonists obliged to live within that government's law. An anonymous poll conducted at OccupyWallSt.org was given to CUNY sociologist Héctor R. Cordero-Guzmán, who declared that "the 99% movement comes from and looks like the 99%" -- a nice tautology if ever there was one. Are the bottom 99% of US incomes 70% politically independent, as revealed by the OWS poll? According to Rasmussen Reports, two thirds of the U.S. population consider themselves members of either the Republican or Democratic parties. (Despite that multibillionnaires such as Steve Jobs and Warren Buffett were Obama supporters in the last presidential election, it's probably not safe to assume that the entire top 1% of incomes has a party affiliation. Even subtracting the top 1% from the party-affiliated population, one seems to find that adding 1% to the 32.4% of the politically-unaffiliated population – down from 33.5% in August – brings it nowhere near the OWS threshold of 70%.) Where is OWS drawing a sample that is 70% independent? What part of the bottom 99% of incomes does it represent?

First, let's look at the other side of the question.

Who is the 1%?
While we occasionally get enforcement for criminal wrongdoing among the financial executives (or those that receive improper tips, or even obstruct investigations into tipping schemes), and it's easy to lay blame on financial-industry executives whose reckless schemes cost so many investors their lives' savings and resulted in a publicly-financed bailout intended to thwart a broader economic collapse, the fact is that most of the top 1% of earners in the United States aren't even members of the financial industry. Among the larger groups of top-1% earners, for example, are physicians (1.85%). Attorneys follow (1.22%). The largest group fall into a category called "executives, managers, and supervisors (non-finance)", which occupies a 6.35% slice of the top 1% of U.S. incomes. Financial professionals only explain 2.77% of the top 1%. Some of the "financial professionals" are surely actuaries that help price life insurance policies, and other highly-compensated specialists whose unexciting but skilled work offers little prospect for social injustice.

What is really going on here? If the OWS video is evidence, the participants aren't in on the secret yet and we must look elsewhere for insight.

According to Univ. Michigan's blogging professor of economics and finance Mark J. Perry, the top 5% of incomes are responsible for 57% of U.S. taxes despite earning 33% of U.S. income. The slant is a bit higher as you reach the thinner air of the 1% earners – which, at present, means an income just north of $340K/y – who earn 19% of all declared income in the U.S. but pay 37% of all U.S. taxes. This isn't to say these high-earning individuals have a rough time of it – they arguably are getting more benefit from public infrastructure and the rule of law than folks whose earnings (or disability checks) barely cover their subsistence. Paying more may be perfectly just.

But they're not paying more because they are causing social inequity; they are paying more because the Internal Revenue Code of 1984 as amended requires persons who declare earned incomes of that scale to pay the highest taxes levied in the nation. Whether a person is a crime boss who declares no income at all, or a fatcat exec whose largess is rendered from the carcasses of innocent victims, means nothing at all under the Internal Revenue Code. You pay taxes based on declared income, period. Well, maybe not period – there's a semicolon and lots of subparagraphs of deductions and income categories (gambling winnings, earnings from the trade of collectibles, long-term capital gains, income subject to Alternative Minimum Tax – all kinds of things complicate the calculation of tax liability, and offer room for high-income enterprises to restructure operations so as to realize income in a lower-taxed category).

Tax liability isn't a social punishment, it's the price of success. Whether obtained through means vile (e.g., deliberately destroying competitors with better products by leveraging market power to prevent fair competition, deceiving the public about impending product launches to prevent the growth of competitors' sales due to fear of their destruction, using monopoly power to contractually bar competitors from being able to obtain retail shelf space or software pre-installation ... I'm looking at your company, Bill) or virtuous (e.g., delivering products and services that participants in an informed market were happy to buy, at prices based on what the market would bear in the absence of antitrust violation, like most of the rest of the country but in particular like Steve's firm), income tax doesn't ask whether you are nice or good but what you earned and in what categories. Because of the various tax credits and deductions available to U.S. filers, only 53% of the population actually pays federal income tax in the United States. The other 47% aren't especially virtuous, they're just sufficiently under-employed that Congress has, for their sake or that of their dependents (or perhaps for the sake of a vote), called off the IRS.

Who is the 53%?
Those who actually pay income taxes in the United States – not those with undeclared crime jobs, or undeclared off-the-books cash work; and not those whose income tax obligation is swamped by personal deductions, dependent deductions, earned income tax credits, home buyer's tax credits, and every other deduction and credit afforded filers under the Internal Revenue Code – are diverse. Interstate truck drivers and local road crews. Doctors and nurses. Employers and employees. Supervisors and supervised. Immigrants and local-born. Self-employed and salary[wo]men. Americans.

(Some of the foreign-born Americans' stories are interesting, like above and here.)

There's a Facebook page dedicated to the 53% who actually pay taxes, filling with comments by those who don't agree with what the Occupy Wall Street crowd appears to advocate. The tumblr link contains self-portraits of self-identified taxpayers (including some whose jobs just evaporated) who believe in personal responsibility rather than government handouts, displaying on one sheet of paper what it means to be part of the 53% who have been paying for everything government claims to provide. To the extent these statements have a theme, it seems to be that however dire their situation, they expect to bear the consequences of their actions and to succeed by the dint of hard work rather than handouts – and they have no expectation that government should be in the business of saving them from their debts or their choices or even their hardships. They expect to keep working even inglorious jobs and to continue paying the taxes that make possible.

Substance Behind the Rhetoric?
Since the Occupy Wall Street group does not represent the 53% – the object of at least this fraction of it is to distinguish themselves from OWS – and OWS appears to disclaim the 1% at the top, it seems we need some math to discern whether OWS represents 46% of the population, or some other fraction. Without some unusual math, it seems unlikely that OWS represents 99% of the population, when the 53% are plainly against seeking the sort of government action apparently hoped for by OWS. (As it happens, the Pew Research Center conducted a poll with a 4% margin of error that suggests that OWS support/opposition recently stood at 40%/35% among Americans.)

Without even a proposed fix, the OWS movement seems a demonstration of a throng that feels more powerful huddled together than back home where toilets are available, and who prefer to complain loudly than to toil for the improvement of the lot of man. The greatest likelihood assigned by the Jaded Consumer is that a political force with superior strategic prowess will co-opt "Occupy Wall Street" for some purpose previously unknown to OWS, and sell participants (at least those on camera, and at least long enough that the cameras catch it) on the snake oil being peddled by the parasite that worked out how to feed from a host too dim-witted to defend itself.

(Dim-witted in this case isn't intended as a disparagement of individual participants, but of the collective, which is investing substantial time and energy in an enterprise with no identified objective. Whoops. I'd give this post more serious treatment, but ... I have to work.)

Irony Award
"If this doesn't stop soon I will be out of business." quoted in BusinessWeek by Charles Mead and Esmé E. Deprez, who wrote on the effect of crowd-control efforts on the ability of local vendors to conduct their otherwise profitable businesses that employ Americans. Whoops again. (On the other hand, a newsstand with a working toilet was doing great business among the protestors. You win some, you lose some.)

iOS 5, iCloud, and the iPad-Only Customer

2011-10-25T14:14:00.003-05:00

When I first learned about iPad's feature set, my primary disappointment was that it could not be pitched to users as a stand-alone computer replacement. In other words, its addressable market was limited to users who'd already bought another computer with which it was possible to sync content and download software updates. It appeared iPad might be doomed to be tethered to some other "real" computer.

With Apple's announcement of iOS 5, Apple enables data sync without a main computer – wirelessly to iCloud – even to the extent of updating the system software. iPad is now a serious contender for a front-line machine for users whose demands are within the realm of iPad. Given what iPad's app developers are doing – and what Apple is doing with iPad development – the scope of those demands will quickly reach quite a few users.

Growing the size of Apple's addressable market for the iPad by freeing it from cable-based sync is a huge boost for the long-term prospects of iPad.

Apple: Trouble Keeping Specialist Recruits?

2011-10-23T12:04:00.002-05:00

Apple hired Kevin Timmons from Microsoft (where he was General Manager of Datacenter Cervices) in April, and may already have replaced him with Scott Noteboom of Yahoo (where he was Head of Global Data Center Infrastructure) following Timmons' departure for CyrusOne earlier this month.

Previously, Apple acquired chip design talent in its purchase of the chip designer PA Semi, but lost its top manager in less than a year. Promptly on the heels of that departure, Apple bought chip design firm Intrinsity – and all its engineering talent.

Is Apple having trouble keeping recruits, or is it getting what it needs in the form of high-intensity consulting on projects that run fine following the departure of the top folks it brings onboard? Are these personnel losses cut by Apple as cultural mismatches, or are they leaving because the Apple job turns out not to be what they expected?

Inquiring minds want to know.

With respect to the new Noteboom recruitment, the expertise of an industry insider with a decade-long positive track record while growing Yahoo's data center by an order of magnitude is likely to provide Apple a valuable resource. Given Microsoft's need to eat its own dogfood and Yahoo's flexibility in tool selection, I'd expect a Yahoo exec to be a better match than a MSFT careerist whose solution to every problem would have to be to buy a bunch of Microsoft solutions or risk running outside his sphere of competence. The indecipherable title accorded Noteboom – "distinguished gentleman" – may say more about Apple's secrecy than about a lack of authority assigned to Noteboom.

Watching Apple enter the data business will be interesting. I'd expected Apple to use Google for this, but Google and Apple have ended up competitors to such an extent that I foresee Apple opting to use non-Google solutions for everything it can. My question is simple: with Apple declining to push ads on users as Google does to fund its operations, how will Apple manage to make its data operations self-funding? If they are not, its data-based endeavors risk becoming a weight around the neck of high-margin hardware and software products. Those datcenters aren't cheap.

ACAS: Another Exit

2011-10-18T11:57:00.003-05:00

American Capital Ltd. (NASDAQ:ACAS), an internally diversified business development company currently taxed as a corporation rather than as a BDC, exited an investment recently when its portfolio company Sixnet Holdings LLC was sold to Spectris Plc. for $72m. Sixnet, in whose recapitalization ACAS invested in 2005, followed by additional investments in 2007 and 2009 to facilitate Sixnet acquisitions, supplies machine-to-machine cellular data products. Equity proceeds from the transaction totaled $12m, including $7m paid to ACAS (part of Sixnet was held by ACAS-managed portfolio companies). ACAS' senior debt investment of $37m was repaid in full as part of the transaction.

ACAS calculated its internal rate of return on the Sixnet investment at 15%. ACAS' compounded rate of return, from the date of its IPO through the second quarter of 2011, was 11%.

ACAS currently trades below $7, though its net asset value per share at the end of 2Q2011 was over $13. Getting a double-digit return on $13 for an investment at $7 seems an interesting prospect, though ACAS' NAV naturally varies with the value of the comparables against which its portfolio is valued.

Dennis Ritchie Preparing the Great Product In the Sky

2011-10-16T20:47:00.003-05:00

Dennis Ritchie may not be as great a household name as Jobs and Gates, but he did something neither of them ever achieved: he wrote code that worked. As the developer of the C programming language, he enabled the work of every programmer whose work depended on it -- developers who worked on OpenBSD, Mathematica, Apache, Linux ... and Microsoft Office, Microsoft Windows, Microsoft Internet Information Server (IIS, which has apparently had its unabbreviated name changed to end with the word "Services"), Microsoft Bob ... you name it. Even MacOS X and everything written using the Cocoa API. There are some folks who wrote programs in Cobol or Fortran, to be sure – but if you're like most of the people on the planet you've not only never run such a programs but never owned a machine that did.

Dennis Ritchie's operating system work further illuminated his philosophy: lots of specialist tools, ready to work in concert to perform complex tasks ... none of which needed to be able to do "everything" to get its job done, all of which were consequently lighter on resources than tools that "had to do everything all by themselves." The simplicity of his systems made them strong; but like a game of go, their simplicity was easily lost on untrained observers. Indeed, Dennis Ritchie famously – and widely quoted in doing so – said "Unix is simple. It just takes a genius to understand its simplicity."

Dennis Ritchie, benefactor of mankind, has departed to prepare the Great Product In The Sky (which, being the rockingest product of its kind, Jobs will surely be set to demo).

Blackberry Outage Ends

2011-10-16T12:59:00.004-05:00

Research In Motion's (NASDAQ:RIMM) Blackberry devices, which depend on RIMM-supplied back-end support for which RIMM charges subscription fees, suffered an intercontinental email service outage that began October 10 and went unresolved until October 14. Now that the outage is over, some customers who bought RIMM's "ready for business" pitch are re-assessing the single-point-of-failure aspect of depending on RIMM for critical infrastructure.

Although RIMM has suffered (and suffered) in stock price (market cap is at the time of writing about a tenth of the $123B RIMM once commanded) and in market share, it now also suffers a setback in something that might be hard to restore: its brand.

If RIMM's profit continues to suffer pressure, infrastructure investment (and service quality) may be in long-term jeopardy. The discussion of RIMM as a takeover target (more here) is interesting, as it offers promise of capital with which to address service quality – and management change to aid re-direction in a more competitive direction.

Frankly, a successful and independent RIMM has been a good motivator of other manufacturers; I hope they pull the firm out of its dive. RIMM has a large subscriber base; hope springs eternal.

A5 Leads Phone Performance

2011-10-09T12:54:00.003-05:00

According to Anandtech, the A5 chip in the iPad2 – and now the iPhone 4S – performs significantly better than (like, 2x) the best of the recently-launched competitors' devices' CPUs. (*cough*Samsung Galaxy S2*cough*) Leading handset performance is certainly an Apple objective: iPad apps will run better on iPhones, and games will work better, and the services Apple wants to supply users while they're doing everything else they do with Apple's products will be easier with more computing power in each device.

Yet, Apple isn't sitting still.

With Apple's A6 apparently set to launch next year as a quad-core part built on a 28nm process (compared to the 40nm process on offer at NVidia's fabs), it's clear that Apple intends maintaining advantages in hardware even as it differentiates it phones with software. The hardware advantage isn't something Apple is taking lightly: it's got a thousand FTEs building the brains in Apple's next mobile devices. (And AppleTVs, and maybe its next MacBooks; who knows where this could go. Based on Apple's control of its developer tool chain and capacity to support compilation of multiple-architecture binaries, Apple can potentially do things others have no chance to duplicate.)

Outperforming NVidia chips in graphics, Apple's chips seem set to dominate mobile gaming and potentially replace games-specialist competitors. Unlike the XBox, which spent years losing money before it went into positive cash flow, Apple's iOS devices have consistently made money while building the platform from which to attack available markets. Where Apple will push the iOS platform is definitely a point of personal curiosity.

The more power I see in Apple's devices, the more I marvel at how auto manufacturers can keep shipping such crummy mapping tools, with kludgy interfaces and quickly-outdated databases of destinations. Surely the opportunity isn't lost on the manufacturers. Apple's devices can replace the stereo head unit, the GPS, the map, the address database, the climate controls, the bluetooth controller ... everything other than, you know, the car. The improvement in usability – especially for borrowed cars, rentals, and other situations in which users won't have unlimited time to become familiar with some screwball new way to identify a destination to a mapping program – is a huge plus for customers. Heck, with cloud music, car renters could log into the i-device in the dash and pull down the music they love rather than fighting local radio for something worth hearing. While using a map app that updates continuously from sources in Apple's cloud.

Apple's departure from the rack server space may certainly be a function of low sales volumes, but as Apple's tools improve for enterprise uses, the demand for something that will free users from high-overhead competitive server software will create an opportunity for Apple to sell low-power server hardware based on homegrown CPUs: cool-running, cheap to operate, and supporting ARM's hardware-supported security tools, Apple's non-x86 servers might be truly attractive for enterprises.

Did someone say Research in Motion was selling for less than Apple's cash on hand, and was becoming more affordable as its unit share teetered? Especially in the post-Jobs era, taking a serious look at the enterprise space might not be that hard to imagine a few years down the road.

Speaking of the post-Jobs era: there's been a lot written about him and what he did for tech. Much of it is really worth reading. I was at an airport when I heard, and as I looked around I saw white earbuds, iPhones, iPads, and other evidence of his passage all over the place. It was moving: he'd changed the world. We can argue how much, perhaps, but the evidence he was here is everywhere. It should be clear from the posts here in what regard his accomplishments are held here at JadedConsumer, but I don't think I have anything especially brilliant to say on the matter. I think much of what he contributed is a result of his expressed view that you only get one shot at life, so it stands to reason you should not waste your time on things that aren't excellent. We've benefited from his pursuit of excellence, and can hope that his successors really share the same value of quality.

Apple has a quality lead and a solid footing for retaining it. Sales seem strong at Apple's store and at AT&T's; nobody else is talking. Sprint's demand for the phone suggests Apple is something of a carrier kingmaker: Sprint's leading cause of customer loss before the iPhone 4S launch was the carrier's lack of an iPhone. (Now, carriers are competing for iPhone customers.) With China a relatively untapped market and smartphones still a minority of worldwide handsets, the long term trajectory of Apple is toward sales volumes increases in the handset market. Notice Apple doesn't drop its old models, just moves them down the performance ladder for customers unwilling to pay more? Apple is moving toward capacity to do with phones what it's done with music players, and overtake most of the business that's worth taking.

And, you know what? Apple is selling more computers, as well!

It's a good time to be Apple.

Thanks, Steve.

Selling Software: What Apple's Competition Is Doing

2011-09-30T20:35:00.003-05:00

Google, having heard anecdotally that hands-on use of its Chromebooks greatly enhanced users' understanding of what they did and why they might want to buy one, is following Apple's strategy of improving the frequency of that hands-on access by opening physical store locations in which to enable customer access to its products in a demo-ready, functional environment. Google will surely sell more ChromeOS this way: people will start to become aware it exists.

By contrast, Nokia is following Microsoft's lead by bribing developers to support "Windows Phone 7" (or whatever it's called these days). And I do mean bribe. Nokia goes beyond Microsoft's platroem-software-plus-development-software-plus-even-yes-the-phone-hardware offer and doesn't just make development access free, it buys development. What else is a "cash incentive"? What other platform's vendors are so desperate as to guarantee third-party developers a minimum return?

Between these two strategies, I'm betting on Google's.

Timing ACAS

2011-09-30T16:14:00.005-05:00

I was looking at ACAS and hunting for relevant news that might explain the apparent panic afoot, and I noticed this:

Since ACAS was "downgraded" from "hold" to "reduce", it is (despite its recent precipitous fall) up by 46.52%. Apparently, timing ACAS isn't their specialty, either. Interestingly, the ratings folks seem to rate their own ratings, too. Let's see how that works:

It seems that the ratings specialists "upgraded" ACAS to hold, and it outperformed the index to which it was compared, the ratings specialists called that a "correct" rating. "Hold" for an index-beating return. The more recent period, the ratings specialists admit to be incorrect. Yet, the rating stands at "reduce".

If they stood by their rating, you'd expect a report that said "just you wait!" But, no. It's "incorrect" but it remains the rating :-)

I'm interested to hear anyone's take on the recent price action. Uncertainty and volatility both work against comparables pricing (thus against NAV), and doubt about the macro-economic environment weighs against performance of ACAS' broad-based portfolio (which one expects to behave as a leveraged proxy for the overall economy).

Buffett has bet long-term on the economy of the US. Is there reason to doubt ACAS can hold on for the long term?

Comments welcome.

Motley Fool Notices Apple Owns Its OS

2011-09-30T11:51:00.003-05:00

In this video, the Motley Fool reveals that Apple has a competitive advantage in not having to pay Microsoft a licensing fee, which results in value and pricing advantages.

Gee, who would have guessed that by acquiring the IP it wanted to deliver to customers, Apple would differentiate itself from beige-box makers not only on product but on price-per-value and ultimately on raw price? And that Apple's multi-language-in-each-installation OS would allow it to sell one version of a product worldwide?

The Motley Fool neglects something worth thinking about: Apple might not need to license the OS, but it needs to license things it bundles with the OS, like Microsoft ActiveSync (at least on iOS devices) and a rich selection of high-quality fonts (particularly on PCs; the reason Apple's font selection on phones is so thin is certainly the margins impact of font licensing for fonts of the quality Apple ships).

The next thing the Motley Fool didn't reach is the hardware: Apple, owning its own OS and providing its developers all the developer tools free-of-charge, is free to swap hardware underneath its software stack with virtually complete transparency to its customers. Sure, developers may have to click a button to build software for multiple platforms, but Apple has made it easy to deliver one software package for multiple hardware architectures. So when Apple decides that it wants to ship ARM chips in some segment of its product lineup in order to obtain a price/value advantage over competitors, Apple is free to do what Lenovo cannot.

The flexibility Apple obtains through its own OS isn't just the price of the OS: it includes flexibility in OEM hardware sourcing, architecture, launch geography, and other concerns that impact margins, supply-chain-management, and addressable market. Apple's control of the intellectual property driving its products is a critical part of Apple's competitive advantage.

MSFT To Earn More from Android Than WinPhone

2011-09-30T11:29:00.003-05:00

Electronista has an interesting story. Samsung's licensing deal with Microsoft to avoid patent battles over IP that is part of Android, at something like $3-6 per handset, will yield Microsoft more revenue than it earns at $15 per Windows Phone 7 license on the 1.7m units that ship with Windows Phone 7.

One wonders what IP Microsoft has that's embedded in the Linux-based open-source phone software. Is there real MSFT innovation in there, or just patent trolling on old tech Samsung preferred not to be in court over?

On ACAS' Debt

2011-09-28T19:34:00.005-05:00

At the end of June of 2010, ACAS announced that its long-running effort to arm-twist its many creditors into exchanging one family of debt instruments (under which ACAS was required to maintain asset levels that, under the combined effects of FAS 157 and the post-2008 liquidity crisis, were impossible for ACAS to meet, and led to default-rate interest, despite that ACAS had never missed a payment) for a different set of debt instruments (which granted creditors what they had long demanded: security) had finally succeeded. In the transaction, ACAS paid $1.03B of its loans back 100% in cash, and exchanged the remaining $1.31B for the new secured notes. The overview is here. At the close of the deal, ACAS owed $11m in unsecured old debt that didn't participate in the swap, and $1.31B of newly-issued secured debt.

I've recently been asked about ACAS' risk for being forced to liquidate its holdings in some kind of fire sale. According to the amortization schedule announced with the press release on the restructuring, ACAS didn't have any principal repayment obligation until December 31, 2011. At that time, if it didn't cough up about $70.4M, ACAS would suffer a higher interest rate. ACAS has further principal amortization requirements at the end of June 2012, December 2012, and June 2013 ($100m, $300m, and $350m respectively). Scary, eh? Shall we have a look at ACAS' outlook for meeting the schedule?

The next quarterly report following the debt restructuring was 2Q2010, which included the announcement that ACAS' total debt stood at $2.924B, placing the company at a debt:equity ratio of 0.9:1. Its interest expense in 2Q2010 was $56m, but that included time under the old debt regime. The total debt included the $1.31B in secured debt, and some securitized debt. The following quarter, 3Q2010, ACAS repaid $407m in debt, including $200m of the secured debt due in 2013. In 3Q2010, ACAS' interest expense had declined to $36m, and it foresaw a 4th-quarter secured debt repayment intended to lower its interest rate to the lowest available under its new debt facility. In 4Q2010, ACAS repaid $258m in debt. In that quarter, its interest receivable was $37m and its interest expense was $28m. (For those who cautiously ask about ACAS' actual income rather than its receivable number, its interest and dividend income in 4Q2010 was $133m.) In 1Q2011, ACAS repaid $517m in debt, including $300m of the secured debt due in 2013. (Interest expense was $29m, while interest and dividend income was $146m; fee income grew over the quarter from $10m to $13m.) The 1Q2011 repayment left ACAS with no principal repayment due under the amortization schedule until it owed $250m at the end of June 2013. ACAS' next quarter, 2Q2011, it repaid $100m of its securitization debt. This left ACAS (whose NAV had increased to $13.16 per share) with a debt:equity ratio of 0.4:1. In 2Q2011, ACAS' interest expense had decreased to $20m while its interest and dividend income stood at $131m.

Since ACAS plainly has the wherewithal to keep current on its interest payments, there is no basis for secured creditors (who aren't due any principal until mid-2013) to execute on the security. They're being paid in full. The whole point of the security was to free ACAS from maintaining specified asset levels; the value of ACAS is no longer the security, because the security is the security. Losing your job doesn't cause home foreclosure so long as you make your payments. ACAS' secured refinancing was designed to give it the flexibility to do what made sense without worrying about the market cap, net assets, etc. This is why ACAS was free to shrink the company by spending cold hard cash simply to retire shares. This raises per share value but it shrinks the company. Without a net asset covenant, it's no longer suicide. A few years ago, share buyback was impossible due to ACAS' ongoing concern about maintaining net asset levels to satisfy covenants under its old debt regime. If someone has a term sheet for the new secured debt, I'd love to see it to be sure I understand what else may be required, but as I understood the refinancing I think ACAS is in a great position based on its current earnings.

So, what happens if Paulson is forced to sell? Well, ACAS' capital is permanent capital: no-one can recall it. If Paulson has to dump shares, we may get a fire sale (if the sale isn't private and if there are no buyers lined up to absorb Paulson's block). Heck, with the share buyback plan in position – a share buyback plan which allows privately-negotiated purchases – ACAS itself might enjoy Paulson's fire sale, if there is one. I for one have no idea what Paulson's finances look like, and don't honestly care except that it may present a short-term buying opportunity.

So, why is ACAS' price in the toilet? We've re-entered a period of heightened uncertainty, ACAS' portfolio of small illiquid firms is viewed as vulnerable to turmoil, ACAS' management has couched positive guidance in terms of a continued favorable macro-economic environment, we don't know from day to day what effect market conditions of ACAS' portfolio's comparables has on ACAS' NAV, etc. With uncertainty comes perceived risk, and lower bids. And lower bids follow misinformation: I read a teaser for a new research report that referred to ACAS as having no dividend in the foreseeable future because of expected capital losses. Um, the dividend is expected to be zero for a while because ACAS' loss carryforwards will absorb taxable earnings (whetehr operating income or capital gains), and ACAS' dividend has historically been calculated on the basis of taxable income because it was regulated as a BDC. Claims of expected losses, even bogus ones, can't be good for share prices. Bogus analysis abounds. Anyone got a hard source for an actual forecast of losses? Didn't think so.

I have never claimed to be able to time anything, and I won't try here. One of the more painful investing errors I made was to decide that the market wasn't going anywhere and lose a ton of AAPL to covered call exercises years ago when the stock hadn't moved in ages, and I don't think the shares ever saw that price again. I'm not keen to replicate the experience by trying to time purchase and sale near $7 of a company whose last-announced NAV was north of $13.

My last move in ACAS was to buy 200sh for a niece, which I put into an asset protection trust. Kid's going to need money when she grows up, I figure. And me too!

Active Internet Users Are 10% Macs (5% iOS)

2011-09-27T11:11:00.006-05:00

Although Apple's sales share numbers are not yet in the double digits for PCs (desktops and notebooks), its share of active users appears to exceed 10%. According to Chitika's surveillance of users accessing its online advertising network, Apple's Macs gained share in the user base in September and hold 10.6%. Apple's iOS devices were slightly down in share, to 5.2%. By comparison, Linux distributions total 2.3% of users and Microsoft's operating systems stand at 77.7%.

Android was up by 0.045% to 2.3%.

Note that measuring users by examining online ads neglects the non-browsing segment of the market. Both Linux and Microsoft have substantial presence in servers, and many point-of-sale systems run Microsoft operating systems. Which numbers are worth watching depends on one's purpose. As an online advertiser, Chitika is of course interested in devices in a position to browse its ad network.

From Apple's perspective, a large share of installed base is valuable in the iPhone business because Apple shares some wireless subscription revenue and shares in App Store sales of content to users. By contrast, Apple's share of the PC installed base has historically only meant that its users haven't yet replaced their Macs. With Apple's launch of the App Store, Apple stands to benefit more from users who don't replace their machines often. The Safari browser probably doesn't generate substantial revenue for Apple, despite that Apple could stand to benefit from ad revenue sharing from searches conducted from a Safari search window. But then, some revenue is better than none.

The major benefit to Apple of controlling a meaningful segment of the devices in use on the Internet is that it makes Apple's ecosystem more valuable. A reliable population of quality (i.e., paying) customers who prefer quality products is attractive to developers inclined to create quality products to sell; quality products from developers make platforms more attractive to customers; large communities create network advantages over small groups (in case you like using video chat, which only works with people whose video chat software is designed to work together); and so on. But as Apple has learned with the App Store (and its Music Store before that), a large installed base also means a large group of customers capable of providing post-sales revenue opportunities. As Apple's installed base grows, the post-sale long tail of content revenue (software, music, books, etc.) may become a material part not only of Apple's ecosystem, but its revenue. (While Apple is in an explosive sales growth phase, the sales will likely continue to dwarf post-sales subscriptions, content, etc.; but the future of Apple platforms as cash cows in the event Apple's market share reaches a "steady state" is potentially attractive and worth thinking about, even if the hypothesis that a "steady state" can exist is a bit fanciful.)

Between Apple's market-topping satisfaction and its share growth, Apple's execution is a thing to behold. Congratulations.

Apple Service Tops PC Vendors Again

2011-09-22T10:50:00.002-05:00

This might not be "news" after 8 years, but ....

MTGE: the first dividend

2011-09-22T09:34:00.005-05:00

American Capital Mortgage Investment Corp. (MTGE) recently announced that for the less-than-a-quarter period from August 9 through September 30 (about 54 days), it is declaring a $0.20 dividend payable October 27, 2011. (As after AGNC's first stub quarter, nitwits are already proclaiming MTGE to have a single-digit yield based on a quarterly dividend of $0.20. Yawn.) As with the 31¢ stub-period dividend initially paid by AGNC, this isn't a full quarter of revenue and doesn't reflect what the company will ultimately do over the duration of a fully-invested quarter.

And it's fair to conclude that MTGE is now fully invested:

During the course of the stub period MTGE's investment team has invested these proceeds, along with proceeds from borrowings under the Company's repurchase agreements, to purchase a portfolio of approximately $1.5 billion of agency, non-agency and other mortgage-related investments.
from MTGE's Press Release

Not only is its equity fully invested, but it's used $200m of equity to invest in approximately $1.5b worth of investments. One concludes that with investment approximating 7.5x equity, the investment is one part equity and 6.5 parts borrowings. Leverage of 6.5:1 may have been a result of the recent marketplace uncertainty – MTGE was first issued during the first day of a marketplace bloodbath, after all. If MTGE's rate spread is like AGNC's was last quarter – above 2% – then MTGE should be making something above 15% on its equity of more than $19/share. ACAS has managed AGNC with leverage that varies with market conditions, and using leverage less than 7:1 is conservative in comparison to the 8x leverage with which AGNC launched.

Interpreting the 20¢ stub-quarter dividend in light of that math suggests that MTGE wasn't fully invested on IPO Day but took some time to ramp to full investment. In light of the market turmoil, this isn't hard to believe. AGNC's first stub quarter was 27 days, and it paid $0.31 – but there was no panic underway at the time. The real question facing investors seeking to read the tea leaves of the stub-quarter dividend is the fraction of the quarter in which MTGE was actually invested. The Jaded Consumer strongly suspects that becoming fully invested involved multiple parties and agreements and was slowed by the fact that everyone in the financial industry was distracted by the apparent meltdown underway in the marketplace.

As I previously wrote, I hoped to buy under $19 – and now I have bought under $17. Deutche Bank's target price of $22 doesn't impress me as much as the fact that MTGE is AGNC with an option to buy non-agency securities (thus improving the possibility of occasionally buying a more feared/hated, and thus potentially irrationally mispriced, mortgage bundle). Since AGNC has performed well and trades at a premium to NAV, the prospects of a similarly-managed MTGE for trading above its $19+ NAV appear favorable over the intermediate term.

At the moment, I expect MTGE's price represents a discount of over $2 to NAV. At today's price of about $16.75, this represents over 12% upside just retracing to NAV – and AGNC's experience suggests normalcy will represent trading at a premium to NAV. Now that the misinformation and uncertainty about MTGE is high, investment is much more interesting than immediately following the IPO.

MSFT: Another Partner Skewered

2011-09-20T20:17:00.003-05:00

Microsoft's recent news – that its billion-per-quarter losing streak with Bing has continued another quarter and is set to keep the same path – is highlighted by another report that partnering with Microsoft is bad for your health. Microsoft's share gain against Google has not only not been at Google's expense, but it has been at the expense of Yahoo! – the search function of which is ... drumroll please ... provided by Microsoft's Bing.

The theory that partnering with Microsoft is bad for the health of a technology enterprise is not novel. The recent "MSFT kills its search partner" sounds a lot like the company's earlier hit, "MSFT kills its music-store partner".

This isn't to say MSFT is doomed: it's finally figured out how to make money on its once laughably-losing XBox, and it's got a huge cash flow based on operating system and productivity software that is fully capable of sustaining it through the effort to succeed at other things. The question at Microsoft is whether top management will allow Microsoft's smart folks to do things successfully, or whether good ideas will be killed to protect legacy business.

Only the shadow knows.

ACAS Buys ... ACAS!

2011-09-17T09:51:00.003-05:00

American Capital Ltd. announced this week that in August it began buying back shares of its own stock on the open market. August purchases totaled 4.9m shares at an average price of $8.12, and September purchases through the 15th of the month had reached 4.23m shares at an average price of $8.31. In all, ACAS has spent $75m on share buybacks, and is still buying. Share retirement at the time of the announcement reached 9.13m shares.

The headline of the press release delivers the punch line: ACAS, which at the moment isn't subject to BDC dividend-paying requirements because of its failed RIC test, has a policy governing share repurchase that's based on factors like operational issues and debt servicing. In the past, ACAS could not spend a material portion of profits on share buybacks because it was obliged to make dividend distributions based on its corporate taxable income (not its per-share taxable income). Now that ACAS is free from BDC-related dividend-paying obligations, it's freer to do things like share repurchases.

In the past, the Jaded Consumer's take on ACAS share repurchases was: don't hold your breath. The recent announcement suggests that the "really slick" idea for cash I'd hoped for is actually pretty simple. Based on the $13+ NAV ACAS announced having at the end of last quarter, ACAS' share repurchases were made at nearly $5 below the value behind each share purchased. (Realize that although the theoretical value of ACAS' holdings logically vacillates with the global and local economic and competitive environments that also impact all the comparable investments trading in liquid markets, ACAS only calculates fair-value estimates for public consumption on a quarterly basis; the recent economic turmoil naturally creates increased uncertainty regarding the value of ACAS' portfolio components, and likely impact on the value of target comparables. Thus, the average of $8.21 spent per share doesn't result in $4.95 per share in recaptured NAV to distribute across the remaining shares, because the NAV was moving independently of the share purchases.) But think about ACAS' management: it's been showing consistent NAV improvement for a nice string of about 8 quarters, and it doesn't want to lose its streak. What does the buyback do for it?

First, $4.95 per share on 9.13m shares is not the same as $4.95 per share on all ACAS' remaining shares; it's like getting $45m to allocate across the shares ACAS has remaining. At the close of 2Q2011, ACAS had an outstanding share count of 345.1m. Now, let's revisit what I wrote the last time I opined on share buybacks:

Buying shares doesn't lead to realized gains (imagine if it could treat issuance as a short, and close the positions it opened north of $40!), and offers no benefit to the bottom line.

This means that the "profit" of 18.36¢ per share (that is, remaining outstanding share) has just been made, tax-free. Yes, I realize that ACAS has loss carryforwards and wouldn't pay tax this year, but this is a "profit" that has several attractive features:

Doesn't lead to reduction or loss of ACAS' valuable loss carryforward (in other words, the lack of a tax payment isn't just temporary; it's real)
Doesn't push ACAS closer to being required to pay a dividend
Doesn't cause confusing one-time impacts likely to be misread or dismissed by those reading the next quarterly report, but instead has a long-term impact on the per-share NOI, NAV, and other interesting metrics because it reduces the denominator by which the company's metrics are divided into per-share metrics.
Did I mention that since the effect isn't taxable, neither ACAS nor shareholders bear a tax burden for the transaction even though it raises NAV 18¢? Which at a 35% tax rate, means it's identical to having earned and paid tax on 28.25¢?

Now, offsetting this 18¢ gain is whatever happened in the market to ACAS' portfolio companies' comparables. Yes, the comparables by which ACAS' portfolio is valued have surely been impacted by the recent market hit, and with them also ACAS' fair-value numbers for its holdings. This will work against the 18¢. But since ACAS is ahead on its debt repayment, and is generating cash it can use for things like share repurchases without putting itself behind the 8-ball on dividend obligations, it can afford to spend even more money: at the close of 2Q2011, ACAS held cash and cash equivalents of $186m. With neither a dividend obligation (the current repurchase policy places dividends and share buybacks within management's discretion based on share price relative to NAV) nor a debt repayment obligation (it pays interest, but hasn't got a principal obligation due for the near future), ACAS is free to game this for the benefit of shareholder value. As shareholders, management has a certain incentive to build share value.

The fact that ACAS can do this same trick again before the close of the quarter (it's got another $75m, after all) is interesting. The fact that ACAS could turn unproductive assets into share-buyback fodder is also interesting. Since ACAS hasn't been exactly setting acquisition records, the lost opportunities in not buying new portfolio companies while on sale may not be a big deal. And this makes sense: many people who'd be trying to sell their company under these conditions would be doing so out of conviction that the company won't last until conditions are better. Why would ACAS take a chance like that when there's a sure thing in-hand?

Mind you, I feel strongly that ACAS should be doing great things with its distressed-situations analysts – and strongly want to see outstanding purchases that will pay off in spades as the market normalizes – but perhaps the biggest contribution they've added is to keep ACAS out of deals on the basis that they're just not worth the risk.

Re ACAS -- To Peter

2011-09-06T23:14:00.001-05:00

In reply to Peter's comment, I offer:

Thanks for reading, and for the kind words. Unfortunately, I started buying ACAS north of 40, so even though I (approximately) doubled at $1.80, I'm still not in the black yet on ACAS.
As to ACAS' sensitivity to the impact of 150 basis points' move on the performance of AGNC, it looks like this has two (or three) parts. First, AGNC uses some hedging techniques and I'm not sure what their impact will be. Back in 2008, when liquidity was tight, AGNC's hedges made more money than its investments. The other side of the AGNC performance is that AGNC's profits aren't based on rates, but rate spreads. AGNC finances its portfolio with repurchase agreements. Since its portfolio is liquid – that is, the portfolio is full of government-backed investments for which there is a ready market and pretty clear valuation – ACAS has (as AGNC's manager) been able to leverage the portfolio, and change the debt:equity ratio as it pleased based on the environment. So, the first part of the equation – the impact of a 150-basis-point increase on AGNC's profitability – is something that is both non-trivial and outside my realm of knowledge. What are the odds of a rate-spread inversion? I'm not really the right person to ask. The last (either second or third, depending how you are counting) part of the question asks: what is the impact of AGNC's fortunes on ACAS. Now that ACAS isn't a big shareholder of AGNC (it's sold its stake, largely at a gain; the latest 10-Q shows no unrealized AGNC-related gains and no AGNC holdings), the real impact is in its monthly management fee. This management fee is based on AGNC's assets under management. Based on the math here (more than half a penny per share per quarter added to ACAS' management fees due to the described issuance) and here (another issuance adds $0.07 per share per quarter to ACAS' revenues), it seems ACAS' revenues from AGNC are likely more sensitive to issuances than to revenues. The three months ended June 30 showed AGNC paying over $12.4m in management fees to ACAS, which based on the nearly 354m shares outstanding at the end of the last quarter reported amounts to over 3.5¢ per share (annualizing to over 14¢ per share). Profits of REITs must be distributed, so they don't generally boost assets much – and ACAS' management fee is based on assets under management, not profits. AGNC must avoid losses to protect its assets under management, but if management is as nimble in reacting to changes in the macro-environment as it has been in the past, the probability is against being stuck for a long time in a money-losing environment.

The dividend historically was paid based on BDC requirements. ACAS deliberately failed a RIC test so that its loss carryforward would not be lost (BDCs can't carry forward all the kinds of losses that C-corps can). ACAS at present has no dividend requirement. By the time ACAS has a taxable profit, I expect it'll arrange to pass RIC tests again. The question is, when will that be? Since the answer depends in part on when ACAS realizes gains and when it realizes losses, it's possible that management controls this much more than would be predicted based on projections based on the macro-environment. Essentially, I wonder what management's preference is, and whether management makes a priority out of any particular tax status. Without that knowledge, I don't think dividend timing projections will mean much.

I think the best place to mine for insight into the future of dividends may be the statements of management on quarterly calls. Still, developments since the time of the calls are likely to impact management's current thinking.

As the market is hit, ACAS' portfolio's comparables will be hit, and with it theoretically ACAS' NAV. This is an interesting time: ACAS announces another great quarter of NAV increase, and its share value is punished. Does the punishment fit the market, or is it excessive? We can't know until next quarter's announcements. Will NAV still move in the right direction? NOI?

ACAS will continue to be volatile. I still view its below-NAV pricing as a value opportunity. I think ACAS' solvency makes it appropriate to consider as a long-term investment, and long-term investments in things so diverse as to represent the broader economy are theoretically a bet on the broader economy itself. The question is, when is it appropriate to make big bets on the broader economy? Buffett has said that's what he's done, so his view is now public. For those of us with a shorter time frame, might we be better able to time entry? I certainly have very limited success timing buys and sells.

I'm much better at spotting long-term opportunity: Apple in 1998, for example. For most of the time from then on most of my assets were in Apple -- my best bet. But as volatile as that's been, there's as much opportunity to have lost money with bad timing as in ACAS. The reason I own much less now than I did was that I got bored with price stagnation during a plateau and lost shares to the exercise of covered calls when the shares started moving again. Heightening exposure to volatility risk might not be the best strategy for the long-term investor. Assuming the underlying thesis is good, the only safety may be adopting a Buffett-like investment horizon.

Best wishes!

ACAS: Nice Gain Selling Another Portfolio Company

2011-09-02T11:06:00.004-05:00

Today, American Capital Ltd. announced the August 26 closing of the sale of its portfolio company VP Acquisition Holdings Inc. ("Value Plastics") for a quarter of a billion dollars. Because some of the company's equity was held in funds under management, ACAS' own proceeds received were $138m – for a recognized gain of $93m, subject to post-closing adjustments.

Value Plastics was founded in 1968; ACAS first invested in it in October of 2005 when it invested $89m in a recapitalization. Over the life of ACAS' investment, ACAS realized a compounded annual return of 29%. The proceeds received in the third quarter of 2011 were $33m greater than the FAS-157-compliant "fair value" reported at the close of the second quarter of 2011. This resulted in a realization of 31% greater proceeds than would have been projected from the prior-quarter valuation.

Although many of ACAS' portfolio company liquidations result in a realization that is within a few percent of prior-listed values, some of the portfolio can be marketed for significantly more. The inability of investors to divine which is which is a concern that bears some thinking. Assuming that management can tell the difference (else, above-valuation sale would not occur), this suggests a certain degree of upside surprise in connection with those portfolio companies that – for whatever reason – are not accurately valued using the methodology ACAS is obliged to apply to its portfolio.

This issue – whether ACAS' management has superior insight into the value of certain illiquid investments – is in play when considering ACAS' publicly-traded managed funds (e.g., AGNC and MTGE). Is ACAS able to buy below real value? Is it able to detect misvalued risks, and underpay for guaranteed loan packages? The fact that AGNC has mostly traded at a premium to NAV suggests that the market is placing a premium on ACAS' investment acumen. Whether MTGE's performance rates such a valuation has yet to be determined. If ACAS is using MTGE to purchase loan packages whose guarantors are not the U.S. government, it may be using perceived risk to obtain a "discount" to real risks it is able to assess through its experience with loan bundle performance.

Whatever the fate of MTGE may be, ACAS has demonstrated continued ability both to raise cash and to realize gains, both of which will be important to remaining atop its debt concerns and placing itself in a position to resume mandatory dividends based on taxable gains.

Buffett Illustrates Private Deals Can Be Sweeter

2011-08-25T14:41:00.003-05:00

Berkshire Hathaway just invested $5,000,000,000 (yes, the zero count is correct) in an investment vehicle that didn't exist last week: 50,000 shares of 6% preferred Bank of America shares with a 6% par value, coupled with a sweetener – warrants totaling some 700,000,000 shares of common stock, exercisable over the next decade at about $7.14. On the news, shares spiked to $8.15, but expect that number to change over the decade.

Given that Bank of America is making me a car loan at less than 4% and a home loan at something close to 5% (I never applied to BoA for a loan, but it bought both notes), I consider Berkshire's 6% coup – coupled, as it is, with a hefty equity upside opportunity – to be pretty slick. Not too long ago, Berkshire Hathaway made a similar deal with Goldman Sachs and General Electric, but with 10% preferred. Capital was tighter in late 2008, so Warren Buffet had more leverage.

Under FAS 157, Berkshire Hathaway must value its warrants using a methodology that will take into account the fact that the warrants are at least hundreds of millions in the money, and that it's got as much as a decade of time premium. It'll also be getting a quarterly dividend at a rate that's fairly respectable. At some point, when it makes sense to exercise the warrants at $7.14, it'll also get whatever the prevailing dividend is on the common shares – but will have a rate of return based on its strike price, not the market price.

Deals like this aren't available directly to small investors. To get involved in a custom-negotiated investment with a counterparty with carefully-examined risks, and a deliberately-engineered upside opportunity, one invests in a firm that makes private deals.

That was my original investment thesis in American Capital: it was (my theory went) Berkshire Hathaway diversification with small-company investment performance. Presently, American Capital is making few new investments, despite the economic climate and its current cash hoard, but instead is paying down a secured debt that it undertook restructuring pre-'08 deals that required it maintain net asset levels that the post-crash value of its illiquid assets didn't make possible. American Capital may be full of these sweet deals, but it's hard to tell because we don't see much deal stream right now. Berkshire Hathaway is clearly making deals, but it's not making them at a high rate and it can't meaningfully invest in anything that isn't enormous.

Anyone else have a line on interesting vehicles for participating in privately-negotiated deals?

UPDATE: ACAS just announced a $50m senior subordinated investment to finance the merger of two opinion survey companies, one of which had previously borrowed from American Capital in 2006. Apparently, the debt pay-down is at levels – or the deals are now at levels – at which it is willing to deploy capital to new investments.

Lenovo Hasn't Read About iPods

2011-08-21T21:04:00.003-05:00

Lenovo's chief executive Yang Yuanquing announced that it will dominate tablets in China because "Apple only covers the top tier." Lenovo, he says, will cover more price points, and reach Chinese customers that can't afford a $500 device.

Remember the Jaded Consumer prediction that Apple was underway with tablets on the same mission it undertook with iPods?

Rewind the clock a few years. Manufacturers of MP3 players were laughing that Apple only sold a $500 player, and that because they could use cheaper (bigger) drives or Flash that they could build things that would reach customers at other price points.

Today? Apple has for years covered every price point from $40 to the top of the market, and with such volume of production and such supply-chain management that nobody else can really make money in the game. No Flash? Now that Flash is big enough to support a player worth printing an Apple on it, Apple is the world's largest buyer of Flash. Trying to build a Flash player to make money in Apple's playground is a tough game.

Hell, Apple's in the process of doing the same things with cell phones, a market in which Apple takes in two thirds of all profit in the entire market. Competitors like Nokia? You can't make it up in volume when you sell at a loss, buddy.

So, what's the difference between tablets and cell phones?

Cheap cell phones don't need a pricey touch screen. Any tablet must, to accommodate the expected UI, include a costly touch-sensitive full-color screen capable of displaying crisp text and viewable movies. This raises the floor on price, except to the extent competitors want to try selling unusably small tablets. Good luck making money in that market, Lenovo.
Cheap cell phones don't need high-end graphics or the horsepower to run all the apps people expect from tablets. What makes tablets so useful are, unfortunately for Lenovo, the apps. That means that unlike phones, in which manufacturers can target customers who won't run apps with a machine whose processor can't run apps, tablet competitors have to ship hardware capable of putting images on the touch-sensitive screens and capable of interpreting touch controls while the apps are running without making the sound skip. These things either involve costly mobile graphics coprocessors, or high-end low-power mobile processors, or terrible battery life that will kill sales. This also puts a floor on parts costs. It also establishes a usability threshold below which the product will suck so badly no-one would want to tarnish their good name selling it. Again: good luck, competitors.
Software. In the phone space, there are market segments in which software is unnoticeable to users. There is of course software on these low-end phones, but all users notice is that it either (a) is unnoticeable (a success) or (b) interferes with making calls (e.g., by introducing a half-second lag between every button-push and every response, so that you can't see the mis-dials caused by the software not picking up keystrokes on cheaply-built buttons, as I "enjoyed" with the phone I owned immediately prior to owning a 1st-gen iPhone). Considering how badly some well-known phone manufacturers are doing at delivering phones that just make calls without irritating users, the ability to deliver quality software and/or adequate hardware is something one can't really take for granted. And since software is a major part of the tablet universe, Apple's edge in software is an extremely serious advantage – especially in markets in which multilingual support is important, or malware makes Apple's curated platform and signed-app system more valuable. Lenovo is launching Android and MS-Windows tablets – both. Just how large are the resources Lenovi is able to put into making both those ecosystems as attractive as Apple's? (In fairness, Google and Microsoft have strong interests in building the value of each of their software platforms, but thus far the "on anybody's hardware" strategy targeted by each hasn't paid off. And in the case of Microsoft, the tablets had better be Intel-compatible unless running in a Microsoft demonstration... and what apps will be running on the non-Intel systems when support becomes official?) So, good luck on the software, which Lenovo won't control.

Given what Apple's achieved in the cell phone market without the above advantages – that is, taken over half the profit in the entire market – it's hard to credit Lenovo as a serious competitor to Apple in a market in which it competes with those advantages. Lenovo may sell units, but units aren't profit. Without profit, who wants to invest in effort to sell units at all?

The tablet market will be interesting for competition, but not for the reasons Lenovo's chief executive identifies. The interesting competition will occur not at the bottom end, but up where the products are highly desirable and capable of running exciting software. This is because the primary competition will ultimately be in software: the hardware will keep getting more affordable until, like the low-end iPod, it's pretty easy to afford. The software will be the primary differentiators, and the question will ultimately be whether the competitors will marry themselves to counterproductive ideas based on ideology, or will make strategically sound decisions that will result in high levels of perceived quality.

That's not where Lenovo is proposing to compete.

UPDATE:
Lenovo explained that it had a phone where Apple competed at $500, but also had a $150 phone for lower-budget families, where Apple could not compete. However, Apple presently holds not only the #1 unit sales slot with its 4G iPhone, but also the #2 slot with its 3GS iPhone. The older model with already-paid-for design and manufacturing setup (and RAM limited to 8GB) helps protect Apple's position on at the top of the market by removing a safe place to compete at the tier just below it. (Much as lower-capacity music players protected Apple's top position in the music-player market.) Lenovo's $150 model hasn't apparently been able to out-compete either phone. Also: Apple's better-selling phone is the more-expensive one.

Windows Phone Optimist Responds to HP's Mobile Device Exit

2011-08-20T09:05:00.004-05:00

Microsoft's Brandon Watson responded (via Twitter) to the HP exit from WebOS hardware with an invitation to extablished (and presumably bummed) WebOS developers. The invitation contains an interesting assumption -- can you spot it?

To Any Published WebOS Devs: We'll give you what you need to be successful on #WindowsPhone, incl.free phones, dev tools, and training, etc.

On my read, the invitation assumes that something Microsoft is able to deliver can enable third parties' success. In particular, it assumes that some combination of Microsoft phone hardware and development tools are capable of enabling developer success for developers whose products targeted WebOS. But given Microsoft's share of the phone OS market, which since the launch of the euphonic and musical-sounding Windows Phone 7 Series has fallen 38% from 8% to less than 5.8%, mostly within the last quarter (7.5% to 5.8%), one wonders what "success" means for a developer receiving this largesse. And whether the share Microsoft might snag from disgruntled WebOS developers (less than 2%) is really capable of moving the needle for Microsoft.

Of course, Microsoft may expect its arrangement with Nokia to result in big share. But think for a moment: Nokia's huge market share (recently just under a quarter of the market) lies in the lower-end, where margins are slimmer. And Nokia's share (measured by units) is falling. Measured by profits ... well, is a share that results in a loss bigger than a half-billion dollars per quarter really a market worth targeting? Last year, Nokia's share exceeded 40%. No longer. If Microsoft is making any money on this deal, it's making more than Nokia. What's the lifespan of a deal like that?

But Watson promises "what you need to be successful". And when has anyone from Microsoft ever lied?

On HP Quitting Tablets

2011-08-19T10:17:00.002-05:00

On The Next Web we learn that HP could not compete with Apple's iPad hardware: WebOS was over twice as fast on Apple's iPad as it was on HP's own tablet. According to Joshua Topolsky, HP claims to have plans for WebOS, even if it doesn't have plans to compete in tablet hardware.

After shelling out one point two billion greenbacks for Palm, HP has a certain amount of motivation to make something of its IP, and to retain the quality engineers it gained with the purchase. How it'll do these things is a question for which it isn't yet offering answers.

ACAS Launches MTGE IPO

2011-08-19T09:00:00.000-05:00

[Note: This post was begun 8/3/11 and, due to distractions, not completed until it was noticed in a draft bin weeks later. Sorry about that.]

As previously discussed, ACAS is launching a REIT to invest in mortgage bundles. Unlike American Capital Agency (AGNC), American Capital Mortgage Investment Corp. (MTGE) will invest mortgage-related investments that aren't necessarily backed by the guarantee of a United States agency. Selling fewer shares than initially planned (8m rather than the planned 17.5m) on the first day of the recent market rout, ACAS maintained pricing at $20. In conjunction with the public offering, ACAS directly purchased a $40m block (2m shares) of MTGE for itself.

Despite a prediction that the investment was doomed to be a loser at issuance prices – based on comparisons with other recent mREITs rather than with ACAS' other mREIT – MTGE shares (which dropped with the whole market over the first two days) have recovered to $19 and above before MTGE even demonstrated any investment performance.

I had hoped to buy under $19, but my plan had been to make the purchase in a new account funded with money I hadn't received yet, and it looks like my window for a steal has closed. I suspect that MTGE will in many ways replay AGNC, with the exception that MTGE will not have access to the derivatives income that aided AGNC during the 2008 panic. This prediction is based on the assumption that non-Agency-backed mortgage securities will be less liquid, and thus will not have a ready derivatives market to use as a hedge.

The investment thesis in MTGE is surely a reflection of ACAS' broader investment thesis: illiquid investments are likely to be underpriced due to the inefficiency of the markets for illiquid hard-to-price investments, so ACAS will buy not to resell but to hold. To counter the risk of being stuck until maturity, I expect ACAS to do things like buy variable-rate mortgages. Without the government guarantee, I expect ACAS to be looking for – and finding – medium-grade mortgage packages at afwul-grade prices, with the intent to hold for the upside of the repayments the sellers are too impatient to bet on. I believe ACAS' experience pricing AGNC's portfolio has given it a good idea where the inefficiency is in the market, and given it a hunger to buy at dirt-cheap prices mortgage bundles that aren't nearly as bad as their pricing would imply.

On the other hand, MTGE isn't barred from investing in the exact same investments as AGNC. MTGE merely has the freedom to invest more flexibly.

Oh, and ACAS is paid by MTGE an advisory fee of 1.5% of MTGE's assets, not the 1.25% it is paid by AGNC. So maybe the MTGE issuance is less exciting than it looks: ACAS gives itself a 0.25% raise while broadening its freedom to invest funds beyond agency-backed securities. The 185m raised in the initial round of funding doesn't all become MTGE assets; the 8m shares actually in the IPO are subject to underwriting fees. Assets were reportedly expected to be something like $199m, meaning that ACAS' monthly advisory fee (1/12 of 1.5% of $199m) is approaching a quarter million dollars a month. By my own math, I expect $242,000 per month to be paid to ACAS, but there may be some assets in MTGE that weren't raised on IPO Day; the expected post-IPO assets are a bit above what I calculated based on the 80¢/sh underwriting fee disclosed here. Based on the greater advisory fee in MTGE, I expect ACAS to try to raise in MTGE funds it previously raised in AGNC. MTGE's performance – and its consequent price relative to NAV – will determine how successful that effort will be.

The other advantage to ACAS? With growing management fee income, ACAS' asset management subsidiary becomes more valuable. As a component of ACAS' NAV, the asset manager is as valuable as any profitable subsidiary.

You heard it here first: MTGE is just like AGNC, but allows ACAS to deploy funds into underpriced mortgage bundles that aren't backed by an agency (which is a factor potentially exacerbating pessimism and thus creating an exciting underpricing opportunity); because ACAS is paid more to hold funds in MTGE than in AGNC, expect ACAS to try to raise future funds in MTGE, where it will also have more investment flexibility.

ACAS: What's The Cash For?

2011-08-19T08:36:00.003-05:00

At the end of last quarter, ACAS had repaid its debt to $1.642B (for a Debt:Equity ratio of 0.4:1) and held cash of $186m. Of that, ACAS has spent $40m buying 2m shares of its newly-public managed fund, MTGE. This leaves $146m, plus whatever it's generating from businesses.

Since ACAS hasn't been snapping up new companies – it's made a few add-on investments in existing portfolio companies and invested in its own subsidiary's IPO and paid down debt – one wonders what exactly ACAS is doing with its brainpower and assets. Holding pat shows confidence, but what about the thesis that economic chaos brings opportunity and that careful investment should pay huge rewards? One has to invest to get that, right?

The Jaded Consumer has a few ideas.

Share Buyback (Or Not)
First, there's been a bit of excitement over the fact that immediately following ACAS' announcement of a NAV exceeding $13, ACAS took a plunge with the rest of the market. ACAS could retire more than 10% of its shares – buying below NAV, thus driving up the assets per share dramatically – and still not run out of cash on hand. A no-brainer, right?

Look at the history. When ACAS' share price was slammed following the Panic of '08, ACAS didn't buy underpriced shares, it bought (to retire) its own underpriced debt. Buying shares doesn't lead to realized gains (imagine if it could treat issuance as a short, and close the positions it opened north of $40!), and offers no benefit to the bottom line. On a per-share basis, it is helpful; but it does nothing for the enterprise. In effect, paying people to retire their shares shrinks the company. As a BDC with aspirations to become a larger asset manager, one of the last things ACAS wants to do is to shrink the company. And look at the other side of the coin: if ACAS thought it worthwhile to issue shares to Paulson at $5.06 so recently, how could it pay a premium of over 50% to get those same shares back?

ACAS has faced below-NAV share price opportunities before. Years ago, before ACAS took ECAS private, analysts asked why ACAS would not use share buybacks to increase value. ECAS had traded below NAV from its inception, and anyone with a blank envelope-back could tell that buying ECAS shares below NAV would increase ACAS' stake in a valuable company with a steady dividend (both companies had to that point paid uninterrupted dividends). ACAS' reply was clear: ACAS was looking to grow its business, to grow ECAS, and to broaden ownership of ECAS in support of its plan to grow the whole enterprise. ACAS had no intention of reducing the size of its enterprise or of its assets under management.

But, the astute reader is surely pointing at the Jaded Consumer and laughing: that analysis is surely wrong, or outdated, or else ACAS would not have bought every share of ECAS when it took the firm private. Surely, something is missing, no? Alas, the explanation shows that nothing has changed.

ACAS did buy ECAS, but the ECAS shares were bought with ACAS shares, not with cash. The transaction did nothing to reduce the size of the enterprise. Because ECAS' discount was greater than ACAS' discount, the below-NAV issuance of ACAS to ECAS holders was accretive to ACAS. Yet, when the dust settled, no shareholders had been paid to stop being shareholders. They just held ACAS shares instead of ECAS shares.

Management Plans Massive Recapitalization
ACAS never wanted to have secured lenders. ACAS fought giving lenders a security interest in its portfolio like there was no tomorrow, and even as it was discussing the new debt agreement on quarterly calls, was already discussing plans to restructure debt to avoid having debt that doesn't move with the markets and exposing ACAS to leverage scares. ACAS wants out of its secured loans. If one recalls, ACAS built up cash during the aftermath of the Panic of '08 – eventually holding over a billion smackers while cash was king and hugely profitable mispriced-investment opportunities lay about the land like stranded fish after a receding tsunami. ACAS is once more quite possibly working on a strategy to address its capital structure issues – to obtain more flexibility than permitted under its agreements with its secured creditors – that will require money.

I don't think ACAS will be retiring equity.

What I dearly hope is that, if ACAS is foregoing panic-selling opportunities that offer decent companies at awful-company prices, its strategy for its cash is really slick. What is ACAS' distressed-opportunity team (the special situations group, mentioned here) doing, anyway? My principal thesis in ACAS is that illiquid privately-held companies trade in an inefficient market in which ACAS has opportunities to buy deals that just don't exist in efficient markets. If ACAS doesn't buy something with its money, what's it doing?

HP Kills Its Tablet, Looks to Exit PCs

2011-08-18T16:05:00.004-05:00

Despite beating Dell at the commodity PC game, HP has killed its TouchPad product and is looking to exit the PC business altogether to focus on higher-margin business (enterprise hardware, services, etc.). With WebOS gone from the mobile market, Apple's platform has fewer competitors, though Google is left (and Microsoft; but partnering with Microsoft can work out differently than expected, and even proving MSFT wrong won't lead to any contrition).

Who will be left to make a quality product?

In news from the other side of the globe, Apple has passed Lenovo in share of the China market (in sales; but remember, unit share isn't profit share). In mobile computers, DisplaySearch reckons that iPads are notebook computers and on that basis concluded that Apple became the worldwide leader in notebook unit volume during the second quarter of 2011 and in that quarter sold just more than 1 of every 5 notebooks sold worldwide. To the extent that platform market share reflects its "stickiness" and serves as a competitive advantage, Apple may have a real and growing platform advantage not just from hipness, but from the virtuous cycle of customers and developer resources being attracted to one another.

MSFT Abandons Another Market Niche (eBooks)

2011-08-15T16:53:00.003-05:00

After dumping its Zune music player product and its Kin phone hardware, it shouldn't be a surprise to see Microsoft closing down its e-Book reader. Amazon and Apple seem to have sewn up that market, and Microsoft hasn't bothered to invest in any significant competition.

At least with the Zune, MSFT tried to create both a music marketplace and a sense of buzz. The e-Book platform seems to have been launched in an expectation that because Microsoft did it, everyone would accept it as a standard, and it would naturally succeed due to fear of competition. This sort of reasoning certainly can't have much currency after the fading of wma-encrypted DRM music as a "standard" just because MSFT was selling it.

MSFT seems to be concentrating on a smaller number of core platforms and software where it's still competing: operating systems for desktop, notebook, and phone hardware; and software for its platforms (either to run on the platforms, or to support them on the back-end). Microsoft's server products have significant revenue – Exchange and IIS are major back-end products licensed at great expense by major corporations – but Netcraft's current web server graphs show that Microsoft's competition from free competition may be denying it share in the growing market even as Microsoft's revenue continues to be rich. (MSFT had once a share approaching 40% of the web server market, but MSFT's IIS now appears to have less than 20% of the web server market and is losing share. Among the million busiest sites, Microsoft's share has been less volatile but is on a steady decline.) The effect of free software's increasing capability on Microsoft's licensing outlook will turn on things like Microsoft's ability to make use of third-party tools seem burdensome and hostile to users and administrators. Microsoft's ability to do this with impunity will turn in some part on the availability of alternatives to Outlook, which customers typically use to access mail, calendar, and contact information for which Microsoft offers back-end management through its Exchange product.

If anyone has information on email server share that might offer for mailservers what Netcraft offers for web servers, I'd love to see that data.

Only 0.01% Wrong?

2011-08-14T16:16:00.005-05:00

As a computer hobbyist, the Jaded Consumer is interested in software projects and thus particularly fond of high-quality open-source software projects. Consequently, I was very interested to read that Daniel Hartmeier reported his automated spam solution had achieved a 99.5% accuracy rate in identifying spam, while only losing 0.01% of legitimate emails to false-positive assignment of "spam" status. As it happens, I am not currently running a mailserver outside my own LAN, so I have little current need for this sort of solution – but I have clients, and I read explanations like his to understand what sorts of solutions can be offered to people who don't want to spend thousands on commercial solutions.

Honestly, though, email is becoming like phone service: you don't run your own cable and tap out your own Morse any more, you pick one of a field of commodity vendors and use the service (including any offered spam control) until you decide you like another better. You usually get email service bundled with an Internet connection; there's really little purpose for many businesses to bother with their own email back-ends unless the business is large enough that in-house handling makes better economic sense for handling the business' particular security concerns. Not that all these big businesses get it right, mind you, but ....

But I didn't try to email Daniel Hartmeier about his spam solution. Instead, I emailed him about pf. The page that leads with the word "History" was last updated in 2006, and there's been a recent development in the availability of pf. As of the launch of MacOS X v.10.7 ("Lion"), the firewall originated by Daniel Hartmeier following the removal of IPFilter from the OpenBSD code repository in May of 2001. I thought I'd point out that – although the fact hadn't been advertised – the world's highest-volume Unix distribution now contained the firewall Daniel originated began some ten years ago.

So I sent Daniel an email showing that pf-specific virtual devices were present in the default installation of MacOS X "Lion". What I got back wasn't what I expected:

A message that you sent could not be delivered to one or more of its recipients. This is a permanent error. The following address(es) failed:
daniel@benzedrine.cx
SMTP error from remote mail server after end of data:
host insomnia.benzedrine.cx [213.3.30.106]: 554 5.7.1 Spam (score 3.5)

I thought the problem might be that I was using a return email address that didn't come from the domain where the mailserver was located. I sent it again from another email address, using the mailserver of the email address' own domain. I got:

Google tried to deliver your message, but it was rejected by the recipient domain. We recommend contacting the other email provider for further information about the cause of this error. The error that the other server returned was: 554 554 5.7.1 Spam (score 3.5) (state 18).

One of my other tries got a totally different failure. I even tried re-writing my email so that its text might be less apt to trigger a Bayesian spam filter set to trigger on something in my prior email; but to no avail. I suppose the lesson is this: Daniel's excellent firewall tool may be everything one might dream (correctly coded, fast, feature-rich, elegant to configure, etc.) but this doesn't mean I can easily accept his claim that he's stopping 99.5% of the spam with a 0.01% false-positive rate. For information about stopping spam successfully, I'll be reading further.

But on that firewall -- congratulations, Daniel Hartmeier, on an excellent product. It's rocked for years, and I'm pleased it's come to my own desktop. Thanks for everything.

China: Another Debt Bubble?

2011-08-13T09:13:00.005-05:00

Although the national government of China is famously a net creditor with substantial sovereign investment assets, the national government in China isn't the only government in China. Closer to where the rubber meets the road, municipal governments stand responsible for building numerous infrastructure and even housing projects. Local government units in China are restricted in their fundraising. As a result, the frauds that are commonplace everywhere else in China (from fake Apple Stores to fake infant formula, nothing appears too sacred to defile) are equally common in government funding schemes.

In one example, Loudi raised infrastructure development funds with municipal bonds fully secured by numerous tracts of developed land. The problem? To secure the huge bond issue, the land – located in a place you've never heard, with an annual household income less than $2,500 and severe under-occupancy of existing housing – is given a fictitious value commensurate with fully-occupied Chicago suburbs with an average annual household income exceeding $250,000. And based on this Bloomberg report, payment on the bonds requires the claimed land values to go up.

Chinese rating agencies, unsurprisingly, are as easily motivated by politics and favor-trading as by financial reasoning. Ratings on the Loudi bonds range from junk status to one step above U.S. Treasury obligations. According to Moody's, the aggregate local government debt in China is understated by Chinese state auditors by 3.5 trillion yuan – reflecting the murkily unclear status of local debt issuance and whether some of the off-balance-sheet local government fundraising schemes even constitute enforceable obligations. To the extent that Chinese banks are debt holders, the safety of Chinese banks may be in jeopardy. To the extent that official Chinese debt accounting is off by as much as 25%, the reliability of Chinese financial reports is gravely in doubt.

Local Chinese debt may not look very big from the U.S – a mere couple trillion bucks – but they haven't been working to build it up very long, they have no apparent checks in place to prevent issuance scams, and they're working with the central government to issue more. CNBC's John Carney asks an interesting question: if the entire GDP of China has yet to reach $5 trillion when its debt exceeds $2 trillion, what should we conclude about the strength of the economy that's producing China's current output? (For comparison, the U.S. GDP exceeds $14 trillion, and its debt has been accumulating for decades at the local, state, and federal level until it presently exceeds $17 trillion. But the U.S. economy isn't rumored to have been on fire these last few years as the Chinese economy has been reputed.)

Asian study of American business strategies didn't end with the adoption of mass production facilities, did it?

"Racehorse" Haynes Was Right About The Old-Woman's Car

2011-08-10T20:01:00.009-05:00

Over ten years ago I climbed out from behind a 1982 Mercedes 240-D – a two-ton Diesel sedan with four cylinders, no turbocharger, and acceleration like a snail heading up a wall. But it was reliable.* There, steps from the old Diesel, I met Richard "Racehorse" Haynes. We talked cars for a few minutes while approaching the auditorium that was our destination.

"I used to have a Mercedes," he said. An 8-cylinder S-Class coupe, as it turned out.

But ... used to? Why'd he get rid of it?

The answer was quick and clear: Mercedes makes "an old woman's car."

Fond of my own (admittedly sluggish) Mercedes, and having no firsthand experience with the Porsche with which he currently drove, I didn't have any particular argument to raise. We changed subjects: law. And given I was speaking to "Racehorse" Haynes, that conversation was amusing in its own right – but that's a different story. This tale is about the old woman's car.

The Old Woman's Car
Being a huge fan of my old Diesel, I was excited when Mercedes in 2004 returned to selling a Diesel sedan in the North American market. I bought a 2005 E320CDI the very summer it launched. I won't go into detail how my neighbors thought I had joined a car-of-the-month club (due to the machine being at the dealer's so frequently for unexpected service), or how little plastic parts in the shoulder belt assembly buzzed near my ear when I drove while trying to listen to the huge-priced sound system, or even how the car left me stranded repeatedly due to unexpected complete failure. And I won't go into the oft-imitated abomination that is the headrest, which forces one's head more than an inch forward of one's shoulders so one can't relax in the passenger seat (the E-class luxury seat had such awful ergonomics that L, who has significant anatomical and ergonomic training, preferred to ride in C-class Mercedes seats). I will just talk about the lag and sag of Mercedes' old-woman's car.

First: the lag. The 2005 E320 CDI did not offer 4-Matic. Two-wheel drive was the only option. So, when road conditions require harsh acceleration (e.g., a right angle on a road that winds so you can't see approaching traffic from either direction), great care was needed to obtain the best acceleration one could without pushing the rear wheels to the point of spinning out, then being called into check by the anti-skid system. But this was impossible due to old-woman's car lag.

Performance
Mercedes' vehicles are very carefully engineered – I asked high-end Mercedes-only mechanics' shops about solutions and learned that the problem exists all the way up to 12-cylinder sport coupe models, some of whose drivers had actually sold their hot rides in disgust over the issue – to wait a half-second before responding to the accelerator. Now, how long is a half-second? When you are carefully applying the accelerator searching for the most juice you can safely give the car in order to traverse a curved road with mere yards of visibility, and do so without losing control of the car to a rear-wheel spinout, you push until you feel the car is doing everything you need and then you let off so you can stop accelerating on the other side of the road. Unfortunately, the half-second lag means that you get nothing as you push, so you push a bit more, and a bit more, and by the time the car starts responding you have no idea what depth of accelerator push is having what effect on the car but by the time the car starts turning the rear wheels it's not moving at all, because they've leapt past the limits of their traction in a way no car ever behaved, even when driving a 440-cubic-inch engine in a car at least as heavy, and you've lost control of the Mercedes to a computer that is flashing a triangular warning with an exclamation point in it -- warning that the car's traction control system has overtaken the wheels.

And this isn't the scary part. Embarrassing yourself while burning rubber off your tires in public probably is bad enough, but its not the depth of this bad. No. The worst is that you are still at a stop sign, perpendicular to a curved road with mere yards of visibility along a road with a 35mph speed limit, but instead of being safely behind the stop sign waiting until it looks clear both ways you are now well into the southbound lane, moving about 2mph, with a flashing exclamation point to tell you that you're not yet in control of the Mercedes' acceleration.

In the ancient Mercury Grand Marquis, this never happened because the accelerator pedal mecahnically pulled a carburator valve, causing immediate power transfer to the rear wheels; you knew precisely what amount of push caused what acceleration because you felt it just as it happened, enabling instantaneous and intuitive adjustment to ensure you got just enough, not too much, and had complete control. But don't blame the computers. Mercedes' brake system makes hundreds of adjustments each second to prevent wheel lock-up during braking (as did the 1991 Lincoln Towncar, with its fuel-injected V-8, even more powerful than the Grand Marquis!), and could in the hands of a competent engineer solve all the same problems with acceleration.

But Mercedes doesn't want you to have controlled acceleration. Mercedes is an old woman's car. Mercedes only cares about stopping. Even when you buy a 4-wheel-drive Mercedes, you don't get 4-wheel acceleration every time you punch it -- you get two wheels until Mercedes thinks traction is failing, then you get a reactive switch into 4-wheel mode, which lasts only so long as Mercedes thinks you need it. I haven't bothered to test whether Mercedes' 4-Matic products are any better about getting across this intersection, but I've found the answer and it's such an elegant, fun answer there's little point to making excuses for Mercedes' broken products.

And a half-second delay in acceleration is broken. It robs drivers of control. It strands them at 2mph half into a lane of traffic that cannot be vetted for safety because the foliage and curving road make a pipe dream out of visibility in any conditions but night, when headlights might warn of traffic by illuminating the opposite side of the road from oncoming traffic. And rush hour is nowhere near nighttime. The half-second isn't required by any computer system, but is a direct result of a computer system that is buggy, sickeningly buggy, and probably drove my stroke risk several-fold before the vehicle finally convinced me it needed replacement.

Reliability
Mind you, the Mercedes didn't suck from bumper to bumper. The engine was a thing of beauty, pumping out ample power from six cylinders of twin-turbocharged Diesel engine. The power would have been much more appreciated, especially at the low end where Diesels have so much torque, if the accelerator lag didn't make it basically uncontrollable unless you drove like you were on your way to Church on Sunday along roads marked only with high-visibility stoplights as traffic signals, so you could trust that at every intersection it didn't matter when you moved or how quickly because you relied implicitly on the safety created by your legal right-of-way. God forbid that some municipality install a stop-sign that required you to wait until judgment and observation were required to assess safety, or that the stop was anything but an all-way stop.

The power of the engine could be felt not only in the acceleration, control of which was usurped by computers whenever lag made it impossible for a human to assess, but even driving. For example, one day I felt a vibration akin to a rumble-strip while slowing to a stop on a freeway access road. I checked, and I was nowhere near the road edge. But as I slowed, so did the frequency of the rumble, until at idle it was a slow procession of little bumps. The light changed and I touched the accelerator -- and felt the pace of the rumble strips speed.

I've seen cars that had plastic bits hanging into their wheel wells, and I've seen cars dragging parts, and I've seen all kinds of things. And this particular car had been in the shop so often with weird and intractable suspension issues that caused all kinds of clicks, bumps, and other strange noises and feelings that I frankly could imagine just about anything. Within a half mile, I had to stop: the vibration became so heinous, and the noise so awful, that I could not be reassured by the voice on the tele-aid system that there was no problem. There was a serious problem, and it was getting worse. I will save you the troubleshooting nightmare and cut to the chase: two of the engine's three (sophisticated, vibration-isolating, liquid-filled) engine mounts had failed. Basically, the engine was being held up from falling into the street by forces being exerted on the transmission. Without warranty, the repair would have been thousands of dollars. This was at about 50K mi, when factory warranty would have just expired. They say extended warranties are not a good buy, but let me tell you: don't own a recent Mercedes without one.

Undrivability didn't require 50k miles to materialize, though. Before 1K, the thing died within a block of home with no explanation, and I found myself pushing it backward out of the intersection in which it had halted. Mercedez-Benz of Greenway Plaza carefully inspected the car and pronounced it cured, but when I went to pick it up, it died the exact same way on the valet. Apparently, dealer-added security technology didn't play well with at least some of the car's numerous built-in computers, which went on strike at odd and unpredictable intervals. Eventually Greenway Mercedes removed the gear and replaced it with LoJack Early Warning, which I do not recommend unless for the insurance discount; it's a long story, but LoJack won't tell you where the car is, and Houston Police Department (to which LoJack will refer you if you call looking for your car when a tow driver drops it in an unknown location in Houston) will transfer you numerous times before you finally realize nobody at HPD has any way to obtain the location from LoJack, either. See, LoJack won't find it for you, only for the police; and the police expect LoJack to help you because finding your car isn't their problem and they've no idea who to call to get a car located with LoJack. But the insurance discount is real; price it, compare it to the LoJack product, and make a business decision. They will never find your car (the owner of the lot where the car is dumped will help you on the next business day), but the insurance discount will come like clockwork.

The clicking and bumping that occasioned slow turns on smooth pavement was an interesting lesson in maintenance. Either Greenway Mercedes lied about replacing all those suspension parts, or Mercedes' suspension parts are horribly short-lived. But there is a third option: Greenway Mercedes is incompetent, and misdiagnosed the problem repeatedly, replaced a part unrelated to the issue you demonstrated over and over after they said they'd fixed it, and kept charging Mercedes for warranty work. Actually fixing the problem would be to kill the goose that was laying the golden service eggs, no? Much better to run you and Mercedes in circles. But I conjecture. Other Mercedes-certified mechanics were shocked to hear the lengthy story of my suspension woes with the 2005 E320 CDI, completely disbelieved that Mercedes would build a product so frequently failing, and suggested in no uncertain terms that the folks at Greenway Mercedes might not be the biggest crooks in the country, but were probably the biggest crooks west of the Mississippi.

So I started having its many warranty problems handled by the evidently more competent technicians at Alex Rodriguez Mercedes. These gentlemen will bring you your loaner, swap you your car, and bring you yours back fixed – all on a schedule you agree in advance. You never have to sit in a waiting room, fight traffic, suffer scheduling problems and so forth just because you had the bad judgment to believe that because Mercedes could build an outstandingly reliable car in 1982, it would surely be able to build a reliable car in this century. Let me save you some trouble: they've completely forgotten how. But if you live anywhere near the Johnson Space Center – the place Man first tried to reach when it spoke those first words back from the surface of the moon and uttered the word "Houston", but which is too unimportant to be allowed to display any of the Space Shuttles it successfully guided into space and back – I urge you to rely on Alex Rodriguez Mercedes-Benz. They can't make the car more reliable, but they'll make you much happier while it's being maintained.

One fine day I made an appointment for A-Rod Mercedes (as they call themselves) to look into why my stereo had quit working. This was a pain for me; I like music, which is why I paid a fortune for a plussed-up sound system. I wasn't exactly surprised that it had failed; I'd had the "Command" system (which includes the plussed-up sound system controls) crash repeatedly, including while I was depending on it for maps in a strange town while under a deadline, and remain broken and unbooting for days at a time, but this time I was determined to show a competent** technician the problem so that it might finally be diagnosed and fixed. After years of this kind of mistreatment, I was determined to have it solved before the extended warranty ran out. So I explained that I had a non-emergency problem, I wanted a loaner, and I was scores of miles away. A-Rod Mercedes' friendly service advisers set me up with an appointment to have a loaner delivered the very next Monday – less than a week away – so they could sort it out with minimal inconvenience.

A few other things associated with the Command system died over the next couple of days. I assumed it was an expansion of the audio problem; the radio, the auxiliary input I used for an iPod, the mapping system (which has a voice component), all became unresponsive. Still, the Mercedes' broad array of potential text messages available to warn the driver about everything from upcoming maintenance to impending engine calamities lay silent, suggesting that nothing particularly critical was amiss, just another audio-related bug. So on Friday – three days before the Monday loaner dropoff appointment – I don't expect serious trouble when I get the car loaded with people for a little outing. Everybody is in the car, everybody is buckled, the garage door is open, and I move to turn the key.

Nada.

A red backlight emphasizes the message that there is a malfunction. But since it's not even trying to turn over, I know damned well there's a malfuction. And I call A-Rod, who promptly sends a flatbed to haul off the dead husk of the "powerful" Mercedes. Diagnosis? For over a week the car had been slowly shutting down "non-essential" systems out of concern over a "dying" battery. One would think that if the car were at the point of deliberately killing non-essential systems in anticipation of failure, it might send me a little note that failure was at least foreseeable. But no, I got stuck for the Nth time by the "new" Diesel, which disgusted me mostly because I had come to Mercedes' defense so many times when explaining how the "old" Diesel had withstood so much for so long. (And still does: everything but the crummy A/C system runs like a champ, and the A/C system is just hopeless because it was designed by people who live in a country where A/C is an option and not a necessity in a roadcar. New Mercedes A/C systems were designed by a team Mercedes sent to Arizona not to come back without an A/C that could be sold in the South with a straight face. So the new A/C is very powerful but assumes that it's being used in a dry desert, and so promptly fills with condensation in the swamps of coastal Texas and thereafter, following an incubation period, gives off a persistent and nasty mold smell that dealers pretend is not a systematic problem even as they cycle through a long list of imaginative fixes that plainly reflect substantial post-development engineering resources, but none of which work. Short term, your dealer can kill it with harsh treatments that leave the car smelling like a chemical plant, but long term it all just grows back.)

So I asked about this "battery failure". The Diesel has, after all, two big-assed batteries. Oh, I'm told, they both failed. Ahem. Both? At once? I'm thinking its the recharging system; one of the batteries had just been replaced less than a year before. Haha, that battery will be replaced under warranty, but the other one will be about $400. I search online, certain I can find a better price, but I can't: the online price for a comparable battery is actually worse than I am quoted by A-Rod Mercedes. The thing is huge, uses cutting-edge technology to produce enormous cold cranking amps, and just can't be had for cheap. The alternative is that I can't start my car; so I shell out, dubious about the charging system and about the battery life and about the reliability of a car that knows it's failing but chooses to keep the fact a secret even while shutting down ill-designed electronic subsystems I assumed were falling to crasher bugs I'd previously seen.

So I start looking for a different ride.

Trading Three-Point Stars for Four Rings
And let me tell you what fun that new ride is. With approximately the same engine displacement, the 6-cylinder 2008 Audi A6 Quattro*** has comparable interior room, a trunk that's vastly bigger even than the 2.5-corpse trunk of the Mercedes, and full-time four wheel drive. This is a huge win. You want to cross an intersection, the car doesn't lose traction then claw to get it back: it uses all four wheels to get you across with no perceptible loss of traction.

You are at full speed on the freeway and some nutjob thinks it's a good idea to swerve directly into you? The Mercedes was controllable at speed, to be sure. You turn the biiig leather wheel and, dampened beneath a fortune in ground-insulating suspension, the front wheels turn and lean on Mercedes' peculiar front-end control system and the car – driven against the front tires by the rear tires' answer to the call of the relentless Diesel – is pushed sideways out of harm's way while you rely on anti-skid technology to protect you from the risk of strange traction issues on the freeway. Once in your new lane, the Mercedes settles down from the swaying induced by the little duel between the turned front tires and the pushing, ever-pushing rear wheels. And then you're back in the bank vault, insulated from the world, safe.

The same incident passes quite differently in the Audi Quattro. You pull the wheel with the same force – part fear of the near-wreck, part anger at the risk caused by the idiot coming your way – and there is no swaying left-to-right, no conflict front-to-back, no post-lane-change settling-down period. You turn the wheel and the Audi doesn't grudgingly agree to change lanes only while grumbling about what an imposition it is to be asked.

Instead, the Audi leaps with excitement, thrilled to do your bidding, ecstatic that you've asked it to do something more interesting than keep straight-on between an endless series of dashed lines. The Audi's all-time four-wheel drive pulls you where you want to go, ignoring road oil, rain, debris of other cars' shredded tires and shattered fiberglass, and eagerly awaits your next command – its next fondest wish. Sure, the Diesel in the Mercedes has more torque and feels like it's got more raw power, even though the Audi's gasoline engine has much more listed horsepower, but most of us aren't in a roadrace and are unconcerned with track times. What we want is to know what it feels like.

And in the Audi, I feel in control. Not worried about unexpected equipment failures. Not worried about lag in reacting to emergency commands. Not worried that the maps will quit while I'm in a rush in a strange place. Not worried even that the buzzing of Mercedes' plastic parts signifies other overlooked details with safety and reliability implications that will bite me, hard, in the back when I am most vulnerable. In the Audi, I am not worried at all about the car failing for any reason to perform exactly as I demand. And that security, and that control, represent the kind power I care most about.

* Except the A/C. Well, that was reliable too I suppose – it reliably sucked.
** Competent technician in this circumstance means a technician qualified by the absence of any relationship to Mercedes-Benz of Greenway Plaza.
*** After the value fiasco I had with the new Mercedes, I was gun-shy about buying new. In 2004, the '05 was the only recent-generation Diesel to buy from Mercedes, and my personal history with cars was to keep them longer than a decade so I didn't really have a lot of concern about resale value. Never having owned an Audi, but liking the reliability and performance implications in a firm able to take 1st, 2nd, and 3rd in a grueling long-distance torture event like LeMans (in 2010; in 2011 they took 1st after losing their other cars to crashes while overtaking slower Ferrarris, for the tenth victory in twenve 24-hour races), I thought buying used would give me an opportunity to try one out for a few years to see it if treated me like I expect a car ought.

ACAS: NAV Up Again In 2Q2011

2011-08-02T18:18:00.004-05:00

American Capital announced its 2Q2011 quarterly result, and the result is more of the same: secured debt decreased ($100m repaid; ACAS has a debt:equity ratio of 0.4:1), and net operating income increased (to $71m, 145% above the year-ago quarter). But this is not the metric that most interests me as ACAS recovers from the liquidity crisis that crushed the valuation of its portfolio assets and share price. The single metric that most impacts my assessment of ACAS' recovery is the increase management is able to achieve in net asset value.

This quarter, management increased NAV to $13.16, up 10% from $11.97 in 1Q2011 and up 44% from $9.15 in 2Q2010. This valuation increase still shows some undervaluation in assets, though: ACAS claims the value of its investment in ECAS is $933m, though the value of ECAS' assets (over which ACAS has complete dominion, just as it has dominion over ECAS itself) is $1.035B. (Note that the gap between asset value and ACAS' claimed "fair value" is decreasing; it's just not yet at parity.)

One might try to draw some conclusion from ACAS' realized losses and compare them to ACAS' unrealized gains. A familiar meme among critics and a repeated question in conference calls is whether ACAS is selling its winners to look good and getting stuck with a portfolio of losers. The fact that ACAS is able to achieve $179m in realizations is nice, but the fact that this resulted in a realized loss of $177m strongly suggests that ACAS is reclaiming unproductive capital from investments whose thesis didn't survive the crash and isn't sticking investors with dogs in the name of making a quarterly number. The realized loss is a decrease from the year-ago quarter, but ACAS realized a gain last quarter. Which brings us to ...

... what games ACAS might be playing with its books. As suggested by management previously, ACAS has just announced that it had, or by the deadline would have, failed a RIC test. Intentionally failing a RIC test was one of management's schemes to roll forward operating losses whose value would otherwise be lost to ACAS and its shareholders. Losses are a tax asset: they offset taxable income. Losing the loss would really suck, and the failed RIC test preserves the perishable asset for next year. Management said at the same time that it expected to meet the RIC test in the future: this is a tax planning stratagem, not some kind of business failure. What does that mean? ACAS may be accelerating losses into this year when they are available so that it will make the most out of its carry-forward opportunity. We usually get an opportunity to see how the quarter's business has affected the portfolio mix, but there's strong reason to doubt that with investments as illiquid as ACAS', there's a lot of power to move the timing of deals in a transaction pipeline. I don't think we'll see that the quarter's business has really changed the overall numbers for the whole ACAS portfolio, even if ACAS management were trying to rush losses and working to bargain up gains in a way that would slow their transactions into a later reporting period.

The quarterly announcement discusses things like unrealized appreciation (can't complain about $587m in unrealized appreciation, can you?) and net earnings ($410m), but these things don't affect its eventual obligation to pay a dividend on resumption of BDC status (that is driven by taxable income, not SEC-reported "earnings"). For the time being, the metrics that have my attention are NAV (what the company is worth) and NOI (what the company earns without swapping assets around). The NOI increase has definitely shown the increases I expected following the debt restructuring, and I look forward to viewing it as a barometer of the success of the company's portfolio companies.

With respect to the NAV and NOI, ACAS has one strategy that has bourne some interesting fruit. Over the last year, ACAS has grown assets under management not only by holding them while value recovered, but by having controlled companies issue equity to new investors. American Capital Agency's issuance has been accretive to shareholders of AGNC (i.e., has raised AGNC's NAV at each issuance), and has boosted ACAS' assets under management – and thus ACAS' management fees, a source of NOI. Whether the public has an appetite for shares of American Capital Mortgage Investment Corp will determine whether ACAS can use MTGE to effect more of the same.

The breadth of the portfolio companies' business across industries and geographies makes it sensitive to broad macro-economic conditions, which is why management's prediction of success bears the qualification "if the economy continues to recover." I think long-term bets are in favor of recovery, and especially as ACAS has 0.4:1 debt:equity and is no longer in debt covenant default, there's very little reason not to regard ACAS as a long-term investment. Indeed, I bought some during the quarter for my niece. This is the niece whose mother sold the AAPL I recommended ten years ago, because her broker told her it had already moved up. This ACAS purchase is an account I won't be handing over to my sister's broker.

See you next quarter :-)

Apple Profit Share Revisited: Phone Revenue Rocks

2011-07-31T16:05:00.003-05:00

As previously discussed (regarding both notebooks and smartphones), Apple's profit share exceeds its market share. This is a result of choosing to compete in market segments where it can command a premium, and ceding undesirable share to commodity vendors.

Recently, asymco's Horace Dediu reported on vendors' profit share in the mobile phone market. According to the article, Apple holds 2/3 of the profit among carriers with substantial market share. The asymco graphs drive this home nicely, with Apple's widening wedge of profit share squeezing everyone else into a shrinking slice of the available profit. The good news for these vendors is that in a growing market, they can still theoretically make a profit.

Of course, Motorola – whose leadership said that making cell phones was hard, and that Apple was not going to succeed as it imagined – has been pushed pretty much off the bottom of the graph since then. And the history of other handset manufacturers who tried to use Microsoft's platform in phones hasn't been much better. Apple's success hasn't been what Apple said it was hoping to achieve – 1% of the cell phone market – it's been much greater. There are complaints to be brought against Apple's products, to be sure – and these will increase in volume as Apple's success grows – but so long as Apple's products are so attractive to users we should expect to see

And You Thought Using MSFT Products Was Bad Enough Already

2011-07-29T15:57:00.004-05:00

You might have thought that Microsoft's customers had enough to worry about with bloatware, viruses, undocumented file formats, vendor-lock-in, unexpected network activity of word processors (for example, MS-Word opens network connections to phone about the LAN to see what license numbers other copies of MS-Word are using), and other irritations from the products themselves. New Aptiquant research suggests (as discussed on CNN) that there may be a problem with Microsoft's customers themselves: its Internet Explorer customers are reportedly also less intelligent than average.

Apparently Microsoft has had trouble getting customers to upgrade off broken and obsolete browsers it no longer supports, suggesting that there may be something to the thickness of Explorer users. Of course, with Microsoft seemingly unable to keep its own systems patched, maybe the issue is something one catches from the products ....

iPad : Tablet :: iPod : MP3 Player

2011-07-04T11:31:00.004-05:00

Another tablet launches, and hit-hungry web "journalists" ask breathlessly whether the iPad is finally done for. According to AllThingsD, the newest HP tablet uses an LG display akin to that of the first-generation iPad and lacks a GPS, allowing it to trim cost to $306.65 for the version it retails for $499. Electronista reckons that this puts HP's current product's parts costs (not including marketing, assembly, licensing, etc.) at $17 less than that of the iPad2. The device is a bit thicker, lacks the breadth of available applications, doesn't support HD video capture, hasn't got a rear camera, and the top user review at cnet reports the device "freezes often [but] otherwise [has a] nice interface". But the most damning indictment of the new tablet isn't something one can cure with a product refresh: it isn't an iPad. John Paczkowski of AllThingsD went beyond JadedConsumer's previous comparisons between Apple's iPad strategy and its prior success with the iPod in declaring that Apple has already succeeded in redefining the tablet product category to the point that consumers want iPads (instead of "tablets") in the same way they began shopping for iPods (instead of "MP3 players").

If Apple's steady state in the iPad market – ahem, sorry, the tablet market – comes to rest north of 70% as it did with the iPod mark– so sorry, I meant the music player market ... then Apple will be sitting pretty on a high-margin and huge-growing consumer segment with international appeal. And Apple's tech is uniquely suited to meeting international demand by supporting international needs of developers. The things that made Apple's iPhone easy to sell internationally make its WiFi and 3G-capable tablet-market-redefining iPads a cinch for international sales. DisplaySearch's forecast suggests Apple's touch screen supply control will leave it in control of the tablet market through 2011. Control of the tablet market didn't mean much a few years ago, but since the launch of the iPad the segment is looking to eclipse notebook computers in worldwide unit volume, according to UK researcher Canalys – with every two tablets costing notebook makers a unit of lost sales. So strong is this trend that Gartner has lowered PC growth forecasts based on tablet cannibalization. Counting tablets as PCs as Canalys does, Apple has grown the market and has become the fourth-largest PC vendor by worldwide unit volume.

I've got a friend who's never synched either of her family's iPads, and a few months ago I sat agape wondering what century she lived in. Yet, with the iCloud announcement, Apple has signaled the view that she isn't expected to, need not be inconvenienced to do so, and should never have to bother to do so except wirelessly from the device itself. Between Apple's online application store, cloud services, and computer-free device synching, Apple stands to improve the stickiness of its products and the value they offer customers in the form of convenience.

Apple is owning this market.

Apple: Still Ripening

2011-05-08T11:48:00.005-05:00

After passing Microsoft in market capitalization, then in revenue, Apple has finally passed it in quarterly profit. This comes not in some quirk of seasonal doldrums or in the wake of some unusual charge-down, but in the very quarter Microsoft announced solid quarterly profit buoyed by record expansion of its server and tools business segment. Apple's profit – and MSFT's struggles in Windows OEM licensing (MSFT's profit surge was attributed to the Office franchise, not the the company's Windows division) – appear directly related to Apple's success against Microsoft's offerings in the netbook space. In a related move, Microsoft launched ads seeking to compare Apple's MacBook Air to underpowered Windows netbooks that are being crushed by iPads.

Netbooks aren't Apple's only success. The iPhone business has been cleaning up. In the United States, Apple's share of the smartphone platform market (as measured not by new sales, but by subscribers) was up about half a percent from 25% to 25.5% over the period Dec'10 to Mar'11, but its share of hardware share of all mobile subscribers gained 1.1% of the entire market, from 6.8% to 7.9% (a 16% gain from its position at the end of 2010). Other vendors sell some non-smartphone products, but Apple does not: as the market heads toward smartphones, it grows Apple's addressable market. Over the period, Apple gained on RIM, which lost smartphone share (from 31.6% to 27.1%) but due to shifts toward smartphones, lost only a tenth of a percent in the broader mobile hardware market.

One can look out into the future and wonder what effect some of the major competitive trends will be – whether "free" operating systems will really place hardware competitors in a position to compete with Apple on margins, or whether control of the OS will allow Apple to capture post-sales revenues that otherwise would be lost to the hardware vendors – but the near-term has a pretty clear outlook: Apple is trouncing the competition. Not by lowering prices in a bid for short-term share, but by raising quality to capture the most premium segment of a growing market. Very nice.

ACAS 1Q2011 Earnings Announcement: What It Suggests

2011-05-03T20:16:00.004-05:00

ACAS has done it again: rather than succumbing to a dissolution in bankruptcy, it's announced another profitable quarter (presentation materials here).

First: the NAV. ACAS closed the quarter with a NAV of $11.97, up $1.26 (12%) from the prior quarter and $2.99 (33%) from 1Q2010. Honestly, this is better than a dividend: you get to defer the income until disposal.

Second: NOI. NOI isn't where ACAS gets most of its money, but it tells a story about the interest income ACAS earns and the success of operations that, due to the consolidated accounting that occurs at ACAS by virtue of its >80% ownership of its control investments, flow straight to ACAS' bottom line. NOI of 23¢ per share is up $0.04 from Q42010, and "includes ... $0.04 ... of non-recurring income related to the removal of investments from non-accrual status." (presentation, p.3) So, NOI is stable except that its non-accruing investment picture has improved over the quarter. Assuming that non-accruing investments going off non-accrual status means future investment performance, this is not really non-recurring in the sense investors care about: it's a prospect for better future performance.

The third thing is realized income. This number is quite different from SEC-reported income, because that number includes things like unrealized appreciation and other factors that readers don't think about as income. It's a useful metric at a Business Development Company because it drives the obligation to pay dividends. The prospect (obligation) for a dividend is looking clear out in the future: with $0.22 in net realized earnings over the quarter, ACAS is building a record that (when its tax loss carryforward has been exhausted) will lead to a dividend-paying requirement. And not a bad one, either.

During the quarter, ACAS paid down $517m in debt, including $300m in secured debt not due to be paid until 2013. The debt-to-equity ratio of 0.4:1 gives ACAS more freedom to do creative things going forward, as it hasn't got the noose of lender veto hanging over its fundraising and financial transaction structuring options.

The $269m in cash realizations show that ACAS is still liquid. Also, it's not involved in a series of equity fire sales: $206m came from principal payments. The exits, as usual, had little impact on overall portfolio characteristics; management offers a table to this effect on page 11 of the presentation materials.

What's ACAS doing for new investments? Slide 10 is educational: ACAS invested in three portfolio companies and provided another $97m for European Capital. ACAS is investing where it understands the business. The distressed opportunities ACAS is pursuing aren't easy to see from the high-level investor presentation (acquisition by a portfolio company?), but I like to see distressed opportunity investments. I'd like that more than the debt pay-down, frankly, though the debt pay-down may be a prelude to late-in-the-year transactions designed to obtain value from soon-to-become-worthless operating losses. I can imagine a structure in which shareholders exchange shares of old-ACAS for shares of new-ACAS that contain the exact same investments but some extra cash, while old-acas merges with a company that can use operating losses and deducts them. There's quite a bit of transaction cost for something like this, but if there are enough millions for someone to make, the transaction cost will be easily worth the price of admission for the buyer. The rumor that GE Capital is interested in ACAS is less interesting than the details of management's current hypotheses regarding mechanisms by which to glean value from the loss carryforwards.

A look at ACAS' loans on non-accrual (p.6 of the presentation) shows that past-due loans at cost have plummeted. ACAS' loans are either on non-accrual, or they're paying on time. The now-nearly-binary nature of ACAS' loan performance (Performing? Y/N) helps us assess ACAS' loan portfolio performance a bit. ACAS has $3.4B in loans at cost, of which 0.7B are on non-accrual. The non-accrual loans represent a bit less than were reported last quarter at cost. This may be a number to watch; non-accrual loans that begin performing again are a potential source of future value. This quarter, loans coming off non-accrual were worth 4¢ per share, for example. I'd like to hear what management says about the extent of this possibility.

Years ago, ACAS' management used to harp on conference calls about how the market should be valuing the company as an asset manager rather than as a heap of assets. ACAS has been working to grow assets under fee-based management – first in private funds, then in ECAS and AGNC – and although ACAS took ECAS private, it's had AGNC issue quite a few shares (in accretive, above-book-value issuances) and appears set to launch a new public fund under the symbol MTGE. Currently, ACAS' $6B in assets are being dwarfed by $37B and growing assets under management (presentation, p.24). Between AGNC and MTGE, the managed-assets column will be almost all mortgage investments. What that tells the Jaded Consumer is that ACAS is getting a lot of mileage out of its mortgage investment team. Raising the deal size is a way to better leverage the same research and market-modeling costs. Management fee doesn't scale with head count, but is linear with net assets. Every above-book issuance at AGNC is a pay raise at ACAS.

Upshot? Until the dividend resumes, I think the NAV tells the story. And that story is good. I really don't want the buyout-at-$15 rumor to be true, I want a few more quarters of this kind of NAV increase. More than a few.

AGNC's Offering Raises NAV

2011-04-23T20:30:00.003-05:00

AGNC's newest offering of 28,000,000 shares has been priced to yield gross proceeds of "approximately $780 million." That means approximately $27.85 per share. Given that the last-reported NAV was $24.24, and the company's shares were just south of 65m outstanding, the issuance should result in a NAV north of $25.

Magic.

This isn't the first time existing shareholders have been blessed with a NAV boost like this. In the last quarter of 2010, the effect of issuance was 97¢ (see p.20 of the 4Q2010 presentation). Holy cow, right?

I think ACAS' management of AGNC has not only been brilliant for ACAS, but a terrific ride for shareholders of AGNC. (I told my mother to buy after the IPO at $20, then again about a year later at $15; the current quarterly dividend of $1.40 is going to do nicely for her as it continues to compound for her tax-deferred on a DRIP in her rollover IRA.)

And what does the issuance do for ACAS? Well, two things. First, 1.25% of $780,000 would be $9.75m in annual fees, but of course the gross proceeds aren't all turning into funds under management; the underwriters are getting paid from that gross. Still, adding a fee income of over $2m/quarter is nothing to sneeze at. It's about 0.7¢ per share per quarter of indefinite income, without requiring ACAS to deploy any more assets. The whole firm just got more valuable.

Dig it?

ACAS is now worth more, and so is AGNC. Who says you can't have a win-win deal on Wall Street?

Apple: 800-Pound Gorilla?

2011-04-09T15:50:00.002-05:00

Apple is being described as "locking up" supplies of touch screens so that competitors can't buy parts. This isn't new, actually. Back before the iPod was big, Apple had ordered so many of Toshiba's new-to-the-market 1.8" hard drives (unavailable elsewhere) that Toshiba wasn't willing to give anyone else a price break: Apple had ordered first, and cornered the market, achieving "almost a complete monopoly of these drives for about a year." Competitors who wanted into the market segment targeted by the iPod had two choices: a physically larger, heavier (ick) player, or a player that had the itty-bitty capacity then supported by Flash memory (bleh). The iPod had a moat borne of superior supply agreements. Apple isn't buying a huge supply just out of spite, though: it wants to secure a large supply at a price known in advance. The cost of that deal is big up-front cash payments for continuous supply at guaranteed-stable prices.

At the very time it threatens the component pricing of its competitors, Apple is accused of "poaching" PR execs from major game companies (presumably to position iPhone/iPod/iPad against Wii/PS2/etc.). What a drag, to compete with Apple's new iPhone5 and derivative iPod Touch just as the parts supply to chase Apple's market niche vanishes beneath a wave of large-scale prepaid supply contracts. Why might Apple be keen to press its advantages so hard? For one, Apple's been on the wrong side of giants with lots of cash making platform-development deals. Apple has been taught in the roughest possible way that computing hardware is about software ecosystems and content as much as about hardware capabilities and prices, and it's a hard-won lesson that may keep Apple from making the same mistakes again in the mobile arena.

To give you an idea about the scale of Apple's current success, consider its competition with what was once the most valuable company on the planet: Microsoft. Despite Jobs' 1996 declaration that the platform wars were over, and that Apple had lost, Microsoft's 2011 chief executive has Apple envy: Ballmer wants as many retail stores as Apple, but the stores just aren't performing well enough to justify the effort.

Steve Jobs' 1996 Wired interview is an interesting read in 2011. Since his return to Apple, the company has definitely leveraged some hard-earned lessons to its great advantage. Who's the 800-pound gorilla now?

Adobe to deliver cross-platform Flash!

2011-04-05T21:24:00.004-05:00

After fighting with Apple over who needed whom, Adobe – after a long and drawn out battle – has created a drag-and-drop converter for developers to turn their useless-on-a-standards-based-device Flash content into something that will run anywhere HTML5 is spoken.

Th irony, of course, is that Adobe has claimed for so long that Flash is "cross-platform development software" and necessary to "browse the whole web" and that these facts were the reason everyone should just shell out for Adobe tools and deploy to Flash. Well, well. How the world turns.

The upside for Adobe is that if its tool makes high-quality HTML5, it will have a much bigger audience for its wares than were willing to sacrifice standards. The upside for everybody else will be the avoidance of Adobe's atrocious reliability and various performance and security problems and overall quality associated with Adobe's Flash player plug-in.

(Although I include it above, I repeat the link to Daring Fireball's discussion of Adobe, Apple, and Flash because it's such an outstanding summary for those of you who may not have the time to read more than one link.)

Apple Mobile Competitors: A Quality/Quantity Conundrum

2011-04-04T08:16:00.004-05:00

IDC predicts that Android and Windows Mobile Phone 7 (or whatever it's called) will take the top two phone operating system slots by volume in the next several years.

Among the leading causes of Microsoft's reversal of its longstanding share decline is a decision by Nokia to kill its own OS in favor of Microsoft's. Just imagine: the world quantity leader in cheap phones, and the world's quantity leader in irritating and buggy desktop operating systems, joining forces to make a consumer product you can carry with you and depend on to function properly under adverse and uncontrolled conditions!

The more interesting question is whether Android's share will be in high-margin products that are genuine iPhone competitors, or whether Apple will dominate profit in phones into the future as it dominates in PC profits. If Nokia and Microsoft appear poised to make the next wave of commodity devices, but Google raises some interesting questions about how hardware partners will perform and whether together they will be able to build something that speaks to users like Apple's products apparently do.

Assuming IDC's volume predictions are accurate (a premise not without trouble; Nokia/MSFT could easily make a perfect storm of mediocrity incapable of sustaining share, and lack of carrier lock-in could impact Apple's addressable market favorably even as its hardware continues to refine and improve), we could be headed into a realm in phones like the one in PCs: Lots of folks sell boxes, but only Apple makes real money in the deal. (MSFT's trivial incremental cost of selling a license makes its software extremely profitable; to gain phone share, though, MSFT may be willing to take a serious haircut on the theory that it needs to choke off competition. NOK's decision to dump its own OS in favor of one with a per-handset licensing fee is an odd choice for a high-volume producer otherwise.)

Does someone outside Apple have a moat in premium phones?

Shallow Analysis Misrepresents Accretive Issuance as "Dilution"

2011-03-26T22:16:00.005-05:00

Today I noticed a 3/22 article at Seeking Alpha that discussed AGNC's ~~27m-share~~ public offering announcement (Seeking Alpha says 27m, but ACAS says 28m plus over-allotments up to 32.2m).

The stupid part of the article isn't getting the share count wrong, of course. The stupid part is this:

While shareholders should never like being diluted, it makes sense for AGNC to keep issuing shares to expand its holdings of securities given that shares trade at a premium to book value, which was last reported being $24.24 on February 8th. The fact that shares continue to march higher, even with the dilution, is a testament to the strength of the company's management American Capital (ACAS), and the 19% yield.

Dilution is when share issuance causes post-issuance shareholders to have less per share than before the issuance. Get it? Dilution. AGNC has been issuing shares above NAV, so that immediately after the issuance the NAV is more than before the issuance. That's not dilution, that's accretion. And no wonder people like it: as long as the same deals are available to AGNC through its ACAS-supplied management at the time of the issuance as was available at the time AGNC entered the deals that led to a NAV premium, the post-transaction NAV premium should make the whole ball of wax even more attractive.

And well it should: AGNC's transactions are in agency-backed securities in which there is no shortage, and increased transaction sizes only allows AGNC's fixed overhead to get leverage on bigger deals. Oh, wait. That's ACAS' overhead. AGNC pays ACAS a management fee based on net assets, so its overhead isn't going to change as a fraction of investment, and I am unaware of any non-ACAS overhead that is material to AGNC's operations. ACAS, on the other hand, makes bigger and bigger deals using the same management team and derives more and more profit from the operation. Its percent ownership of AGNC decreases with each issuance, but as the value of its fixed number of shares continues to swell and its management fees continue to grow, the asset manager does quite well by making the company available to more and more investors.

Fee-based asset management isn't a bad business: ask Ameriprise and Edward Jones about it. ACAS doesn't need to market very hard, though, just run the business while we bid for shares. Assuming AGNC doesn't issue any shares under over-allotments, and raises the net proceeds of $780m it anticipates, ACAS' management fee increases by nearly $10m/yr ($780m x 1.25% = $9.75m) or $813k/mo. That's quite a jump: in 2008, ACAS' entire management fee for running AGNC was $800k per quarter. Currently, with a book value over $24/share and a post-issuance share count of 92.9m (64.9m at the end of 2010 and 28m on offer, disregarding the potential for further issuance under over-allotments), ACAS' fee income for managing AGNC is over $28m/year (over $7m/q). This has grown to dwarf the dividend paid to ACAS on the 2,500,100 shares of AGNC it owned into last quarter, which at the $1.40 quarterly dividend paid $3,500,140 per quarter in dividend income ($14m/y).

ACAS has gone from having a trivial investment management fee as a bonus atop its dividend to having substantial fee income. ACAS' last annual report discloses 353.1m average diluted shares outstanding in the last quarter of 2010 (although only 342.4m outstanding). Assuming that this number remains accurate (I haven't noticed any 2011 issuance of ACAS), ACAS' post-AGNC-issuance income from its AGNC business ($28m/y) leads to per-share receipts of 7.9¢. About a penny a year is attributable to the last issuance, and the shares still trade at a premium, inviting more issuance.

Not too shabby.

ACAS isn't succeeding with AGNC by diluting investors in some share-printing Ponzi scheme, it's attracting additional investment to a strategy the investment in which has been valued by the marketplace above NAV for quite some time. Investors who buy in public offerings of new shares at prices below current market but above NAV aren't getting less than prior investors, and prior investors enjoy an increase in the assets backing each share rather than the dilution described by the article linked above. Sloppy use of language in the article tends to lead readers to believe investors are somehow being fooled by confidence into bidding up shares even as their interests are being devalued by dilutive issuance, which is just wrong, wrong, wrong.

Accretive issuance is good for AGNC owners, which is why ACAS – a former shareholder itself – has been steadily performing this very trick over and over to the delight of capital-profiting dividend investors.

Apple's Competitors' Marketers Lie To Compete

2011-03-26T21:14:00.003-05:00

Samsung has been caught not only using paid actors in its supposedly "real-world" interviews with seemingly ecstatic users purportedly found in the wild (as Microsoft was caught doing), but even lying about the thickness of the hardware it has positioned against the iPad 2.

Amazing, isn't it? How, exactly, did they suppose this would go unnoticed? Did they think nobody else had a set of calipers?

MSFT To Kill Zune?

2011-03-22T01:57:00.008-05:00

When I read that MSFT was "to Kill Off Development of New Zune Hardware" my first reaction was: someone is still selling Zune hardware?

I thought the killing-off of the Zune had been done already, by the marketplace's long yawn at the product. Decisions about the product in Redmond in 2011 smack more of coup de gras than of execution. I declared the Zune dead here in late '08, when it was clear its share came mostly at the expense of Microsoft's "partners" in its PlaysForSure DRM strategy (remember that?). Heck, just to illustrate what a lousy deal MSFT "on sale" was in 2008, I've prepared this little chart to compare it to the Dow (which I believe it's lagged since joining) and to two stocks that have the Jaded Consumer Seal of Approval (Apple and American Capital):

+25% isn't bad in two years, but it's peanuts compared to some not-too-hard-to-find alternatives.

In 2008 Microsoft's web browser share had just dipped below 90%. Now, Microsoft faces the same fate not just in browsers but on the whole operating system. Microsoft faces not just a raft of Unix and Linux distributions in various high-end-server and ultra-low-budget markets, but even one single competitor with double-digit OS share in an increasing number of markets. (MSFT's "share" in Asia and Africa, where it certainly doesn't garner retail or even US-standard OEM licensing revenues, might not be something to brag about.)

More interesting than desktop os share (c'mon, some of those are Internet-unaware point-of-sale systems whose idea of a peripheral is a cash drawer; I've seen an iPod Touch do better, wirelessly, with a cash drawer built into an Apple Store table) is the OS share as seen by online vendors. NetMarketShare offers this view of Microsoft's share of operating systems used by those who browse the web (this ignores, for example, most of the installed Unix and Linux – those are largely deployed in servers, not desktops that would run a browser). Microsoft's share of web-facing consumer machines has, according to that survey, crossed below the 90% threshold that Microsoft crossed in web browsers a couple of years ago.

This doesn't mean Microsoft is irrelevant – there are definitely areas in which neither Apple nor Google have any hope of competing at present – but the Zune isn't part of MSFT's best case for future upside. Identifying the next success story isn't necessarily obvious, and every Goliath must fear a David behind every little pile of rocks (or fall accordingly). Apple can't sleep on the music market or the phone market, and Microsoft sleeps on the desktop operating system market at its significant peril.

The death of the Zune isn't the death of MSFT, but it's a sign that the company is capable and willing to put a lot of resources into things that don't produce returns. Is that a management you want on your side? MSFT's significant cash cows (MS-Windows OS licensing and MS-Office licensing) will keep filling the milk trucks for years to come, but what is the expected upside in a world increasingly based on standards and not on locked-in proprietary formats of the sort that keep people using MS-Office?

UPDATE: despite claims that Zume is not dead, Zune has gone out of stock and the Zune podcast series terminated.

Bon Jovi: Real Men Don't Know What Music They're Buying

2011-03-20T18:09:00.005-05:00

This latest piece from Bon Jovi isn't a musical number, it's a screed against the tide.

Let's back up a few centuries. Let's say you want to hear world-class music from artists you've read about in the papers. Unless you're in Berlin, London, Paris, Vienna, Rome, or maybe Moscow, you're kinda out of luck: that's where the top acts play. There is no recording. If there's a carriage collision on the way to the venue and you are delayed, there's no way (other than by asking patrons how good it was) to know, or re-hear, what you missed. Homebound invalids get to daydream about music, unless someone can carry them to a pub where a traveling act stops – but the traveling act gigging in a local pub won't be the world-class stuff you read about in the papers, it'll be a knockoff by someone who may never have heard it. Or something completely different. And if two acts compete in the same time slot, you may miss one entirely. And there's only so many seats. And the pubs can be noisy – a poor place to hear music.

Moving forward toward the modern era, we transited through an era in which a large hand-cranked wheels carefully manufactured at great expense spun fragile graphite slabs beneath a needle connected to an amplifying cone (don't drop the recording media!) and into an era in which mass-produced handheld players let users carry an entire hour-long concert on one's belt while walking. For a few hours' wages and no trip across the ocean, the best tenor on the planet – or a rock act that died before you were born – could be enjoyed for as long as the tape held out (which might be years if not left on the dash in the summer sun). If you couldn't bear to part with that much money, bands' labels marketed as "singles" a favorite song, paired with a lesser-known song the sellers hope will get some notice due to the packaging. The "single" might be on a cheap-to-press plastic disc designed to be spun at 45 revolutions per minute (that wouldn't shatter when dropped – nice!), in which case it'd be hard to carry with you (too big), or you could plug the player's output cables into an available-everywhere tape recorder and make your own mix tape full of singles, album fragments, and everything else you might want to hear. Sometimes, whole albums were aired on the radio ad-free and you could tape the whole thing.

Today, whole songs can be found digitally encoded online, with free evaluation ranging from a 30-second clip to a full-song stream. Instead of having to buy twelve tracks from Golden Earring just to hear Radar Love and Twilight Zone, you can buy the ones you like for a small fraction of the federally-established minimum wage employers must pay employees for an hour of labor. If you fall in love with the cheap music, you can drink straight from the fire hydrant: everything that's for sale electronically is for sale on your computer, and so is everything that's not available digitally, because all record shops and secondhand book venues have become major retailers online.

Against this background, Bon Jovi's kvetch against user-previewed per-track online purchase is a quaint "we walked to school in the snow, uphill both ways"-style joke. He literally argues that the "magic" buyers "enjoyed" involved buying closed albums with no idea what they sounded like – buyers were in effect playing a lottery as to whether the music was worth the money. Bon Jovi argues this was a good thing.

Well, maybe if you are Bon Jovi: people recognize the name and buy it. It's a brand. But let's face it: for the average Joe, who wants to get what he pays for, he benefits from knowing what he's buying – and he benefits from being able to see a selection bigger than can be carried in the inventory of a physical-media-peddling corner store.

I for one never wanted to buy the picture on the album, I wanted to know what it sounded like inside. That's why, when Napster was new and I could gather songs from the libraries of likeminded listeners for review by L, we bought more music in a month than previously we'd bought in an entire year.

ACAS: ECAS Making Money, Too

2011-03-18T19:33:00.009-05:00

Recently, the Jaded Consumer posted on ACAS' recent year-end and Q4 results. One recurring feature of ACAS' finances is its undervalued holdings in European Capital (ECAS), its formerly (before early 2009) publicly-traded European investment subsidiary, which occasionally gets news releases of its own. (E.g., consider ACAS' 2Q2010 report, which discusses ECAS' valuation as a feature of ACAS' long-term prospects.)

Now, ECAS has released some 4Q2010 and full-year results of its own.

Just like ACAS, ECAS has raised its NAV over the reporting period. At the close of the fourth quarter of 2010, ECAS' NAV of €629m (for those on the left side of the pond, $890m) was up 8% over the prior quarter and up 19% over its NAV at the close of 2009. Not only have NAV increases resulted in SEC-reportable income (remember, unrealized appreciation in securities is now "income" for SEC purposes but not IRS purposes; in the case of this reporting period, it's €47m (31% ROE) on the quarter and €105m (18% ROE) over the year), but ECAS' consolidated financial statements have been boosted by its operating companies' results to a net operating income (NOI) of €29m ($41m) over the quarter and €48m ($68m) for the full year (a 29% increase over the 2009 result).

So, why is a 29% y/y increase in NOI a result to smile about? For starters, ECAS is ACAS' largest single investment. Returns like that on a large investment are much more interesting than a similar return at a portfolio company too tiny to materially impact ACAS' results. More importantly, ECAS isn't just some portfolio company: it's an application of ACAS' business model to European markets, and thus a signal both of (a) results one should expect from ACAS itself, and (b) how ACAS' management should be expected to perform across larger geographies going forward. In the near term, it shows that ACAS can grow a substantial investment's NAV from €528m to €629m in just a year, even as ACAS continues to report the investment as having a FAS-157-compliant "fair value" of $636m (that's not a typo; it really is about €449).

Since ECAS' NOI and NAV increases are not based on ACAS' "fair value" of ECAS but on the capital actually available to ECAS and the particular deals in which ECAS has that capital deployed, the NAV-discounted "fair value" of ECAS doesn't impact ACAS except to the extent that it makes it a better deal to buyers while the "fair value" ACAS continues to report trails not only the value one might assign on the basis of future cash flows but also the value ECAS would realize liquidating its holdings, or that ACAS would fairly report if it dissolved ECAS in favor of direct ownership by ACAS.

Another investment that ACAS investors will want to watch is Mirion Technologies (MION), ACAS' company that provides surveillance equipment and services to the nuclear industry. Events in Japan have raised awareness and concern about nuclear power and its safety, potentially making MION's products and services more valuable. Theoretically, Japan's recent experiences may create additional headwind for new nuclear projects, but let's face it: new nuclear projects weren't exactly queuing up to launch, and have long been subject to NIMBY opposition and regulatory hurdles of various sizes all around the globe. Japan's news will tend to prolong this trend against nuclear as a clean power option, by helping depict it as potentially frighteningly unclean. Nothing in the news out of Japan will drive existing nuclear power offline, however, but may make compliance and safety a bigger-profile issue going forward. How this impacts MION's eventual pricing as ACAS seeks to take it public is a definite must-see event for ACAS investors, because MION is ACAS' second-largest holding and – for that reason – has the potential to offer a material impact to ACAS' bottom line.

Much larger than MION, however, and much more reflective of ACAS' broader business and the success of its business model, is ECAS. Good news on ECAS – like that in the recent results – is good news indeed for ACAS.

Libyan Tyrant Attracts Likeminded Fan Praise

2011-03-06T19:38:00.002-06:00

Beleaguered Gaddafi, longstanding strongman of a state sponsor of international terror, is attracting supportive comments from other heads of state equally out of touch with the civilized world. The quotes can't be done justice; read them yourself.

On ACAS' Recent Reporting Period (Q42010 and full-year 2010)

2011-03-06T13:24:00.006-06:00

American Capital Ltd. recently posted an improved quarterly result. Net Operating Income was up to $0.19 per share in 4Q2010, and net earnings reached $1.08 per share. Return on equity in the quarter was at an annualized rate of 44%. Not bad. Over the quarter, ACAS increased net asset value (NAV) by $1.12 (12%) to $10.71. Compared to a year ago, ACAS' NAV is up 29%. Remember a couple years ago when ACAS traded under a buck?

At its 25th anniversary, American Capital was able to look back on a pretty good year. ACAS' full-year 2010 result included over a billion in net earnings ($3.02/sh) reportable under the SEC rules. (The SEC-reportable income isn't the same as IRS-reportable income, which is what drives ACAS' dividend-paying obligation. One major difference is that under FAS 157, ACAS is required to call capital appreciation "income" which private investors are not required to do in their own portfolios, because the tax rules call for recognition of income on disposition rather than on change in value. This factor – the difference between earnings based on valuation change and earnings based on recognition at disposition – is likely to make SEC-reported income and taxable income rather different since ACAS' business is investments.)

Slide #10 of the investor presentation shows ACAS has continued to experience consistent (though "lumpy") liquidity. Some of the liquidity results from borrowers making repayments of obligations outside of ACAS' control, and some results from ACAS acting to dispose of a portfolio company. ACAS hasn't been trying to dump portfolio companies, but pursuing opportunities and consummating those that were good deals. The 2010 realizations may total $1.3B, but they don't represent ACAS bailing out of its equity investments: of the billion-plus in principal payments, $874m consists principal prepayments (e.g., principal returned on exit from entire investments in which ACAS held both debt and equity) and $36m resulted from scheduled principal amortization. $40m came back to ACAS from syndications and sales of debt. ACAS' equity sales of $266m aren't trivial, but that's not where ACAS seems to have been reclaiming cash. Slide #11 shows that ACAS has gotten for its investments what ACAS has reported the investments to be worth in its quarterly SEC filings. Slide 14 shows that ACAS' investment portfolio statistics haven't changed much with ACAS' realizations (i.e., ACAS isn't selling off its best investments and collecting dogs that will later bite investors; it's selling a fair cross-section of what it's got left). One thing that's worth noting is that as a percent of the fair value of ACAS' assets, equity has grown from 27% of the portfolio's value in 1Q2009 to 40% in 4Q2010, which may simply reflect that in 1Q2009 there was no market for the equity of illiquid portfolio companies and now there is.

Following the close of 2010, American Capital continued repaying debt, not satisfied to have hit its debt:equity target ratio of 0.6:1. Over the last 6 quarters, ROE has been 44% (so 4Q2010 wasn't a fluke). From ACAS' book-value nadir at the end of 2Q2009, debt repayments have exceeded $2.1B, book value is up $1.8B.

What's the future hold? ECAS alone offers $234M in further appreciation based on evaporation of internal discounts. Expected performance of debt currently bearing a FAS-157-compliant "fair value" below face value promises a further $237M in increases. Capital loss carryforward stood at $590M at the end of calendar 2010, protecting ACAS from future tax expense while that loss carryforward is eroded by future income. Loss carryforwards protect ACAS from tax expense this year or dividend obligation in 2012, so gross results and after-tax results will be the same and liquidity can be kept rather than drained in mandatory dividends. Management believes the reports that the economy is recovering, and offered Slide #6 to suggest an association between GDP and ACAS' net earnings. ACAS' pickiness in deal selection has paid off: despite the worst recession in decades, ACAS has over the last couple of years exited control companies at higher multiples than at the time of purchase (of course, if EBITDA sucks, a high multiple may not save price; the behavior of the market generally still matters ... still, having multiples go up over this period is quite a feat).

ACAS has continued to pay down debt following the close of the 2010 calendar year (to the tune of another $150M). This doesn't reduce ACAS' interest rate, as it's as low as its current debt facility permits. Debt retirement presently provides ACAS a risk-free 9% return while strengthening ACAS' balance sheet toward the ability to borrow at more favorable rates. ACAS' management made it very clear that it didn't think its existing cost of borrowing was attractive: ACAS prefers to borrow at AAA rates, and will repay debt to get there. Share buyback, by contrast, constitutes a leverage-increasing transaction that impairs liquidity without improving the balance sheet: don't expect share buyback soon. ACAS would rather improve its portfolio and balance sheet than shrink the company with share buybacks. Refinancing would occur following the expiration of the August, 2012, yield maintenance provisions of its current debt agreements. Prepayment is available without fees, however.

The recovery program at ACAS is being conducted in two phases: (1) growing book value, then (2) re-starting the dividend. While book can still be grown tax-free (due to loss carryforwards), current shareholders benefit. Dividend resumption will turn on taxable net income following complete erosion of the loss carryforward, and will when it appears will signify that ACAS has made enough money long enough that the government again wants it paying 90% of its taxable income. It will also put ACAS back on the map for income investors. If the dividend is attractive, income investors can be expected to bid ACAS back out of its discount-to-NAV share prices.

ACAS has gotten out of a few lines of business: (1) Credit opportunities, (2) early-stage technology investment, and (3) second-lien investing and trading. American Capital's financial services business hasn't been active, but management welcomes that business as it becomes available. ACAS continues to seek new investment opportunities.

ACAS has continued to increase its funds under management, reduce its operating expenses, improve its net income, and grow its asset value. The future promises more NAV discount evaporation within ACAS' investments, and when (after 2012) ACAS re-initiates its dividend (which will be required based on taxable income) its own NAV discount will be reduced by income investors seeking regular returns based on ACAS' trailing-year taxable income. Management is focused on near-term book-value-building enterprises based on sound financial theory rather than gimmicks designed to game per-share metrics.

I have only accumulated shares since the liquidity crisis in 2008, and I expect the shares to continue appreciating under the management that's helped ACAS to recover so well since the liquidity-related collapse in 2008-9. By the time ACAS resumes a dividend, I hope to have come up with some scheme to migrate those shares into an account in which the dividend – which I expect to become substantial once more – will be less painful than in a regular account. I don't think I'll manage to move it all, though ... ahh, well.

Paying taxes on a huge dividend isn't the most awful thing that ever happened at the Jaded Consumer :-)

Hollywood Mined for Chinese Propaganda

2011-02-06T12:44:00.003-06:00

CNN posted a story about China getting caught faking video in a news broadcast about Chinese fighter pilots. The news compares the fake to the Iranian video fakes previously discussed here. The comparison is fair – the Jaded Consumer was thinking about it even before CNN drew the comparison.

There's something about despotic regimes' cheerleaders that seems to draw them to faked images and other distortions when illustrating their claims. Working hypothesis: they have no respect for the truth. Indeed, they may even have no respect for their own claims.