In the summer of 2008, I started accumulating shares of Ingersoll-Rand (IR). At that time, American economy had shown plenty of uneasy signs, while I identified IR as one of the stocks with the potential to thrive through the possible upcoming downturn. I had three reasons to back up my beliefs, first, Warren Buffet's stake in the company, second, IR's move to acquire Trane, and third, its global footprint - the Asian market would provide immense growth opportunities.
Then the unfolding of the financial turmoil later the same year proved my timing was not right. IR was hit way harder than I had figured, primarily due to their exposure to the construction (both commercial and residential) market, and the increased debt level - as a result of Trane acquisition. However, I held onto my positions and haven't changed my long-term views on the company. Now we started seeing some positive signs of the economic trend, and I think it is a good time to revisit my thoughts on IR.
A Company in Transition
First of all, a simple description of IR's business from their 10K.
"Ingersoll-Rand Company Limited (IR-Limited), a Bermuda company, and its consolidated subsidiaries (we, our, the Company) is a diversified, global company that provides products, services and solutions to enhance the quality and comfort of air in homes and buildings, transport and protect food and perishables, secure homes and commercial properties, and increase industrial productivity and efficiency. Our business segments consist of Air Conditioning Systems and Services, Climate Control Technologies, Industrial Technologies and Security Technologies, each with strong brands and leading positions within their respective markets. We generate revenue and cash primarily through the design, manufacture, sale and service of a diverse portfolio of industrial and commercial products that include well recognized, premium brand names such as Club Car, Hussmann, Ingersoll-Rand, Schlage, Thermo King and
Trane."
Here are some key points from reading their 10K, 10Q and other financial presentations.
- On June 5, 2008, for $9.6 billion, IR completed the acquisition of Trane Inc, one of the top HVAC (heating, ventilation and air conditioning) companies, previously known as American Standard Companies Inc.
- On November 30, 2007, IR completed the sale of Bobcat, Utility Equipment and Attachments business units (collectively, Compact Equipment) to Doosan Infracore for cash proceeds of approximately $4.9 billion.
- On April 30, 2007, IR completed the sale of the Road Development business unit to AB Volvo for cash proceeds of approximately $1.3 billion.
- The international share of IR's revenue has been growing at fast pace, and the trend will continue. For example, for Climate Control, in 2001, 39% of the revenue is from outside North America, and in 2008, 47%. Overall in 2008, 34% of its revenue is from outside North America.
- IR's revenue is across multiple markets, including Parts & Service (25%), Commercial Construction (23%), Residential Construction (12%), International Construction (11%), Industrial/Process (9%), Supermarkets – Cases / Install (8%), Truck and Trailer (6%), Bus, Container & Other (3%), Golf & Utility Vehicles (3%). It seems to be very well balanced, not tying to any single market.
- The parts & service revenue, as mentioned above, is 25%, a very healthy number. It represents the recurring revenue, the very type that every company seeks with greatest effort. Its increase indicates the deepened independence of the customer upon the service/parts provider, which translates into guaranteed revenue. IR continues to put high priority on developing the capabilities to deliver recurring revenue.
- IR has been using Lean Six Sigma for years, and will continue to rely on it to achieve operational excellence, which reflects IR's clear and constant awareness of efficiency and cost.
So clearly, IR is a company in transition, from a traditional asset intensive American company, towards a light-weight, international company with good margin, steady stream of revenue and maximized immunity to American economic cycle. In other words, IR has been constantly recalibrating itself to remain as a GROWTH company.
Growth
1) Both high energy cost and environmental regulations will boost the demand for energy efficient solutions for HVAC and Climate Control technologies, which is the key to IR's growth in matured market.
The combination of HVAC and Climate Control accounts for 67% of IR's total revenue. Though IR is reasonably internationalized, North America still contributes more than 60% of the revenue in both segments, especially the residential HVAC, is very much like a typical American business.
Basically both businesses are tightly linked to the economic infrastructure. HVAC services the commercial market and residential market. The commercial market can be further divided into commercial (offices, retail, lodging, etc), institutional (health care, education, government, etc) and industrial (process manufacturing, life sciences, data centers, etc). The climate control mainly serves food transport and grocery stores.
In North America, these markets have been very mature. The population and the overall economy will continue to grow, the HVAC and Climate Market should follow, but I don't see the overall demand outpaces the overall economy. Here I believe the surging energy price and stricter environmental regulation will play a significant role in IR's future. They will force the customers to seek solutions with higher energy efficiency, or green enough to meet the legal standards. This is a process to consolidate the fragmented market, where the companies with superior technology, larger market share, better management and higher productivity win. Today's IR is well positioned to take advantage of this trend.
2) IR's international footprint creates itself golden opportunities to profit from the emerging markets.
More than 30% of IR's total revenue comes from outside North America and its international appearance is very impressive. For all the four businesses, IR has manufacturing & distribution sites, sales consultant offices, and integration & service offices virtually across the entire world.
In the emerging markets, notably China and India, the bottleneck of their economic growth is the infrastructure. As a result, we see both countries put high priority, accordingly high investment into this area. For better understanding, let's paint a simplified picture here.
Combining the population of the two countries, the number we get is 2 billion. Now the 2 billion people need to live (residential development, which creates demand for IR's residential HVAC and security technologies), eat (cold chain and grocery store development, which creates demand for IR's Climate Control technology), work (commercial/institutional/industrial development, which creates demand for IR's commercial HVAC and Industrial Technology products) and move around (transportation development, which creates demand for IR's Industrial Technology products). The key here is that the demand is driven by this gigantic population, and both countries are struggling to keep up with it. Therefore, IR is presented virtually unlimited growth space.
One extra point to note. Both countries have very limited farm land but are experiencing rapid urbanization, which actually creates an exceptional demand for the cold chain technologies. Currently the Climate Control contributes around 20% of IR's total revenue. I see high chance this business becomes a key driver of IR's growth in the next 5 to 10 years.
3) IR's leading market position will continue to generate revenue from parts & services
As mentioned above, currently more than 25% of IR's total revenue is from parts and services. This is a very healthy number.
In today's business world, especially the manufacturing section, we see more and more companies sacrificing the margin to win the customer's initial adoption of their solution. The logic is simple. Once the dependency of the customer on the solution provider is established, the parts & service revenue will eventually follow, which normally has higher margin, and recurring. IR's leading market position and technology advantage means they have stronger leverage to win the customer, in turn, the increased market share will consolidate such leverage and make IR even stronger. I am expecting the parts & service revenue continue to grow at a faster pace than the overall growth rate of the entire company.
Conclusion
IR operates in a traditional industry, where we won't see explosive growth, but a steady one. We see opportunities to be created by both the recovering American economy, and the unabated emerging markets. To certain extent, IR meets the definition as a 'boring' company as defined by Peter Lynch, which makes it an even better long-term stock. At the micro level, I liked the direction that the management is driving IR towards. Normally when we analyze a company, the most tricky part would be the evaluation of the management. Since IR is Warren Buffet's pick, things get easy - there is no need to question the capability of its management. While I'd like to point out that I was impressed from reading the IR related material. I see a management team with clear vision, sound mindset and a long term strategy that is constant, simple and well defined.
One more point to add. I believe IR has the option to combine its four businesses and acts as a solution package provider, which may be an important competitive edge that IR has been enjoying, and will continue to enjoy. In IR's presentation, it frequently used the grocery store to showcase its high performance solutions, where products from all its four businesses are employed and IR is very much like a one-stop service provider for the grocery operators/builders. For the customer, the benefit in cost, efficiency and maintenance to use service from this type of 'package provider' is apparent. And for IR, its four businesses should be able to continue to create opportunities for each other and bring in more and more organic growth opportunities.
Monday, May 25, 2009
Wednesday, May 6, 2009
Thoughts on Recent Earning Reports from Visa and MasterCard
Last week, both Visa (V) and MasterCard (MA) released their quarterly earning results. Here are some thoughts on their reports and the conference calls.
1) Economic Indicator
For a long time, consumer spending has been the driving force of American economy. Albeit the arguments that now finally comes the end of such an era, it is fair to say the consumer spending remains as the most accurate indicator of the economy. Many researchers publish reports, articles, statistics, etc. to track the economic activities, looking for all sorts of signs of the economic trend. But as a matter of facts, no indicators are more accurate than the financial results from Visa and MasterCard. Actually in my opinion, both companies themselves are the indicators.
There are two aspects of the consumer spending, the number of transactions and the total spending volume. I believe there are no entities capable of tracking these numbers as accurate as V and MA. The reasons? these numbers are their business and they simply occur on the information systems owned by the big two. On the other hand, Visa and MasterCard dominate the electronic payment market, which has been widely adopted across all industries. Listening to their conference call, you will hear them talk about virtually everything, the gas, the grocery stores, the fall of CircuitCity, the restaurants, the overseas travel, etc, somewhat their business represents the overall economic picture.
Then what does this mean for the investors in both companies? In my first article on my blog (read it here), I mentioned in the bear market, we pick companies capable of holding up well during the economic downturn, and benefiting the most from the economic upturn. At that time, I listed both MA and V as my favorites. Economic recovery means more consumer spending transactions and higher spending volume, which translate directly into the improved financial results from both companies. When observers read these numbers and conclude the economy is back to life, both companies have already harvested the fruits. From this perspective, we say both companies proceed the economic upturn, and not in a speculative manner, but in a concrete and logical manner. So if you believe the American economy will come back, these two stocks will be the ones definitely flying earlier and very probably, higher.
2) Visa's Advantage Over MasterCard
In my previous discussion about MA (here), we mentioned that the Visa's dominant market position gives it the competitive edge over MA. Since MA can't produce anything with real or perceived difference from Visa's products, the competition pattern somewhat mimics that between Intel and AMD. Now based on the recent reports, it seems the Visa's dominance in the debit market gives it another layer of advantage over MA.
When we look back, the logic seems to be really simple. We are experiencing the credit crisis. Consumers cut back in credit card usage, and resort more to debit cards. This simply is a big positive for Visa. Visa saw the growth in debit card revenue offset the negative results from credit cards, but MA doesn't have such a luxury. In addition,talking about the future growth in the international market, especially in the developing countries, we all know that the credit system is a lot more complex and sophisticated than the debit system. It requires a series of setups, establishments, regulations, etc, which normally take long time to mature. But the debit card system, basically only requires the card holders have cash in their bank accounts. Therefore, the debit card's growth usually proceed the credit card. On one hand, compared to MA, Visa's dominance in the debit card market will position it better to take advantage of these growth opportunities. On the other hand, not everything is so negative for MA. Visa's advantage is mostly in the developed countries, while in the emerging markets, the opportunities presented to both are equal.
One noteworthy interesting point. In MA's 2008 10K, they quoted the recent bank consolidations as one potential risk, but in Visa's earning conference, they confirm that they expect to be the beneficiary of such consolidations. This certainly reflects Visa's dominant position, but also servers as a sign of Visa's long-term, established, strong relationships with big banks, which is intangible, but might very well be another advantage over MA.
3) International Growth
Both companies posted strong growth in the international market. Their strong performance outside the US helped offset the weak US market, guaranteeing their stock will recover at a faster pace than the US economy. Actually the global diversification is another rule I proposed to apply to pick stocks during the recession.
4) Energy Play
Both companies noted the dropping gas price negatively affected their results.
Actually MA and Visa are all good candidates for energy play.
Many believe the future era will be featured by high energy price, in that case, both companies will be benefited from this trend. After more than 100 years, the human world has been built to be relying on energy. There is no short term solutions to change this fact. High gas price may reduce several trips to Florida, but the enormous basic need will still be there, and grow, when you count in the developing countries from Asia. Both companies benefited from the short time energy bubble we witnessed in 2007 and early 2008, and I won't be surprised to see the similar situation reappear in the near future.
5) The Unabated Trends: Go Plastic and More Transactions
I continue to hold and increased my holdings in MA and Visa during the economic downturn. The underlying theory is based on two beliefs. First, the worldwide worldwide secular shift from cash and checks to electronic forms of payment will be inevitable and fast. And second, when people scale back their spending, it may, on the other hand, boost the total number of transactions. The report from both companies confirmed such views.
6) Final Conclusions
- Both companies delivered very solid performance, and Visa is even more impressive.
- I won't say MA is cheaper than Visa. I am holding onto my old opinion, Visa deserves a higher multiplier owing to its advantage over MA.
- Both stocks are not cheap. But I think the overall market may continue to push them higher.
1) Economic Indicator
For a long time, consumer spending has been the driving force of American economy. Albeit the arguments that now finally comes the end of such an era, it is fair to say the consumer spending remains as the most accurate indicator of the economy. Many researchers publish reports, articles, statistics, etc. to track the economic activities, looking for all sorts of signs of the economic trend. But as a matter of facts, no indicators are more accurate than the financial results from Visa and MasterCard. Actually in my opinion, both companies themselves are the indicators.
There are two aspects of the consumer spending, the number of transactions and the total spending volume. I believe there are no entities capable of tracking these numbers as accurate as V and MA. The reasons? these numbers are their business and they simply occur on the information systems owned by the big two. On the other hand, Visa and MasterCard dominate the electronic payment market, which has been widely adopted across all industries. Listening to their conference call, you will hear them talk about virtually everything, the gas, the grocery stores, the fall of CircuitCity, the restaurants, the overseas travel, etc, somewhat their business represents the overall economic picture.
Then what does this mean for the investors in both companies? In my first article on my blog (read it here), I mentioned in the bear market, we pick companies capable of holding up well during the economic downturn, and benefiting the most from the economic upturn. At that time, I listed both MA and V as my favorites. Economic recovery means more consumer spending transactions and higher spending volume, which translate directly into the improved financial results from both companies. When observers read these numbers and conclude the economy is back to life, both companies have already harvested the fruits. From this perspective, we say both companies proceed the economic upturn, and not in a speculative manner, but in a concrete and logical manner. So if you believe the American economy will come back, these two stocks will be the ones definitely flying earlier and very probably, higher.
2) Visa's Advantage Over MasterCard
In my previous discussion about MA (here), we mentioned that the Visa's dominant market position gives it the competitive edge over MA. Since MA can't produce anything with real or perceived difference from Visa's products, the competition pattern somewhat mimics that between Intel and AMD. Now based on the recent reports, it seems the Visa's dominance in the debit market gives it another layer of advantage over MA.
When we look back, the logic seems to be really simple. We are experiencing the credit crisis. Consumers cut back in credit card usage, and resort more to debit cards. This simply is a big positive for Visa. Visa saw the growth in debit card revenue offset the negative results from credit cards, but MA doesn't have such a luxury. In addition,talking about the future growth in the international market, especially in the developing countries, we all know that the credit system is a lot more complex and sophisticated than the debit system. It requires a series of setups, establishments, regulations, etc, which normally take long time to mature. But the debit card system, basically only requires the card holders have cash in their bank accounts. Therefore, the debit card's growth usually proceed the credit card. On one hand, compared to MA, Visa's dominance in the debit card market will position it better to take advantage of these growth opportunities. On the other hand, not everything is so negative for MA. Visa's advantage is mostly in the developed countries, while in the emerging markets, the opportunities presented to both are equal.
One noteworthy interesting point. In MA's 2008 10K, they quoted the recent bank consolidations as one potential risk, but in Visa's earning conference, they confirm that they expect to be the beneficiary of such consolidations. This certainly reflects Visa's dominant position, but also servers as a sign of Visa's long-term, established, strong relationships with big banks, which is intangible, but might very well be another advantage over MA.
3) International Growth
Both companies posted strong growth in the international market. Their strong performance outside the US helped offset the weak US market, guaranteeing their stock will recover at a faster pace than the US economy. Actually the global diversification is another rule I proposed to apply to pick stocks during the recession.
4) Energy Play
Both companies noted the dropping gas price negatively affected their results.
Actually MA and Visa are all good candidates for energy play.
Many believe the future era will be featured by high energy price, in that case, both companies will be benefited from this trend. After more than 100 years, the human world has been built to be relying on energy. There is no short term solutions to change this fact. High gas price may reduce several trips to Florida, but the enormous basic need will still be there, and grow, when you count in the developing countries from Asia. Both companies benefited from the short time energy bubble we witnessed in 2007 and early 2008, and I won't be surprised to see the similar situation reappear in the near future.
5) The Unabated Trends: Go Plastic and More Transactions
I continue to hold and increased my holdings in MA and Visa during the economic downturn. The underlying theory is based on two beliefs. First, the worldwide worldwide secular shift from cash and checks to electronic forms of payment will be inevitable and fast. And second, when people scale back their spending, it may, on the other hand, boost the total number of transactions. The report from both companies confirmed such views.
6) Final Conclusions
- Both companies delivered very solid performance, and Visa is even more impressive.
- I won't say MA is cheaper than Visa. I am holding onto my old opinion, Visa deserves a higher multiplier owing to its advantage over MA.
- Both stocks are not cheap. But I think the overall market may continue to push them higher.
Sunday, April 26, 2009
Railroad Companies: the Good, the Better and the Best
It is well known that Warren Buffet is bullish on the railroad industry. But among the top four American railroad companies, Burlington Santa Fe (BNI), Union Pacific (UNP), CSX (CSX) and Norfolk Southern (NSC), he has clear preferences. BNI is no doubt on the top, UP comes as the second, and NSC and CSX are much less favored. Through this article, I will try to provide my understanding of his logic behind his preferences. I will attempt to answer three questions, 1) why does he pick the railroad industry? 2) Why are CSX and NSC less favored? And 3) why is BNI more favored than UP?
To Question 1: Railroad has to be the future of American freight transportation
When we talk about moving freight around without incurring hefty cost, normally there are two options, the trucks and the locomotives. In the old times, thanks to the low energy cost, the advanced highway infrastructure and their point-to-point flexibility, the trucks dominated the shipping market. But now the picture is changing. I believe in the long run, the railroad will become the backbone of American freight transportation network, while the truck companies will be confined to short distance shipping, operating between railroad stations and the customer locations as a support to the national railroad network.
The above statement is based on the following facts and beliefs.
First, railroad is simply a more efficient way to move freight. According to BNI, one intermodal train removes more than 280 long-haul trucks from the nation’s highways.
Second, based on the type of freight (industrial material, agriculture product, coal, etc) , the rail is 2-8 times more fuel efficient than trucks.
Third, Rail is more environment friendly. It emits only 2.6% of the total U.S. green house gas emissions, while trucks, 21%.
Fourth, the progress of information technology helped the railroad companies build more sophisticated train control systems, resulting in increased accuracy, efficiency and flexibility, continuously narrowing the advantage of trucks over railroad.
Fifth, I believe the coming era will be featured by high energy price, which will continue to consolidate rail's cost advantage over the trucks.
Sixth, intensified environment concerns will drive stringent regulations, which will drive up the operation cost for both rail and trucks, but the impact will be a lot more punishing for trucks than for rail, thus the cost advantage of the latter will be further consolidated.
Seventh, under the recession, the cost awareness of the customers makes rail an even more attractive alternative to trucks. This will help rail companies gain market share against trucks, better position themselves to take advantage of opportunities created by the upturn economy, thus further build its dominance over trucks.
To Question 2: For BNI and UNP, The geographic layout of their railway network gives them insurmountable competitive advantage over NSC and CSX
The competitive advantage of BNI and UNP is of a unique type. It has nothing to do with branding, technology superiority or management excellence, but originates from the simple fact that BNI and UNP happen to be the ones that operate the railroad network in Midewest and West America. To be more specific, the advantage lies in the following aspects:
1) Intermodal. For all four companies, intermodal is a significant portion of their revenue. CSX and NSC operate in East America. They connect with ships from the Atlantic ocean, transport shipments originating from or destined for Europe and Latin America. Whereas BNI and UNP connects to the Pacific ports, eventually with Asia and Australia. Now the picture is clear. Across the Pacific ocean, BNI and UNP has China. On one hand, China is the world factory, manufacturing virtually everything required in American daily life, on the other hand, an emerging economic giant, thirsty for all sorts of goods produced from the American land, especially energy and agriculture products. This type of import and export is projected to grow strong for the coming dozens of years, thus offering BNI and UNP vast growth potential.
2) Agriculture. In the past several year, externally, Asian countries need to import grain from the US to feed their people, and internally, America needs corn to make ethanol. The soaring demand for these types of goods created the agricultural boom. The recession slowed things down, but will it change the domestic and international demand pattern of American agricultural products? My answer is No. Again BNI and UNP happen to own the railroads that run through the enormous American farmlands, and there is no means that is more cost effective than trains to move grain, corn or beans. The farmlands now give BNI and UNP another growth opportunity that their two brothers in the east can only dream of.
3) Geography and industrialization. In East America, the territory controlled by CSX and NSC, we see higher industrialization, dense population, numerous big cities, a slew of ports along the Atlantic Ocean, in other words, a well developed environment for all means of transportation to prosper, including trucks, ships and rail. Therefore, for CSX and NSC, in addition to competing with each other, they have to compete with other shipping means, which normally are already mature and well managed. While in the west, Rocky mountain and the desert somewhat confined the industrialization to the strip along the Pacific ocean. It is the vast plain running deep into the heart of the continent. Here we see small population, sparse cities, tiny towns and infinite farmland. It is never preferred means to move the common goods, such as coal or grain, around with trucks, because the volume would be small, the cost would be high, and normally you have to move long distances. In summary, this is an environment where only the rail can manage to survive and prosper. For BNI and UNP, except competing with each other in certain regions, they don't face any other serious challenges.
To Question 3: The black gold gives BNI the edge over UNP
In West America lies one of the largest coal reserve in the world - Power River Basin (PRB). Once it was estimated to have 200 billion short tons. The newly published study revised the number in a shocking manner, claiming 190 billion tons of reserve, about 95% of the original assessment, as economically unrecoverable. So there is only 10 billion tons left, let's accept it for now. In 2008, around 40% of American coal production came from this area, around 450 million tons, and most of them were used for power generation. With 10 billion as the reserve, it is safe to say the supply is guaranteed for at least 10 years.
And for the next 10 year, I believe the amount of coal that the railroad ships out of this area will grow year after year.
First, the growing demand of power generation requires greater coal output.
Second, currently the fuel types for power generation include petroleum, renewables, nuclear, natural gas and coal. For renewables, there is still a long way to go before they become reliable and significant sources for power generation. For nuclear, there is always the key concern about safety. For petroleum and natural gas, they are turning too expensive, and there is no chance for the trend to reverse considering the worldwide demand will only go intensified. So coal somewhat becomes the only option. I see power generations will rely more and more on coal, which adds further demand for the output from this area.
Third, coal from this area has extremely low sulfur content. Thus, many coal-fired power plants in the U.S. buy PRB coal to blend with other coal with higher sulfur content to meet the environmental regulations. We foresee the environmental regulation will become stricter, which may become another contributor to the higher demand of PRB coal.
Now comes the last and the key question. Who has the privilege to move the PRB coal? Checking the railroad network map, you will find BNI almost has exclusive coverage in the area. In 2008, 22% of BNI's revenue was from coal, and now it seems this big chunk of revenue is not only guaranteed, but also guaranteed to grow. Therefore, right here, lies the ultimate advantage of BNI over UNP.
To Question 1: Railroad has to be the future of American freight transportation
When we talk about moving freight around without incurring hefty cost, normally there are two options, the trucks and the locomotives. In the old times, thanks to the low energy cost, the advanced highway infrastructure and their point-to-point flexibility, the trucks dominated the shipping market. But now the picture is changing. I believe in the long run, the railroad will become the backbone of American freight transportation network, while the truck companies will be confined to short distance shipping, operating between railroad stations and the customer locations as a support to the national railroad network.
The above statement is based on the following facts and beliefs.
First, railroad is simply a more efficient way to move freight. According to BNI, one intermodal train removes more than 280 long-haul trucks from the nation’s highways.
Second, based on the type of freight (industrial material, agriculture product, coal, etc) , the rail is 2-8 times more fuel efficient than trucks.
Third, Rail is more environment friendly. It emits only 2.6% of the total U.S. green house gas emissions, while trucks, 21%.
Fourth, the progress of information technology helped the railroad companies build more sophisticated train control systems, resulting in increased accuracy, efficiency and flexibility, continuously narrowing the advantage of trucks over railroad.
Fifth, I believe the coming era will be featured by high energy price, which will continue to consolidate rail's cost advantage over the trucks.
Sixth, intensified environment concerns will drive stringent regulations, which will drive up the operation cost for both rail and trucks, but the impact will be a lot more punishing for trucks than for rail, thus the cost advantage of the latter will be further consolidated.
Seventh, under the recession, the cost awareness of the customers makes rail an even more attractive alternative to trucks. This will help rail companies gain market share against trucks, better position themselves to take advantage of opportunities created by the upturn economy, thus further build its dominance over trucks.
To Question 2: For BNI and UNP, The geographic layout of their railway network gives them insurmountable competitive advantage over NSC and CSX
The competitive advantage of BNI and UNP is of a unique type. It has nothing to do with branding, technology superiority or management excellence, but originates from the simple fact that BNI and UNP happen to be the ones that operate the railroad network in Midewest and West America. To be more specific, the advantage lies in the following aspects:
1) Intermodal. For all four companies, intermodal is a significant portion of their revenue. CSX and NSC operate in East America. They connect with ships from the Atlantic ocean, transport shipments originating from or destined for Europe and Latin America. Whereas BNI and UNP connects to the Pacific ports, eventually with Asia and Australia. Now the picture is clear. Across the Pacific ocean, BNI and UNP has China. On one hand, China is the world factory, manufacturing virtually everything required in American daily life, on the other hand, an emerging economic giant, thirsty for all sorts of goods produced from the American land, especially energy and agriculture products. This type of import and export is projected to grow strong for the coming dozens of years, thus offering BNI and UNP vast growth potential.
2) Agriculture. In the past several year, externally, Asian countries need to import grain from the US to feed their people, and internally, America needs corn to make ethanol. The soaring demand for these types of goods created the agricultural boom. The recession slowed things down, but will it change the domestic and international demand pattern of American agricultural products? My answer is No. Again BNI and UNP happen to own the railroads that run through the enormous American farmlands, and there is no means that is more cost effective than trains to move grain, corn or beans. The farmlands now give BNI and UNP another growth opportunity that their two brothers in the east can only dream of.
3) Geography and industrialization. In East America, the territory controlled by CSX and NSC, we see higher industrialization, dense population, numerous big cities, a slew of ports along the Atlantic Ocean, in other words, a well developed environment for all means of transportation to prosper, including trucks, ships and rail. Therefore, for CSX and NSC, in addition to competing with each other, they have to compete with other shipping means, which normally are already mature and well managed. While in the west, Rocky mountain and the desert somewhat confined the industrialization to the strip along the Pacific ocean. It is the vast plain running deep into the heart of the continent. Here we see small population, sparse cities, tiny towns and infinite farmland. It is never preferred means to move the common goods, such as coal or grain, around with trucks, because the volume would be small, the cost would be high, and normally you have to move long distances. In summary, this is an environment where only the rail can manage to survive and prosper. For BNI and UNP, except competing with each other in certain regions, they don't face any other serious challenges.
To Question 3: The black gold gives BNI the edge over UNP
In West America lies one of the largest coal reserve in the world - Power River Basin (PRB). Once it was estimated to have 200 billion short tons. The newly published study revised the number in a shocking manner, claiming 190 billion tons of reserve, about 95% of the original assessment, as economically unrecoverable. So there is only 10 billion tons left, let's accept it for now. In 2008, around 40% of American coal production came from this area, around 450 million tons, and most of them were used for power generation. With 10 billion as the reserve, it is safe to say the supply is guaranteed for at least 10 years.
And for the next 10 year, I believe the amount of coal that the railroad ships out of this area will grow year after year.
First, the growing demand of power generation requires greater coal output.
Second, currently the fuel types for power generation include petroleum, renewables, nuclear, natural gas and coal. For renewables, there is still a long way to go before they become reliable and significant sources for power generation. For nuclear, there is always the key concern about safety. For petroleum and natural gas, they are turning too expensive, and there is no chance for the trend to reverse considering the worldwide demand will only go intensified. So coal somewhat becomes the only option. I see power generations will rely more and more on coal, which adds further demand for the output from this area.
Third, coal from this area has extremely low sulfur content. Thus, many coal-fired power plants in the U.S. buy PRB coal to blend with other coal with higher sulfur content to meet the environmental regulations. We foresee the environmental regulation will become stricter, which may become another contributor to the higher demand of PRB coal.
Now comes the last and the key question. Who has the privilege to move the PRB coal? Checking the railroad network map, you will find BNI almost has exclusive coverage in the area. In 2008, 22% of BNI's revenue was from coal, and now it seems this big chunk of revenue is not only guaranteed, but also guaranteed to grow. Therefore, right here, lies the ultimate advantage of BNI over UNP.
Wednesday, April 15, 2009
MasterCard (MA): Long Term Risks
There are many articles discussing the future of the big two of the credit companies, Visa and MasterCard, and the majority expressed very positive views. In summary, the long case is built upon the following points:
1) The trend to go plastic. There are more and more people making payments by swiping the plastic cards instead of writing checks or using cash. This is a trend across the world, not only limited to the US.
2) The international market. The plastic cards in Asian and Latin American countries just started to gain popularity, which presents great growth opportunities for both companies.
3) They are not directly exposed to consumer credit risks. Both companies operate a payment network that connect the consumer, the merchant, the consumer's bank and the merchant's bank. They earn profits by charging the corresponding transaction fees, not from the interest from the credit issued to the customers. As a result, the credit crisis didn't have direct impact on their business.
4) Economic downturn caused the consumers to cut expenses, which doesn't necessarily indicate the number of payment card transactions will decline. The lost transactions in the luxury stores may be well offset by the increased volume in everyday life spending, such as groceries and gasoline.
I agree with the analysis. I think both companies operate a beautiful business model with extremely high entry barrier and great growth potential. The bear market actually presented us the rare chance to buy in at a sale price. However, there is no companies running without risks. This article is going to discuss some of the potential issues with both companies, focusing on MA. As a long term investor, I believe these are items we need to keep monitoring over time.
Bank consolidation, store cards and rebate: dangerous trend?
In MA's 10K, it describes its payment system as a 'four-party' system that involves the cardholder, the merchant, the issuer (the card holder's bank) and the acquirer (the merchant's bank). Here is a good example how the system works.
'For one example of how interchange functions, imagine a consumer making a $100 purchase with a credit card. For that $100 item, the retailer would get approximately $98. The remaining $2, known as the merchant discount and fees, gets divided up. About $1.75 would go to the card issuing bank (defined as interchange), $0.18 would go to Visa or MasterCard association (defined as assessments), and the remaining $0.07 would go to the retailer's merchant account provider.' (source: http://en.wikipedia.org/wiki/Interchange_fee)
In this model, it seems the acquirer is the role with the least importance, simply sitting behind the merchant to pocket some easy money. The issuer is the one with strongest motives, as it gets the majority of the pie. The merchant is the one with the most resistance. It is forced to raise the price of its merchandise without seeing the profit flowing into its account. The card holder is another key. His decision to use a plastic card instead of cash or check initiates the entire money flow. In addition, his decision to use whose card (which bank), and what type of card (Visa or MasterCard) decides who gets the money. Furthermore, the collective preference for the plastic cards among cardholders put the pressure on the merchants, somewhat forcing the latter to play the card game. Therefore, in MA's business model, the issuer, the merchant and the cardholder are the keys to its success and future growth.
All three groups display certain trend that we need to be aware of.
1) The banks: the collapse of the Wall Street reshuffled the entire financial industry and the banking system has undergone rapid consolidations in recent years. In 2008, 30% of MA's revenue came from the 5 largest customers, and now with fewer banks remaining and each one growing larger in size, we may see the shares of MA's revenue controlled by these banks grow bigger accordingly. As MA can't afford to lose any of these customers, they will gain more leverage over MA, capable of negotiating certain profit away from MA, thus squeeze the margin.
2) The merchant: for a long time, there have been the discussions, the controversies and the lawsuits about the interchange fee. In theory, the advance of technologies should have reduced the cost to process the payment transactions, but in reality, the proportion of the money landed in the banks' pocket went up. To be fair, I don't think the banks can justify such fat profit, and this will eventually be addressed and corrected. However, for MA or VISA, this is not necessarily a negative trend. First, the proportion of the payment distributed to MA and VISA is already minimal. It may go lower, but I doubt would be significant. Second, certainly it will demotivate the banks, but on the other hand, more merchants should become willingly to participate in the 'fairer' system, which actually will translate into more revenue for MA and VISA.
Actually the trend that bears negative indications to MA or VISA is the store card.
Nowadays, it is common to see merchants making efforts to avoid the interchange fees. The bigger players such as WalMart, Amazon, Lowe's, Macy's, etc, offer the store cards. Normally the program combines the issuer bank and acquirer bank into one, and provides incentives to the consumers to use the card by offering sales events exclusively to the card members. There are many variations in the practice, but one thing in common, MasterCard or Visa is left out of the picture.
In my opinion, the store card system is an efficient payment system that can challenge MA or Visa. I am not sure how this system will evolve, but a bold speculation, think about WalMart, Macy's and Lowe's form a coalition and negotiate one deal with one bank, say, JP Morgan, and issue one common card. This one bank will handle the entire transaction cycle between the card holders and the merchants. I see many reasons that MA and V should feel seriously threatened.
3) The consumer: in the past few years, the rebate card gained great popularity. My question is, where does the rebate come from? I know ultimately this drives up the merchandise price, kind of like the consumer pays himself part of the rebate (a hoax, isn't it?). I also understand part of it comes from the merchant, they have to give up a little extra profit if the shoppers simply choose to swipe their rebate cards. Also for the issuer banks, it is a perfect and very rewarding strategy to give up a tiny profit margin to promote the usage of the card, hence bring in larger revenue. But how does this affect MA or VISA? In 2007, MA recorded $332 million rebate as the cost against the $3,335 million fees earned, and in 2008, $357 million against $4,1116 million. I believe, on one side, they are willing to give up some profit to promote their card brand, whereas on the other side, it may be an unwillingly accepted results from negotiations with banks.
We need to monitor how this trend will affect the profit margin of the big two.
Competition with Visa: another AMD vs Intel?
In the electronic payments market, we know that Visa has the controlling market share, around 60%, and MA, around 30%. In addition, MA operates a business model almost identical to Visa, in other words, MA doesn't make any products with real or perceived difference from the Visa. Does this sound disturbing? And familiar? Won't it remind you the competition between AMD and Intel? As AMD can't produce anything significantly different from Intel, it has no resistance if Intel would like to pull it into the price war. With a controlling market share, Intel may still earn profit with a lowered profit margin, but AMD can only post loss. Then how about MA? is it free from this fate or pattern?
My answer is No.
I like MA's 'Priceless' commercials. Time and time again, I was touched or amused. I don't think any marketing campaigns from any other companies can be more successful. But does it make me feel my MasterCard different from my Visa card? adding another fact that I always felt the Visa commercials kind of awkward. The answer is No. In the store, I simply use whatever card that brings back more rebate. In other words, I use the card where the issuer gives up more of their profit and puts it in my pocket. Between Visa and MA, which one can afford giving up more of their profit? The obvious answer is Visa. I believe for any incentive program that MA offers to the banks, Visa can top that, but not the opposite.
Nonetheless, I don't think there is anything really worrisome here - both companies have immense growth space and there is no need for them to engage in any type of price war in the near term. But as an investor, it is a good thing to acknowledge this. Also owing to same reason, I think Visa's stock deserves a multiplier higher than MA.
Competition with American Express and Discover: whose business model is better?
The business model of AXP and DFS differs from the big two in the fact that they issue credit to the cardholders, to a certain extent, they operate as a bank. Then which business model is better? My preference is AXP and DFS.
The stock price of AXP and DFS was punished harsh during this bear market, partly owing to their own management mistakes. However, neither the stock price nor the capability of their management should be used to evaluate their business model. Adding MA itself to the so called four-party payment system, it is actually a five-party system. From the operation perspective, it is far from a lean or efficient process. The numerous interfaces and interchanges are cumbersome, though inevitable, which adds up the cost and inflexibility. On the other hand, the business model of AXP and DFS offers the potential to consolidate the five party system into a three party system, with AXP or DFS operating as a payment system provider, an issuer as well as an acquirer. Each could pocket all the profit that is distributed between three parties under the big two's model. And further, they could extend offers to the merchants or the cardholders with a lot more flexibility and generosity.
In summary, the business model from AXP and DFS actually offers more opportunities, but for the same reason, it demands a more capable management team. In the long term, I believe both companies may have better growth potential than the big two, certainly, the assumption is that they are properly managed.
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1) The trend to go plastic. There are more and more people making payments by swiping the plastic cards instead of writing checks or using cash. This is a trend across the world, not only limited to the US.
2) The international market. The plastic cards in Asian and Latin American countries just started to gain popularity, which presents great growth opportunities for both companies.
3) They are not directly exposed to consumer credit risks. Both companies operate a payment network that connect the consumer, the merchant, the consumer's bank and the merchant's bank. They earn profits by charging the corresponding transaction fees, not from the interest from the credit issued to the customers. As a result, the credit crisis didn't have direct impact on their business.
4) Economic downturn caused the consumers to cut expenses, which doesn't necessarily indicate the number of payment card transactions will decline. The lost transactions in the luxury stores may be well offset by the increased volume in everyday life spending, such as groceries and gasoline.
I agree with the analysis. I think both companies operate a beautiful business model with extremely high entry barrier and great growth potential. The bear market actually presented us the rare chance to buy in at a sale price. However, there is no companies running without risks. This article is going to discuss some of the potential issues with both companies, focusing on MA. As a long term investor, I believe these are items we need to keep monitoring over time.
Bank consolidation, store cards and rebate: dangerous trend?
In MA's 10K, it describes its payment system as a 'four-party' system that involves the cardholder, the merchant, the issuer (the card holder's bank) and the acquirer (the merchant's bank). Here is a good example how the system works.
'For one example of how interchange functions, imagine a consumer making a $100 purchase with a credit card. For that $100 item, the retailer would get approximately $98. The remaining $2, known as the merchant discount and fees, gets divided up. About $1.75 would go to the card issuing bank (defined as interchange), $0.18 would go to Visa or MasterCard association (defined as assessments), and the remaining $0.07 would go to the retailer's merchant account provider.' (source: http://en.wikipedia.org/wiki/Interchange_fee)
In this model, it seems the acquirer is the role with the least importance, simply sitting behind the merchant to pocket some easy money. The issuer is the one with strongest motives, as it gets the majority of the pie. The merchant is the one with the most resistance. It is forced to raise the price of its merchandise without seeing the profit flowing into its account. The card holder is another key. His decision to use a plastic card instead of cash or check initiates the entire money flow. In addition, his decision to use whose card (which bank), and what type of card (Visa or MasterCard) decides who gets the money. Furthermore, the collective preference for the plastic cards among cardholders put the pressure on the merchants, somewhat forcing the latter to play the card game. Therefore, in MA's business model, the issuer, the merchant and the cardholder are the keys to its success and future growth.
All three groups display certain trend that we need to be aware of.
1) The banks: the collapse of the Wall Street reshuffled the entire financial industry and the banking system has undergone rapid consolidations in recent years. In 2008, 30% of MA's revenue came from the 5 largest customers, and now with fewer banks remaining and each one growing larger in size, we may see the shares of MA's revenue controlled by these banks grow bigger accordingly. As MA can't afford to lose any of these customers, they will gain more leverage over MA, capable of negotiating certain profit away from MA, thus squeeze the margin.
2) The merchant: for a long time, there have been the discussions, the controversies and the lawsuits about the interchange fee. In theory, the advance of technologies should have reduced the cost to process the payment transactions, but in reality, the proportion of the money landed in the banks' pocket went up. To be fair, I don't think the banks can justify such fat profit, and this will eventually be addressed and corrected. However, for MA or VISA, this is not necessarily a negative trend. First, the proportion of the payment distributed to MA and VISA is already minimal. It may go lower, but I doubt would be significant. Second, certainly it will demotivate the banks, but on the other hand, more merchants should become willingly to participate in the 'fairer' system, which actually will translate into more revenue for MA and VISA.
Actually the trend that bears negative indications to MA or VISA is the store card.
Nowadays, it is common to see merchants making efforts to avoid the interchange fees. The bigger players such as WalMart, Amazon, Lowe's, Macy's, etc, offer the store cards. Normally the program combines the issuer bank and acquirer bank into one, and provides incentives to the consumers to use the card by offering sales events exclusively to the card members. There are many variations in the practice, but one thing in common, MasterCard or Visa is left out of the picture.
In my opinion, the store card system is an efficient payment system that can challenge MA or Visa. I am not sure how this system will evolve, but a bold speculation, think about WalMart, Macy's and Lowe's form a coalition and negotiate one deal with one bank, say, JP Morgan, and issue one common card. This one bank will handle the entire transaction cycle between the card holders and the merchants. I see many reasons that MA and V should feel seriously threatened.
3) The consumer: in the past few years, the rebate card gained great popularity. My question is, where does the rebate come from? I know ultimately this drives up the merchandise price, kind of like the consumer pays himself part of the rebate (a hoax, isn't it?). I also understand part of it comes from the merchant, they have to give up a little extra profit if the shoppers simply choose to swipe their rebate cards. Also for the issuer banks, it is a perfect and very rewarding strategy to give up a tiny profit margin to promote the usage of the card, hence bring in larger revenue. But how does this affect MA or VISA? In 2007, MA recorded $332 million rebate as the cost against the $3,335 million fees earned, and in 2008, $357 million against $4,1116 million. I believe, on one side, they are willing to give up some profit to promote their card brand, whereas on the other side, it may be an unwillingly accepted results from negotiations with banks.
We need to monitor how this trend will affect the profit margin of the big two.
Competition with Visa: another AMD vs Intel?
In the electronic payments market, we know that Visa has the controlling market share, around 60%, and MA, around 30%. In addition, MA operates a business model almost identical to Visa, in other words, MA doesn't make any products with real or perceived difference from the Visa. Does this sound disturbing? And familiar? Won't it remind you the competition between AMD and Intel? As AMD can't produce anything significantly different from Intel, it has no resistance if Intel would like to pull it into the price war. With a controlling market share, Intel may still earn profit with a lowered profit margin, but AMD can only post loss. Then how about MA? is it free from this fate or pattern?
My answer is No.
I like MA's 'Priceless' commercials. Time and time again, I was touched or amused. I don't think any marketing campaigns from any other companies can be more successful. But does it make me feel my MasterCard different from my Visa card? adding another fact that I always felt the Visa commercials kind of awkward. The answer is No. In the store, I simply use whatever card that brings back more rebate. In other words, I use the card where the issuer gives up more of their profit and puts it in my pocket. Between Visa and MA, which one can afford giving up more of their profit? The obvious answer is Visa. I believe for any incentive program that MA offers to the banks, Visa can top that, but not the opposite.
Nonetheless, I don't think there is anything really worrisome here - both companies have immense growth space and there is no need for them to engage in any type of price war in the near term. But as an investor, it is a good thing to acknowledge this. Also owing to same reason, I think Visa's stock deserves a multiplier higher than MA.
Competition with American Express and Discover: whose business model is better?
The business model of AXP and DFS differs from the big two in the fact that they issue credit to the cardholders, to a certain extent, they operate as a bank. Then which business model is better? My preference is AXP and DFS.
The stock price of AXP and DFS was punished harsh during this bear market, partly owing to their own management mistakes. However, neither the stock price nor the capability of their management should be used to evaluate their business model. Adding MA itself to the so called four-party payment system, it is actually a five-party system. From the operation perspective, it is far from a lean or efficient process. The numerous interfaces and interchanges are cumbersome, though inevitable, which adds up the cost and inflexibility. On the other hand, the business model of AXP and DFS offers the potential to consolidate the five party system into a three party system, with AXP or DFS operating as a payment system provider, an issuer as well as an acquirer. Each could pocket all the profit that is distributed between three parties under the big two's model. And further, they could extend offers to the merchants or the cardholders with a lot more flexibility and generosity.
In summary, the business model from AXP and DFS actually offers more opportunities, but for the same reason, it demands a more capable management team. In the long term, I believe both companies may have better growth potential than the big two, certainly, the assumption is that they are properly managed.
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Wednesday, April 8, 2009
Microsoft: No Chance to Challenge Google
Note: this is a re-written version of the Microsoft vs Apple: Monopolist vs Innovator (part 3).
Around 10 years ago, in order to dominate the Internet browser market, Microsoft fought hard and virtually killed Netscape. This is an old and well-known story. MSFT abused its monopoly power in the Operating System market to achieve its goal, for which, it almost paid the price with its own existence - just narrowly escaped the fate to be broken up. The reasons that MSFT resorted to these 'extreme' measures were because it believed, first, Internet was the future, and second, Netscape browser had the potential to grow into an Operating System. In other words, MSFT viewed Netscape as a real strategic threat to its core business. Now ten years later, when we revisit the history, we see things that nobody could imagine in the old days. Yes, Internet turned out to be the future and presented immense business opportunities across all industries. And as MSFT expected, it maintained the monopoly control over the software used to surf the internet, but almost pitifully, its achievements never went beyond. The sweetest fruit from the Internet tree was reaped by a company called Google, which started from developing the search engine, something that Microsoft never paid attention until it was too late. From this search engine company comes the threat that MSFT fears the most - a competition OS. This time, it is a lot more real than that from Netscape. Google has the capability, the wealth and more troubling, the vision to build something to compete with Windows.
MSFT's distress and pressure are not something hidden behind the scene. Several months ago, MSFT offered to buy Yahoo for around $40 billion, my opinion, a mutual-destructive move, somewhat out of desperation. Yahoo was well on its track to become a mediocre and forgettable company, while MSFT's involvement may only speed up the process. So I was glad that MSFT backed out, notably, with the help of the stupidity of Yahoo's management (here the stupidity is defined by their IQs as a group of businessmen).
Here comes the key question that this post tries to answer. When the Internet was a wide open space, MSFT couldn't establish itself as anything significant, and now with Google looming huge, having the power to match MSFT toe to toe, what chance does MSFT stand in the Internet/search market? My answer is, none.
First, innovation is the only key that MSFT could use to break into Google's territory, unfortunately, its innovation potential has been exhausted by its internal and external pressure.
In my previous post, Microsoft vs Apple: Monopolist vs Innovator, we discussed why Apple is a company more creative than Microsoft. In summary, it is extremely demanding to develop and maintain Windows OS, which may be the most complex software in human history. This creates the internal pressure on MSFT. Externally, the brain power of its 1 billion users bears unlimited possibilities, posing all sorts of challenges to the software company, such as virus, piracy, hacking, etc. Unfortunately, I don't see any reasons MSFT could avoid addressing any one of these. This environment put MSFT under constant pressure, shaped its culture and gradually turned MSFT into a solid implementer, rather than an innovator.
On the other hand, Google, also as a monopolist, faces much less pressure than MSFT. After all, its product, the search engine, is only an applications sitting on its own servers. Even for the most malicious and capable hacker, there is not much to manipulate from Google's almost blank home page. This is a lot more forgiving operating environment, resulting in an innovation-friendly atmosphere. Actually Google's innovation capability matches well with Apple. For example, AdSense is purely a genius idea; and from GMail, you can easily detect the underlying innovation pattern, very similar to the impression you get from playing with an iPod - relentlessly focusing on the user experience.
If I rank the innovation power of Google as 10, Microsoft is 3. While in the Internet market, pretty much it is all about innovation.
Second, even as a business behemoth, Google cautiously maintains its image as a technology company, but Microsoft is perceived to be a lot more business/profit oriented. While Search is always a technical term, never a marketing term.
I don't think it is exaggerating to say that MSFT won the battle against Netscape, but at the same time completely ruined its image as a technology company. Since then, MSFT grew bigger and stronger, widely perceived to be a business juggernaut or an almighty empire. On the other hand, we saw Google spent billions of dollars to develop many normal as well as 'geeky' applications, then offered them to the public for FREE. Pretty much this is what an enthusiastic dude in the open source community would do.
Somewhat Google became a symbol of the spirit of internet technology, being open, equal and winning by technology superiority. It is even more applauded as it continues upholding the spirit after diving deep into the profit driven business world. As a result, Google created a vast fan base - another similarity with Apple - there are people that simply love Google, instead of toward Microsoft - a have-to choice.
I won't say that Google's intention to maintain itself as a technology company is not genuine, while obviously there is business strategy behind it. By offering all sorts of free applications, it is building itself into a platform for 'everything', thus growing the users' dependencies and personal attachments - another similarity with Apple, and not surprisingly, significantly increased the entry threshold for the competitors.
Talking about search, MSFT feels too clumsy, similar as Yahoo feels too shallow, but Google feels just right, simple, straightforward and a technology savvy. From this perspective, MSFT is doomed.
Third, MSFT has some basic issues to fix.
GMail is original, Yahoo Mail is solid, Hotmail is like a piece of junk. I know it maybe too biased to say this, but that is my true experience. For the past 10 years, I maintained my accounts with both Yahoo and Hotmail, but for the latter, there is always something that don't feel right, something that gets me easily annoyed. Microsoft would like to compete in the Internet field, while in this field, nothing is more basic than an email application. If they couldn't even get this one right, where is the hope?
Another one, we all understand what Google is, what Amazon is, and what eBay is, but does anybody really understand what the heck Windows Live is?
For Google, or Amazon, or eBay, it developed its understanding of the Internet, held onto it and finally found the key and opened the door to the wealth. But MSFT, after struggling for more than 10 years, still an outsider. It simply hasn't figured out the Internet. Maybe the best explanation is that they never had the right people in the right position.
In summary, maybe MSFT doesn't stand much chance against Google in the Internet/search market, but even before considering challenging Google, they have some basic and internal issues to address.
I see a re-organization a must.
Support my blog by clicking the Ads!
Around 10 years ago, in order to dominate the Internet browser market, Microsoft fought hard and virtually killed Netscape. This is an old and well-known story. MSFT abused its monopoly power in the Operating System market to achieve its goal, for which, it almost paid the price with its own existence - just narrowly escaped the fate to be broken up. The reasons that MSFT resorted to these 'extreme' measures were because it believed, first, Internet was the future, and second, Netscape browser had the potential to grow into an Operating System. In other words, MSFT viewed Netscape as a real strategic threat to its core business. Now ten years later, when we revisit the history, we see things that nobody could imagine in the old days. Yes, Internet turned out to be the future and presented immense business opportunities across all industries. And as MSFT expected, it maintained the monopoly control over the software used to surf the internet, but almost pitifully, its achievements never went beyond. The sweetest fruit from the Internet tree was reaped by a company called Google, which started from developing the search engine, something that Microsoft never paid attention until it was too late. From this search engine company comes the threat that MSFT fears the most - a competition OS. This time, it is a lot more real than that from Netscape. Google has the capability, the wealth and more troubling, the vision to build something to compete with Windows.
MSFT's distress and pressure are not something hidden behind the scene. Several months ago, MSFT offered to buy Yahoo for around $40 billion, my opinion, a mutual-destructive move, somewhat out of desperation. Yahoo was well on its track to become a mediocre and forgettable company, while MSFT's involvement may only speed up the process. So I was glad that MSFT backed out, notably, with the help of the stupidity of Yahoo's management (here the stupidity is defined by their IQs as a group of businessmen).
Here comes the key question that this post tries to answer. When the Internet was a wide open space, MSFT couldn't establish itself as anything significant, and now with Google looming huge, having the power to match MSFT toe to toe, what chance does MSFT stand in the Internet/search market? My answer is, none.
First, innovation is the only key that MSFT could use to break into Google's territory, unfortunately, its innovation potential has been exhausted by its internal and external pressure.
In my previous post, Microsoft vs Apple: Monopolist vs Innovator, we discussed why Apple is a company more creative than Microsoft. In summary, it is extremely demanding to develop and maintain Windows OS, which may be the most complex software in human history. This creates the internal pressure on MSFT. Externally, the brain power of its 1 billion users bears unlimited possibilities, posing all sorts of challenges to the software company, such as virus, piracy, hacking, etc. Unfortunately, I don't see any reasons MSFT could avoid addressing any one of these. This environment put MSFT under constant pressure, shaped its culture and gradually turned MSFT into a solid implementer, rather than an innovator.
On the other hand, Google, also as a monopolist, faces much less pressure than MSFT. After all, its product, the search engine, is only an applications sitting on its own servers. Even for the most malicious and capable hacker, there is not much to manipulate from Google's almost blank home page. This is a lot more forgiving operating environment, resulting in an innovation-friendly atmosphere. Actually Google's innovation capability matches well with Apple. For example, AdSense is purely a genius idea; and from GMail, you can easily detect the underlying innovation pattern, very similar to the impression you get from playing with an iPod - relentlessly focusing on the user experience.
If I rank the innovation power of Google as 10, Microsoft is 3. While in the Internet market, pretty much it is all about innovation.
Second, even as a business behemoth, Google cautiously maintains its image as a technology company, but Microsoft is perceived to be a lot more business/profit oriented. While Search is always a technical term, never a marketing term.
I don't think it is exaggerating to say that MSFT won the battle against Netscape, but at the same time completely ruined its image as a technology company. Since then, MSFT grew bigger and stronger, widely perceived to be a business juggernaut or an almighty empire. On the other hand, we saw Google spent billions of dollars to develop many normal as well as 'geeky' applications, then offered them to the public for FREE. Pretty much this is what an enthusiastic dude in the open source community would do.
Somewhat Google became a symbol of the spirit of internet technology, being open, equal and winning by technology superiority. It is even more applauded as it continues upholding the spirit after diving deep into the profit driven business world. As a result, Google created a vast fan base - another similarity with Apple - there are people that simply love Google, instead of toward Microsoft - a have-to choice.
I won't say that Google's intention to maintain itself as a technology company is not genuine, while obviously there is business strategy behind it. By offering all sorts of free applications, it is building itself into a platform for 'everything', thus growing the users' dependencies and personal attachments - another similarity with Apple, and not surprisingly, significantly increased the entry threshold for the competitors.
Talking about search, MSFT feels too clumsy, similar as Yahoo feels too shallow, but Google feels just right, simple, straightforward and a technology savvy. From this perspective, MSFT is doomed.
Third, MSFT has some basic issues to fix.
GMail is original, Yahoo Mail is solid, Hotmail is like a piece of junk. I know it maybe too biased to say this, but that is my true experience. For the past 10 years, I maintained my accounts with both Yahoo and Hotmail, but for the latter, there is always something that don't feel right, something that gets me easily annoyed. Microsoft would like to compete in the Internet field, while in this field, nothing is more basic than an email application. If they couldn't even get this one right, where is the hope?
Another one, we all understand what Google is, what Amazon is, and what eBay is, but does anybody really understand what the heck Windows Live is?
For Google, or Amazon, or eBay, it developed its understanding of the Internet, held onto it and finally found the key and opened the door to the wealth. But MSFT, after struggling for more than 10 years, still an outsider. It simply hasn't figured out the Internet. Maybe the best explanation is that they never had the right people in the right position.
In summary, maybe MSFT doesn't stand much chance against Google in the Internet/search market, but even before considering challenging Google, they have some basic and internal issues to address.
I see a re-organization a must.
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Sunday, April 5, 2009
Microsoft vs Apple: Monopolist vs Innovator (part 3)
4) Microsoft's chance against Google in the search market
This is a piece about MSFT and AAPL, but I think I have valid reasons to bring Google into the picture. In my opinion, Google is one of the very rare companies that enjoys an MSFT type monopolist position, and at the same time, maintains the AAPL type of innovation. In addition, innovation is the only key that Microsoft could use to break into GOOG's territory.
This is a big topic, here I'd like to share some general thoughts which I will explore further in my future posts.
First, the external pressure from being a search engine monopolist is much less than being Microsoft. GOOG has better control over the usage of its product, after all, it is an application sitting on Google's servers.
Second, Google matches Apple in the innovation power. Apple's innovation is in users' experience, which is the combination of original ideas and brilliant designs. And Google simply manufactures genius ideas, for example, AdSense.
Third, Combining the first and the second point, Google matches Apple in the capability to continue their path towards more innovations - the corresponding mechanism, culture, atmosphere all have been well established.
Fourth, Google spent billions of dollars, developing a lot of normal as well as 'geeky' applications, then offered them to the public for free. There are many reasons behind this, and I believe one of them is that they just have too much money (hehe). Another one, they are building Google into a platform for 'everything', thus growing the users' dependencies, resulting in the increased threshold for the competitors.
Fifth, even after Google turns into a business behemoth, it maintains the image as a technology company (another reason why it developed and distributed those 'geeky' applications), but Microsoft, since the days it fought and killed Netscape, has turned its public image into something like 'it is all about business' . This is another barrier that MSFT has to break. Talking about search, MSFT feels too clumsy, similar as Yahoo feels too shallow, but Google feels just right, simple, capable and a technology savvy.
Sixth, MSFT needs a big break-through in innovation ideas to challenge GOOG. But as mentioned above, its culture is about being a solid implementer, instead of an innovator. As a result, I don't see MSFT making even a dent in Google's market share in the near future.
Seventh, GMail is original, Yahoo Mail is solid, Hotmail is like a piece of junk. Nothing can explain this type of failure and it is a sign how badly Microsoft manages its internet project. Another one, does anybody really understand what the heck Windows Live is? Micorosft's issue in the search market is not something so complicated that can only be explained at a deeper level by factors such as the culture, atmosphere, etc, they have some very basic and obvious problems to address. I see a re-organization a must before there is any hope to turn things around.
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This is a piece about MSFT and AAPL, but I think I have valid reasons to bring Google into the picture. In my opinion, Google is one of the very rare companies that enjoys an MSFT type monopolist position, and at the same time, maintains the AAPL type of innovation. In addition, innovation is the only key that Microsoft could use to break into GOOG's territory.
This is a big topic, here I'd like to share some general thoughts which I will explore further in my future posts.
First, the external pressure from being a search engine monopolist is much less than being Microsoft. GOOG has better control over the usage of its product, after all, it is an application sitting on Google's servers.
Second, Google matches Apple in the innovation power. Apple's innovation is in users' experience, which is the combination of original ideas and brilliant designs. And Google simply manufactures genius ideas, for example, AdSense.
Third, Combining the first and the second point, Google matches Apple in the capability to continue their path towards more innovations - the corresponding mechanism, culture, atmosphere all have been well established.
Fourth, Google spent billions of dollars, developing a lot of normal as well as 'geeky' applications, then offered them to the public for free. There are many reasons behind this, and I believe one of them is that they just have too much money (hehe). Another one, they are building Google into a platform for 'everything', thus growing the users' dependencies, resulting in the increased threshold for the competitors.
Fifth, even after Google turns into a business behemoth, it maintains the image as a technology company (another reason why it developed and distributed those 'geeky' applications), but Microsoft, since the days it fought and killed Netscape, has turned its public image into something like 'it is all about business' . This is another barrier that MSFT has to break. Talking about search, MSFT feels too clumsy, similar as Yahoo feels too shallow, but Google feels just right, simple, capable and a technology savvy.
Sixth, MSFT needs a big break-through in innovation ideas to challenge GOOG. But as mentioned above, its culture is about being a solid implementer, instead of an innovator. As a result, I don't see MSFT making even a dent in Google's market share in the near future.
Seventh, GMail is original, Yahoo Mail is solid, Hotmail is like a piece of junk. Nothing can explain this type of failure and it is a sign how badly Microsoft manages its internet project. Another one, does anybody really understand what the heck Windows Live is? Micorosft's issue in the search market is not something so complicated that can only be explained at a deeper level by factors such as the culture, atmosphere, etc, they have some very basic and obvious problems to address. I see a re-organization a must before there is any hope to turn things around.
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Wednesday, April 1, 2009
Microsoft vs Apple: Monopolist vs Innovator (part 2)
3) Competition pattern between MSFT and AAPL
In the famous PC vs Mac Apple commercial, we laugh at the PC guy that makes a fool out of himself every time. While don't forget the fact, which is not even hidden, that these two dudes are friends. It would be too bold to claim that Microsoft and Apple are friends in the real world, but the relationship between these two is never like that between Intel and AMD.
One simple fact is that it is impossible for MSFT to control 100% of the OS market, and another one, there are always people looking for alternatives when something becomes too popular. These actually guaranteed Apple a niche but very stable market. As it is somewhat out of the reach of MSFT and is relatively small, there is no sign indicating that the OS monopolist is worried or taking serious measures to fight for it. The series of 'I am a PC' commercials from Microsoft, led by Bill Gates himself, reads to me more like taking a high road, focusing on cleaning its own name without initiating attacks to Apple. From the Apple side, it keeps its low-end laptop around $1000, a price tag of a medium/high end PC system, while it could have easily got into a much wider market by releasing laptops between the $600 and $900 price range. My opinion, Apple has three concerns here. The first is to maintain the good margin it has been enjoying all along. The second is to maintain Apple as a somewhat luxury image. And the third, maybe the most important one, Apple would like to increase its market share in a controlled manner, rather than an explosive manner. I believe Apple has the weapon to boost its market share significantly overnight (for example, licensing Mac OS), but I doubt even Apple itself thinks it is ready to handle the consequential issues.
It seems that there is some type of implicit agreements between these two. As long as AAPL doesn't openly license its OS, it will never seriously threaten MSFT. In acknowledgment of this, MSFT has no issues seeing Apple take away some customers who would like to pay a premium to be cool and happy. As a result, we see MSFT in firm control of the overall market, while Apple enjoys a 'care-free' operation environment, as well as good profit and growth opportunities even though it only has a smaller piece of the pie.
With all these said, I have a big NO for the question 'shall Apple license the Mac OS?' It is like Apple is to bet with EVERYTHING it has for something that is doubtful it can handle, and doubtful it wants. Think about the immediately intensified pressure from MSFT and the long-term internal/external pressures similar to that of MSFT (discussed in the previous post), I think Apple is far from being ready. (read the speculated scenario if Apple starts licensing its OS here).
One more topic to cover: MSFT's chance against Google in the search market.
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In the famous PC vs Mac Apple commercial, we laugh at the PC guy that makes a fool out of himself every time. While don't forget the fact, which is not even hidden, that these two dudes are friends. It would be too bold to claim that Microsoft and Apple are friends in the real world, but the relationship between these two is never like that between Intel and AMD.
One simple fact is that it is impossible for MSFT to control 100% of the OS market, and another one, there are always people looking for alternatives when something becomes too popular. These actually guaranteed Apple a niche but very stable market. As it is somewhat out of the reach of MSFT and is relatively small, there is no sign indicating that the OS monopolist is worried or taking serious measures to fight for it. The series of 'I am a PC' commercials from Microsoft, led by Bill Gates himself, reads to me more like taking a high road, focusing on cleaning its own name without initiating attacks to Apple. From the Apple side, it keeps its low-end laptop around $1000, a price tag of a medium/high end PC system, while it could have easily got into a much wider market by releasing laptops between the $600 and $900 price range. My opinion, Apple has three concerns here. The first is to maintain the good margin it has been enjoying all along. The second is to maintain Apple as a somewhat luxury image. And the third, maybe the most important one, Apple would like to increase its market share in a controlled manner, rather than an explosive manner. I believe Apple has the weapon to boost its market share significantly overnight (for example, licensing Mac OS), but I doubt even Apple itself thinks it is ready to handle the consequential issues.
It seems that there is some type of implicit agreements between these two. As long as AAPL doesn't openly license its OS, it will never seriously threaten MSFT. In acknowledgment of this, MSFT has no issues seeing Apple take away some customers who would like to pay a premium to be cool and happy. As a result, we see MSFT in firm control of the overall market, while Apple enjoys a 'care-free' operation environment, as well as good profit and growth opportunities even though it only has a smaller piece of the pie.
With all these said, I have a big NO for the question 'shall Apple license the Mac OS?' It is like Apple is to bet with EVERYTHING it has for something that is doubtful it can handle, and doubtful it wants. Think about the immediately intensified pressure from MSFT and the long-term internal/external pressures similar to that of MSFT (discussed in the previous post), I think Apple is far from being ready. (read the speculated scenario if Apple starts licensing its OS here).
One more topic to cover: MSFT's chance against Google in the search market.
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Monday, March 30, 2009
Microsoft Vs Apple: Monopolist vs Innovator (part 1)
Both Microsoft and Apple belong to the Most Innovative Companies category, however, we rarely see anything original from MSFT, instead, they are widely accused of copying ideas from Apple. I guess the reason MSFT is in this category is because the Windows OS has an innovative meaning to the entire human being. And this type of innovation doesn't necessarily indicates creativity, which, on the other hand, is the exact characteristics that differentiates Apple from the rest.
On the other hand, Microsoft is the indisputable monopolist in the Operating System world, owning around 88% of the market, and Mac OS, around 10%. However, according to many users that had experience in Mac, the OS from Apple is so much cooler than Vista, and for years, there have been voices arguing that Apple should license the OS to the OEMs, the same way that Microsoft sells its flagship product.
Here are some thoughts on the rivalry.
1) Why is Microsoft less creative?
With such a dominating market share, you may think that the business operation environment for MSFT won't be that tough. But it is the opposite - MSFT is constantly under immense internal/external pressure, which exhausts its power to stay innovative.
First, internally, the Windows OS, if not the most complex software system in human history, is well qualified to be one of the most complex ones. Virtually it is like a platform of your daily life, somewhat matching the unlimited possibilities in real life. To develop and support such a system is a daunting task for any single company. Think about it, billions of dollars in budget, thousands of developers, hundreds of modules, dozens of versions, iterations, releases, integrations, testings, code bases, documents ... there is an endless task list. If you have the experience managing a one million dollar project, you know it only takes a few mistakes to see your process spin out of control. Then try to imagine this monster at MSFT's hand. I have no clue how MSFT manages the life-cycle of Windows, but for sure it is a process demanding rigor, consistency, cautious planning and solid implementation. I won't say these values prohibit creativity, but for sure, they won't encourage creativity.
Second, Windows is an OS independent of the hardware, and MSFT only specifies the minimum hardware requirements. We understand that this is required for MSFT to maximize its market share. And the result is, MSFT has to deal with the compatibility issue with hundreds of hardware variations. On the other hand, the OS is a platform, i.e., it opens its interface for thousands of other software companies to build upon, which creates another compatibility issue. Then adding the challenges created by rapid evolving technologies and backward compatibility, these could easily turn into a disaster that devours the company. Again this is the daily task of MSFT.
Third, Windows is estimated to have more than 1 billion users worldwide, which means it is open to unlimited possibilities/challenges/risks created by the immense brain power of a vast crowd, where exist countless usage patterns/habits, unbelievable stupidity and unimaginable brilliance, geeks, hackers, pirates, virus writers, Windows lovers, Microsoft haters..... As an indicator, MSFT never escaped from the criticism about the security flaws of Windows, even after spending billions of dollars year after year attempting to fix it. Here, code quality actually is only one side of the story, the other side, the enormous user base.
In summary, all these demanding tasks that fill the daily life of MSFT ultimately defined the overall operation atmosphere and corporate culture. Here, the top priority is about being solid, thorough, proactive and making less mistakes. Then how about creativity - stay original and novel? Sure it is nice to have, but it is fine to live without it. It is a shame to copy ideas invented by others. But business-wise, what is the big deal? As long as it is legal, it simply means less cost.
2) Why is Apple more innovative?
At first glance, it looks in the CPU market we have a similar competition pattern with Intel controlling the market and AMD as a challenger. Here, the dominating market share gives Intel extra power over AMD, because it may directly squeeze the margin of AMD by reducing the price of its own chips. You may think that in the OS world, MSFT would have the same leverage over Apple, but not really.
The secret lies in Apple's bundling strategy, i.e., it doesn't allow the Mas OS to be installed on any non-Apple branded hardware. In other words, Apple refuses to open its software to the open public. What does Apple gain from this? It avoids the full-blown competition, as well as the big headaches that MSFT has to deal with (listed above). Furthermore, from the space that the monopolist's power can't reach, Apple created itself a very stable niche market with a group of very loyal users.
First, through bundling, Apple has full control over the hardware platform its software runs on, virtually eliminating all hardware compatibility issues that MSFT has, and rendering the backward compatibility into a minor problem. This translates directly into a lean product management process and less cost. Second, Apple has full control over the look and feel of its product, thus retaining the leverage to consistently maintain the luxury and sleek style of its product, which caters well to its target customer. Third, fat margin. A Mac normally cost twice as a PC with similar processing power. And fourth, a small but friendly user base, characterized by higher income and education, which frees Apple from dealing with all sorts of malicious behaviors that are very common in the Windows world. As an example, the user doesn't even need an anti-virus software on their Mac. In summary, with MSFT taking on all the hatred and accusation, Apple operates under an environment with much less internal and external pressure, thus gaining the luxury to be internally focused, thus more innovative.
Two Topics I plan to cover, first, the competition pattern between MSFT and AAPL and second, Microsoft's chance against Google in the search market. Please visit my blog for the latest updates.
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On the other hand, Microsoft is the indisputable monopolist in the Operating System world, owning around 88% of the market, and Mac OS, around 10%. However, according to many users that had experience in Mac, the OS from Apple is so much cooler than Vista, and for years, there have been voices arguing that Apple should license the OS to the OEMs, the same way that Microsoft sells its flagship product.
Here are some thoughts on the rivalry.
1) Why is Microsoft less creative?
With such a dominating market share, you may think that the business operation environment for MSFT won't be that tough. But it is the opposite - MSFT is constantly under immense internal/external pressure, which exhausts its power to stay innovative.
First, internally, the Windows OS, if not the most complex software system in human history, is well qualified to be one of the most complex ones. Virtually it is like a platform of your daily life, somewhat matching the unlimited possibilities in real life. To develop and support such a system is a daunting task for any single company. Think about it, billions of dollars in budget, thousands of developers, hundreds of modules, dozens of versions, iterations, releases, integrations, testings, code bases, documents ... there is an endless task list. If you have the experience managing a one million dollar project, you know it only takes a few mistakes to see your process spin out of control. Then try to imagine this monster at MSFT's hand. I have no clue how MSFT manages the life-cycle of Windows, but for sure it is a process demanding rigor, consistency, cautious planning and solid implementation. I won't say these values prohibit creativity, but for sure, they won't encourage creativity.
Second, Windows is an OS independent of the hardware, and MSFT only specifies the minimum hardware requirements. We understand that this is required for MSFT to maximize its market share. And the result is, MSFT has to deal with the compatibility issue with hundreds of hardware variations. On the other hand, the OS is a platform, i.e., it opens its interface for thousands of other software companies to build upon, which creates another compatibility issue. Then adding the challenges created by rapid evolving technologies and backward compatibility, these could easily turn into a disaster that devours the company. Again this is the daily task of MSFT.
Third, Windows is estimated to have more than 1 billion users worldwide, which means it is open to unlimited possibilities/challenges/risks created by the immense brain power of a vast crowd, where exist countless usage patterns/habits, unbelievable stupidity and unimaginable brilliance, geeks, hackers, pirates, virus writers, Windows lovers, Microsoft haters..... As an indicator, MSFT never escaped from the criticism about the security flaws of Windows, even after spending billions of dollars year after year attempting to fix it. Here, code quality actually is only one side of the story, the other side, the enormous user base.
In summary, all these demanding tasks that fill the daily life of MSFT ultimately defined the overall operation atmosphere and corporate culture. Here, the top priority is about being solid, thorough, proactive and making less mistakes. Then how about creativity - stay original and novel? Sure it is nice to have, but it is fine to live without it. It is a shame to copy ideas invented by others. But business-wise, what is the big deal? As long as it is legal, it simply means less cost.
2) Why is Apple more innovative?
At first glance, it looks in the CPU market we have a similar competition pattern with Intel controlling the market and AMD as a challenger. Here, the dominating market share gives Intel extra power over AMD, because it may directly squeeze the margin of AMD by reducing the price of its own chips. You may think that in the OS world, MSFT would have the same leverage over Apple, but not really.
The secret lies in Apple's bundling strategy, i.e., it doesn't allow the Mas OS to be installed on any non-Apple branded hardware. In other words, Apple refuses to open its software to the open public. What does Apple gain from this? It avoids the full-blown competition, as well as the big headaches that MSFT has to deal with (listed above). Furthermore, from the space that the monopolist's power can't reach, Apple created itself a very stable niche market with a group of very loyal users.
First, through bundling, Apple has full control over the hardware platform its software runs on, virtually eliminating all hardware compatibility issues that MSFT has, and rendering the backward compatibility into a minor problem. This translates directly into a lean product management process and less cost. Second, Apple has full control over the look and feel of its product, thus retaining the leverage to consistently maintain the luxury and sleek style of its product, which caters well to its target customer. Third, fat margin. A Mac normally cost twice as a PC with similar processing power. And fourth, a small but friendly user base, characterized by higher income and education, which frees Apple from dealing with all sorts of malicious behaviors that are very common in the Windows world. As an example, the user doesn't even need an anti-virus software on their Mac. In summary, with MSFT taking on all the hatred and accusation, Apple operates under an environment with much less internal and external pressure, thus gaining the luxury to be internally focused, thus more innovative.
Two Topics I plan to cover, first, the competition pattern between MSFT and AAPL and second, Microsoft's chance against Google in the search market. Please visit my blog for the latest updates.
Support my blog by clicking the Ads!
Sunday, March 29, 2009
134th Edition of Festival of Stocks
About Individual Stocks
D4L presents Genuine Parts Co. (GPC) Stock Analysis posted at Dividends Value.
Zachary Scheidt presents Syniverse (SVR) - Recovering, Beating Expectations posted at ZachStocks, saying "Syniverse has solutions to support wireless providers. The company is adding new customers and although they experienced an important lost contract last year, the stock has recovered and the company is in growth mode."
About Overall Stock Market
Silicon Valley Blogger presents 1929 Stock Market Cycle: Are Technical Indicators, Stock Trends Repeating History? posted at The Digerati Life.
Dan presents If You Thought Americans Suffered This Year... posted at Everyday Finance, saying "This article highlights how much worse this financial crisis could have been if the nefarious plans that Wall Street had in mind actually came to be".
Michael Haltman presents Pop The Economic Pimple While The Cancer Runs Wild posted at The Political and Financial Markets Commentator, saying " I find the bonuses paid to the AIG executives and financial "geniuses" that created and sold the products that has helped to bring the economy of the United States and the world to its knees to be abhorrent and bordering on the immoral. If there is a way to abrogate them within the boundaries of contract law, then it must be done! But that is not the point of this post. That said, let's move on."
Ian Welsh presents How to Understand the March 23 Market Rally posted at Ian Welsh, saying "On March 23, the Dow went up almost 500 points in response to news that Treasure Secretary Geithner was promising private investors almost $1 trillion to gamble with. But instead of signaling economic recovery, the Dow rally points to the Japanification of the US economy, and that's very bad news."
About Stock Investing Methodologies
George presents Consistent Cash Creators with High Normalized Earnings Yield posted at Fat Pitch Financials, saying "These are the results of a stock screen that looks for companies that produce consistent free cash flows over the past seven years and are trading at low prices relative to their normalized earnings".
Pinyo presents Should You Own Individual Stocks? posted at Moolanomy.
Manshu presents Greater Fool Theory and Keynes Beauty Contest | OneMint posted at OneMint.
Fine-Tuned Finances presents Why Young People Will Benefit Greatly from the Recession | Fine-Tuned Finances posted at Fine-Tuned Finances.
Steve Alexander presents Are Greenblatt's Published Gains Achievable? posted at MagicDiligence - The Best Magic Formula Stocks, saying "In Joel Greenblatt's The Little Book that Beats the Market, the Magic Formula strategy returned over 30% a year. Is this result obtainable going forward or did the study's time period skew results unrealistically?"
Disciplined Investing presents Is Benjamin Graham Still Relevant? posted at Disciplined Approach to Investing, saying "A few years ago, Jason Zweig worked with the publisher of The Intelligent Investor in order to update the classic investment book. Zweig outlines some of the thoughts that went into the 2003 update of the Intelligent Investor in a paper titled, Equity Analysis Issues, Lessons, and Techniques."
The Financial Blogger presents What Does The Broker Do? (Besides taking your money away with fees!) posted at The Financial Blogger.
Ramis presents Asset Allocation-What it is and Why it’s Important posted at Financial Highway.
The Investor presents How stop loss investing can save you money posted at Monevator.
ChristianPF presents How to plan for your financial future posted at Christian Personal Finance Blog.
Investing School presents Realized and Unrealized Gains and Losses posted at Investing School.
Other
The Dividend Guy presents Do Precious Metals Belong in My Portfolio | The Dividend Guy Blog posted at The Dividend Guy Blog, saying "Asset Allocation is the most important aspect of portfolio planning. This post asks the question, "Do Precious Metals Belong in My Portfolio?) "
D4L presents Genuine Parts Co. (GPC) Stock Analysis posted at Dividends Value.
Zachary Scheidt presents Syniverse (SVR) - Recovering, Beating Expectations posted at ZachStocks, saying "Syniverse has solutions to support wireless providers. The company is adding new customers and although they experienced an important lost contract last year, the stock has recovered and the company is in growth mode."
About Overall Stock Market
Silicon Valley Blogger presents 1929 Stock Market Cycle: Are Technical Indicators, Stock Trends Repeating History? posted at The Digerati Life.
Dan presents If You Thought Americans Suffered This Year... posted at Everyday Finance, saying "This article highlights how much worse this financial crisis could have been if the nefarious plans that Wall Street had in mind actually came to be".
Michael Haltman presents Pop The Economic Pimple While The Cancer Runs Wild posted at The Political and Financial Markets Commentator, saying " I find the bonuses paid to the AIG executives and financial "geniuses" that created and sold the products that has helped to bring the economy of the United States and the world to its knees to be abhorrent and bordering on the immoral. If there is a way to abrogate them within the boundaries of contract law, then it must be done! But that is not the point of this post. That said, let's move on."
Ian Welsh presents How to Understand the March 23 Market Rally posted at Ian Welsh, saying "On March 23, the Dow went up almost 500 points in response to news that Treasure Secretary Geithner was promising private investors almost $1 trillion to gamble with. But instead of signaling economic recovery, the Dow rally points to the Japanification of the US economy, and that's very bad news."
About Stock Investing Methodologies
George presents Consistent Cash Creators with High Normalized Earnings Yield posted at Fat Pitch Financials, saying "These are the results of a stock screen that looks for companies that produce consistent free cash flows over the past seven years and are trading at low prices relative to their normalized earnings".
Pinyo presents Should You Own Individual Stocks? posted at Moolanomy.
Manshu presents Greater Fool Theory and Keynes Beauty Contest | OneMint posted at OneMint.
Fine-Tuned Finances presents Why Young People Will Benefit Greatly from the Recession | Fine-Tuned Finances posted at Fine-Tuned Finances.
Steve Alexander presents Are Greenblatt's Published Gains Achievable? posted at MagicDiligence - The Best Magic Formula Stocks, saying "In Joel Greenblatt's The Little Book that Beats the Market, the Magic Formula strategy returned over 30% a year. Is this result obtainable going forward or did the study's time period skew results unrealistically?"
Disciplined Investing presents Is Benjamin Graham Still Relevant? posted at Disciplined Approach to Investing, saying "A few years ago, Jason Zweig worked with the publisher of The Intelligent Investor in order to update the classic investment book. Zweig outlines some of the thoughts that went into the 2003 update of the Intelligent Investor in a paper titled, Equity Analysis Issues, Lessons, and Techniques."
The Financial Blogger presents What Does The Broker Do? (Besides taking your money away with fees!) posted at The Financial Blogger.
Ramis presents Asset Allocation-What it is and Why it’s Important posted at Financial Highway.
The Investor presents How stop loss investing can save you money posted at Monevator.
ChristianPF presents How to plan for your financial future posted at Christian Personal Finance Blog.
Investing School presents Realized and Unrealized Gains and Losses posted at Investing School.
Other
The Dividend Guy presents Do Precious Metals Belong in My Portfolio | The Dividend Guy Blog posted at The Dividend Guy Blog, saying "Asset Allocation is the most important aspect of portfolio planning. This post asks the question, "Do Precious Metals Belong in My Portfolio?) "
Sunday, March 22, 2009
Apple Will Be the Same Apple Even Without Steve Jobs
In my previous post, I expressed my concerns over Apple's innovation power in case that Steve Jobs won't return from his medical leave (read it here). From reading the comments on the article, I had the impression that some of the readers thought of me as a short of the Apple stock. Actually I am not. In the disclaimer, I stated that 'I am considering selling my AAPL shares', maybe the more accurate words would be 'reevaluating my positions'.
But is it even worth to reevaluate? Under normal market conditions, sure we should look into the uncertainties introduced by Steve's leave. But we are in this unprecedented bear market and there are a lot of solid companies out there with a stock price at a bargain level. In other words, we have investment options that may bring in similar returns, but with lower risks, then why bother with AAPL? For me, I seriously considered switching my holdings of AAPL to Nike (read the analysis of NKE here).
I admit it is the emotions that drove me to look deeper into Apple's situation - I don't feel ready to give up Apple and I like their products. I owned several versions of iPod, and I am managing my music library with iTunes. I am waiting for my Sprint contract to expire in April to get rid of their crappy service, then I am going to buy an iPhone. Good chance my year-end gift would be a Mac Book. So my starting point is like this, if Steve's leave is a big negative factor, are there any positive ones that would keep Apple on its old and glorious track? My answer is Yes, there are quite a few. Honestly, I was a little surprised by my conclusion.
1) This is a logical inference. Steve Jobs was at the helm of Apple for more than 10 years, had been continuously and aggressively driving Apple from one innovation to another. There has to be something got embedded into Apple's corporate culture and management system, which, somewhat should be self-sustainable even without the big man on the top. For example, Apple still retains the top-talented designer team that envisioned and sketched generations of their beloved gadgets; there should be some process that guarantees the original ideas and innovative efforts to receive proper attention and, some form of established routines to facilitate the interactions between the design team, the technical team and the management. I briefly touched this point in my old post, and as an outsider of Apple company, I can't provide any proof. But again, I believe these are valid inferences.
2) Under Steve Jobs, Apple is a company with clear focuses. It has a very limited and straightforward product line, basically iPod, iPhone and Mac. IPod and iPhone share the same design concepts, and both leverage the capabilities of the Mac OS. This allows AAPL to pool its resources to develop winner products, while at the same time retain a relatively simple and agile organization structure, thus creating an innovation-friendly environment at the macro level. I'd like to say this is a strategy deliberately maintained by Apple. An example, it started accumulating cash since Steve Jobs took the office, and for the time being, has around 30 billion cash in the pocket. It could have used it to expand into other territories, but it didn't. In other words, as long as Apple continues this strategy, maintains its focus and avoids impudent business moves, they should be able to keep their innovation power from endangered by unnecessary or unprepared market pressures.
3) This may be my most important finding. Through years of brilliant design and innovation, AAPL developed a certain form of 'Personal Attachment' between the customers and its products. This is rarely seen in the technology world. This solid and expanding 'Fan Base', to an extent, provides a buffer between the company and the external competition, thus offering Apple a very open and forgiving atmosphere and a very healthy mindset for innovation.
I always hear people say, 'Apple never competes in price', which I agree and behind this simple statement, actually lies its unmatchable brilliance. You may not agree with me that all gadgets Apple manufactures in nature are commodities, but the fact is there are load of companies selling them at only a fraction of Apple's price tag. Simply put, Apple managed to differentiate itself from others by unique design in look and feel (hardware), providing different (better) user experience (software), clever marketing (those easily memorable commercials) and in the personal computer field, it actually benefits from Microsoft's monopoly position, which creates the appetite to look for alternatives. (one extra comment here, actually something interesting and bewildering to me. I know to be creative in software is at a more sophisticated level, but in hardware design, just the look and feel, for me it is virtually all about paying good money to find the talented personnel, I don't understand why there is no match with Apple even here. Or is it because I brain-washed by Apple's commercials?) Apple's success created two far-reaching results, the popular cravings to its products, and the second, it obtains the tight hold of its target customer - actually a group of people with relatively higher income. In return, the pressures that normally link to the commodity player are pretty much taken off Apple's shoulder, such as maintaining the market share, the thin margin, the excessive marketing efforts, and the timing (be the first few to rush the products into the market). As a result, you see today's Apple, taking its time to be creative and elegant, which is a form of 'temperament' that I don't see with any other companies.
I'd like to say only the greatest strategist is capable of leading Apple into this position, and no doubt, Steve Jobs is the one. Personal opinion, this is the greatest contribution as well as most precious legacy from him. On the other hand, Steve's leave won't take Apple off this position, and more importantly it doesn't necessarily require a CEO as great as him to maintain this position. In summary, Apple is already there, a certain pattern between the innovation, the products and the market has been in place; even just relying on the momentum should be enough to keep it safe on the right track for several years.
One more comment to make, I don't sense anything revolutionary in Mr. Cook, instead, he was regarded as a 'business operation maestro'. I view this as a big positive. After all, what we need for Apple is not an unproven innovator, but rather an executor that is well qualified to continue Steve's path.
4) Apple already reached the end of its innovation. I know it is a bold statement, but think about it, the way Apple makes a digital music player is the way it makes a iPod Touch, the way it makes a wireless phone is the way it makes an iPhone, and the way it makes a personal computer is the way it makes a Mac Book. Do you think anybody, or any company (including Apple itself) is capable of topping that? Another perspective, once you hold your own iPod touch or iPhone in your hand, do you think it is even necessary for any companies to come up with anything that is 'Better'?
Let's take the controversy away and make some realistic points. Innovation comes at two different levels, the concept level and the implementation level. Using Microsoft as the example - it completed the innovation at the concept level in 1980s and 1990s with the introduction of the initial generations of Windows Operation System, and since then, the innovation is mostly at the implementation level, including architecture redesign, adding more functions, features, etc. Obviously, it requires a prophet type of person on the top during the concept stage. For MSFT, Bill Gates is the one. But once the company stepped into the second stage of innovation, he is not that critical anymore. For Apple, it already completed the innovation at the concept level for all three fields it plays in. What Steve Jobs accomplished is not just a few versions of MP3 player/wireless phone/computer, but a concept/package/platform of how these gadgets should be built. Without Steve Jobs, Apple is not today's Apple, but in this implementation stage, Tim Cook should do OK.
With all these said, I'd like to say the impact of Steve's leave is somewhat exaggerated. The great CEO already lifted Apple to one level where the company is self-sustainable. We all know that eventually he will leave, then is it really bad if it is now? For me, his mission is completed, excellently completed, and I'd like to see how his successors will continue. Steve left the legacy which may turn Apple into an all-time greatest company, and if the new management team holds it well, AAPL might simply become a stock of a life-time.
But is it even worth to reevaluate? Under normal market conditions, sure we should look into the uncertainties introduced by Steve's leave. But we are in this unprecedented bear market and there are a lot of solid companies out there with a stock price at a bargain level. In other words, we have investment options that may bring in similar returns, but with lower risks, then why bother with AAPL? For me, I seriously considered switching my holdings of AAPL to Nike (read the analysis of NKE here).
I admit it is the emotions that drove me to look deeper into Apple's situation - I don't feel ready to give up Apple and I like their products. I owned several versions of iPod, and I am managing my music library with iTunes. I am waiting for my Sprint contract to expire in April to get rid of their crappy service, then I am going to buy an iPhone. Good chance my year-end gift would be a Mac Book. So my starting point is like this, if Steve's leave is a big negative factor, are there any positive ones that would keep Apple on its old and glorious track? My answer is Yes, there are quite a few. Honestly, I was a little surprised by my conclusion.
1) This is a logical inference. Steve Jobs was at the helm of Apple for more than 10 years, had been continuously and aggressively driving Apple from one innovation to another. There has to be something got embedded into Apple's corporate culture and management system, which, somewhat should be self-sustainable even without the big man on the top. For example, Apple still retains the top-talented designer team that envisioned and sketched generations of their beloved gadgets; there should be some process that guarantees the original ideas and innovative efforts to receive proper attention and, some form of established routines to facilitate the interactions between the design team, the technical team and the management. I briefly touched this point in my old post, and as an outsider of Apple company, I can't provide any proof. But again, I believe these are valid inferences.
2) Under Steve Jobs, Apple is a company with clear focuses. It has a very limited and straightforward product line, basically iPod, iPhone and Mac. IPod and iPhone share the same design concepts, and both leverage the capabilities of the Mac OS. This allows AAPL to pool its resources to develop winner products, while at the same time retain a relatively simple and agile organization structure, thus creating an innovation-friendly environment at the macro level. I'd like to say this is a strategy deliberately maintained by Apple. An example, it started accumulating cash since Steve Jobs took the office, and for the time being, has around 30 billion cash in the pocket. It could have used it to expand into other territories, but it didn't. In other words, as long as Apple continues this strategy, maintains its focus and avoids impudent business moves, they should be able to keep their innovation power from endangered by unnecessary or unprepared market pressures.
3) This may be my most important finding. Through years of brilliant design and innovation, AAPL developed a certain form of 'Personal Attachment' between the customers and its products. This is rarely seen in the technology world. This solid and expanding 'Fan Base', to an extent, provides a buffer between the company and the external competition, thus offering Apple a very open and forgiving atmosphere and a very healthy mindset for innovation.
I always hear people say, 'Apple never competes in price', which I agree and behind this simple statement, actually lies its unmatchable brilliance. You may not agree with me that all gadgets Apple manufactures in nature are commodities, but the fact is there are load of companies selling them at only a fraction of Apple's price tag. Simply put, Apple managed to differentiate itself from others by unique design in look and feel (hardware), providing different (better) user experience (software), clever marketing (those easily memorable commercials) and in the personal computer field, it actually benefits from Microsoft's monopoly position, which creates the appetite to look for alternatives. (one extra comment here, actually something interesting and bewildering to me. I know to be creative in software is at a more sophisticated level, but in hardware design, just the look and feel, for me it is virtually all about paying good money to find the talented personnel, I don't understand why there is no match with Apple even here. Or is it because I brain-washed by Apple's commercials?) Apple's success created two far-reaching results, the popular cravings to its products, and the second, it obtains the tight hold of its target customer - actually a group of people with relatively higher income. In return, the pressures that normally link to the commodity player are pretty much taken off Apple's shoulder, such as maintaining the market share, the thin margin, the excessive marketing efforts, and the timing (be the first few to rush the products into the market). As a result, you see today's Apple, taking its time to be creative and elegant, which is a form of 'temperament' that I don't see with any other companies.
I'd like to say only the greatest strategist is capable of leading Apple into this position, and no doubt, Steve Jobs is the one. Personal opinion, this is the greatest contribution as well as most precious legacy from him. On the other hand, Steve's leave won't take Apple off this position, and more importantly it doesn't necessarily require a CEO as great as him to maintain this position. In summary, Apple is already there, a certain pattern between the innovation, the products and the market has been in place; even just relying on the momentum should be enough to keep it safe on the right track for several years.
One more comment to make, I don't sense anything revolutionary in Mr. Cook, instead, he was regarded as a 'business operation maestro'. I view this as a big positive. After all, what we need for Apple is not an unproven innovator, but rather an executor that is well qualified to continue Steve's path.
4) Apple already reached the end of its innovation. I know it is a bold statement, but think about it, the way Apple makes a digital music player is the way it makes a iPod Touch, the way it makes a wireless phone is the way it makes an iPhone, and the way it makes a personal computer is the way it makes a Mac Book. Do you think anybody, or any company (including Apple itself) is capable of topping that? Another perspective, once you hold your own iPod touch or iPhone in your hand, do you think it is even necessary for any companies to come up with anything that is 'Better'?
Let's take the controversy away and make some realistic points. Innovation comes at two different levels, the concept level and the implementation level. Using Microsoft as the example - it completed the innovation at the concept level in 1980s and 1990s with the introduction of the initial generations of Windows Operation System, and since then, the innovation is mostly at the implementation level, including architecture redesign, adding more functions, features, etc. Obviously, it requires a prophet type of person on the top during the concept stage. For MSFT, Bill Gates is the one. But once the company stepped into the second stage of innovation, he is not that critical anymore. For Apple, it already completed the innovation at the concept level for all three fields it plays in. What Steve Jobs accomplished is not just a few versions of MP3 player/wireless phone/computer, but a concept/package/platform of how these gadgets should be built. Without Steve Jobs, Apple is not today's Apple, but in this implementation stage, Tim Cook should do OK.
With all these said, I'd like to say the impact of Steve's leave is somewhat exaggerated. The great CEO already lifted Apple to one level where the company is self-sustainable. We all know that eventually he will leave, then is it really bad if it is now? For me, his mission is completed, excellently completed, and I'd like to see how his successors will continue. Steve left the legacy which may turn Apple into an all-time greatest company, and if the new management team holds it well, AAPL might simply become a stock of a life-time.
Silent Treasure Is To Host Festival of Stocks (Edition 134)
My pleasure to host the 134th edition of Festival of Stocks. Please click here to submit your blog.
The deadline of the submission is Eastern Time 11PM 03/28/2009, Saturday. I will have the new edition posted before Eastern Time 8AM 3/30/2009, Monday.
Drop me one email if you have any questions.
The deadline of the submission is Eastern Time 11PM 03/28/2009, Saturday. I will have the new edition posted before Eastern Time 8AM 3/30/2009, Monday.
Drop me one email if you have any questions.
Tuesday, March 17, 2009
Apple (AAPL): Still the Unique Innovator without Jobs?
As a long-term investor in Apple (AAPL), I was accumulating more shares during 2008 as the market was spiraling downward, and stopped, guess I had to, when my cash ran out, sometime long before the market bottomed out (longer if the new lows it reached the first week of March were not the bottom). I had strong beliefs in Apple's growth potential, based on its international appearance, and another one was based on the future of the Mac computers. The sole cornerstone of this all was my belief in its unmatchable powers of innovation.
I'd like to admit that my research on AAPL was not thorough enough, because I had this unanswered question both before and after I jumped in, and I am still having the same question today: why no other companies are capable of coming up with anything to match the iPod? Bottom-line, it is just a MP3 player. Resource wise, there are many others that can match or beat Apple, the most obvious being Microsoft (MSFT).
So why it is Apple, Apple Only, and Again and Again Apple Only? Though I couldn't find any answers that I myself felt 100% satisfied with, all my reading seems to suggest that AAPL has established certain forms of corporate culture, a systematic way to encourage creative thinking and channel such creativity through the product development life-cycle. Once such a system is in place, its innovation became sustainable and in return, gave the company a significant competitive edge that is usually pretty difficult for competitors to surmount. This is the underlying theory of all my analysis of AAPL, including my Buy decision. However, I found my belief system cracked a little bit when several weeks ago, CEO Steve Jobs declared a medical leave with very slim chance to return to the helm again - at least according to some analysts.
Apple ranked high every year in various versions of the Most Innovative Companies list, side by side with companies such as Intel (INTC), GE, Microsoft, Amazon (AMZN), eBay (EBAY), P&G (PG), etc. However, if you look deeper, you can find the type of innovation that AAPL delivers is different from almost all the others.
1) The difference between Apple and companies such as eBay and Amazon is like the product vs. the business model. The main focus for eBay or Amazon is not to introduce new products to the world, and eBay is actually more interested in used stuff. But I always have the opinion that eBay may be one of the best business models ever invented in human history. To summarize, it is smart and lazy; smart, because it brings in fat margins; and lazy, because once it is in place, you just sit back and count the money that keeps flowing in.
Basically, Apple's innovation is never about its business model. Instead it sticks to a very traditional one - build something and then sell it above cost to make a profit. You can argue it is a revolution for Apple to combine iPod with iTunes, but this has more meaning for the digital music world than for the MP3 player, and I think ultimately the popularity of the music store was driven by the popularity of the MP3 player, not the opposite. Furthermore, I don't see anything new the way AAPL sell the iPhone. And in the Mac computer sector, again, nothing is truly fresh in the past 10 years - they still stick to and protect their bundling strategy, i.e. Mac OS is allowed to run on Apple computers only. I do believe this bundling strategy gives Apple some edge in software development, allowing it to stay elegant and creative by avoiding a face-off competition with Microsoft (read analysis here). Still, I don't believe this business model is anything innovative.
2) Similar to Intel and GE, Apple's innovation focuses on the product. However, for companies such as Intel and GE, they delve into brand new areas with only a handful of competitors having the expertise and resources to tap in. For example, Intel continuously made breakthroughs in the CPU technology, or GE introduced various means to generate green energy. Apple didn't actually invent MP3 players or smart phones. Rather, they just built on the existing concepts and innovate to revolutionize the user experience. Nothing explains this better than the iPhone, or another more recent example, the new iPod shuffle, the first MP3 player that 'speaks for itself', as they tout. In other words, these are innovations that interact with each individual customer.
From another perspective, we can say innovation for companies like Intel is more about implementation, the idea is already there - making the CPU run faster or running several of them together seamlessly. But for Apple, the innovation is more about bringing up the right ideas, and the implementation seems to be relatively easy.
I'd like to say the Apple's innovation is a lot more demanding, which requires more than placing the right talent in the right position. How difficult is it? Let's say this, there is only one company in the world that is capable of doing it. Microsoft tried with Zune, Dell (DELL) tried with Jukebox and Creative tried with Zen. They simply couldn't match up. For this very reason, Apple's innovation became the cornerstone of its competitive edge and the driver of its future growth. If a new version of iPod fails to impress or a new iPhone is something mediocre, then we may see their market share drop overnight. This is the pattern of competition in the technology world.
As this is so critical an element of Apple's success, we must question its sustainability. Steve Jobs must have played a critical role in this process of constant innovation. Apple sounds like a huge company on paper, but at the end of the day their product line is very simple and limited - several versions of MP3 players, one wireless phone, iTunes and several varieties of computers. I wouldn't be surprised to find out in retrospect that Steve Jobs actually controlled the entire product development process when he was at the helm. With Jobs leaving, can Apple really be the same constant innovator of unique products? I don't know. I admit I am a little nervous, and I am watching.
Disclosure: I am holding a long position in AAPL, but am considering selling it.
I'd like to admit that my research on AAPL was not thorough enough, because I had this unanswered question both before and after I jumped in, and I am still having the same question today: why no other companies are capable of coming up with anything to match the iPod? Bottom-line, it is just a MP3 player. Resource wise, there are many others that can match or beat Apple, the most obvious being Microsoft (MSFT).
So why it is Apple, Apple Only, and Again and Again Apple Only? Though I couldn't find any answers that I myself felt 100% satisfied with, all my reading seems to suggest that AAPL has established certain forms of corporate culture, a systematic way to encourage creative thinking and channel such creativity through the product development life-cycle. Once such a system is in place, its innovation became sustainable and in return, gave the company a significant competitive edge that is usually pretty difficult for competitors to surmount. This is the underlying theory of all my analysis of AAPL, including my Buy decision. However, I found my belief system cracked a little bit when several weeks ago, CEO Steve Jobs declared a medical leave with very slim chance to return to the helm again - at least according to some analysts.
Apple ranked high every year in various versions of the Most Innovative Companies list, side by side with companies such as Intel (INTC), GE, Microsoft, Amazon (AMZN), eBay (EBAY), P&G (PG), etc. However, if you look deeper, you can find the type of innovation that AAPL delivers is different from almost all the others.
1) The difference between Apple and companies such as eBay and Amazon is like the product vs. the business model. The main focus for eBay or Amazon is not to introduce new products to the world, and eBay is actually more interested in used stuff. But I always have the opinion that eBay may be one of the best business models ever invented in human history. To summarize, it is smart and lazy; smart, because it brings in fat margins; and lazy, because once it is in place, you just sit back and count the money that keeps flowing in.
Basically, Apple's innovation is never about its business model. Instead it sticks to a very traditional one - build something and then sell it above cost to make a profit. You can argue it is a revolution for Apple to combine iPod with iTunes, but this has more meaning for the digital music world than for the MP3 player, and I think ultimately the popularity of the music store was driven by the popularity of the MP3 player, not the opposite. Furthermore, I don't see anything new the way AAPL sell the iPhone. And in the Mac computer sector, again, nothing is truly fresh in the past 10 years - they still stick to and protect their bundling strategy, i.e. Mac OS is allowed to run on Apple computers only. I do believe this bundling strategy gives Apple some edge in software development, allowing it to stay elegant and creative by avoiding a face-off competition with Microsoft (read analysis here). Still, I don't believe this business model is anything innovative.
2) Similar to Intel and GE, Apple's innovation focuses on the product. However, for companies such as Intel and GE, they delve into brand new areas with only a handful of competitors having the expertise and resources to tap in. For example, Intel continuously made breakthroughs in the CPU technology, or GE introduced various means to generate green energy. Apple didn't actually invent MP3 players or smart phones. Rather, they just built on the existing concepts and innovate to revolutionize the user experience. Nothing explains this better than the iPhone, or another more recent example, the new iPod shuffle, the first MP3 player that 'speaks for itself', as they tout. In other words, these are innovations that interact with each individual customer.
From another perspective, we can say innovation for companies like Intel is more about implementation, the idea is already there - making the CPU run faster or running several of them together seamlessly. But for Apple, the innovation is more about bringing up the right ideas, and the implementation seems to be relatively easy.
I'd like to say the Apple's innovation is a lot more demanding, which requires more than placing the right talent in the right position. How difficult is it? Let's say this, there is only one company in the world that is capable of doing it. Microsoft tried with Zune, Dell (DELL) tried with Jukebox and Creative tried with Zen. They simply couldn't match up. For this very reason, Apple's innovation became the cornerstone of its competitive edge and the driver of its future growth. If a new version of iPod fails to impress or a new iPhone is something mediocre, then we may see their market share drop overnight. This is the pattern of competition in the technology world.
As this is so critical an element of Apple's success, we must question its sustainability. Steve Jobs must have played a critical role in this process of constant innovation. Apple sounds like a huge company on paper, but at the end of the day their product line is very simple and limited - several versions of MP3 players, one wireless phone, iTunes and several varieties of computers. I wouldn't be surprised to find out in retrospect that Steve Jobs actually controlled the entire product development process when he was at the helm. With Jobs leaving, can Apple really be the same constant innovator of unique products? I don't know. I admit I am a little nervous, and I am watching.
Disclosure: I am holding a long position in AAPL, but am considering selling it.
Wednesday, March 11, 2009
What China Market Offers Nike(NKE) to Fight Recession?
In the deep dive analysis of Nike (NKE) (read it here), I covered its growth potential in Asian countries. Later, I had one discussion about NKE on a stock forum, which prompted me to think deeper about the opportunities that China market presents to NKE. We'd like to pick companies managing to grow despite the worldwide recession. But given today's situation, it is reasonable to assume that the overall economic activities may slow down to such an extent that growth becomes unattainable for most of the companies. Nonetheless, we know that almost every company has some numbers from 'Wall Street' to beat, which, for some, is the key of the entire stock game. So the question is, does China market present a chance for Nike to beat its numbers? My answer: very likely.
1. Aggressive expansion may offset flat or declining revenue from existing stores. In the F2Q09 earning call, NKE management described China market as, 'China remains a premiere growth opportunity for the Nike brand. Revenue there is up 27% and futures are up 25%. Nothing has softened our enthusiasm for this market, or the Chinese consumers and their passion for sports. We’ve lightened our lead in brand awareness in China and now with more than 4,000 stores in tier-1 and tier-2 cities, we are well-positioned to compete and capitalize on the consumer connections we have built there.' (http://seekingalpha.com/article/111314-nike-f2q09-qtr-end-11-30-08-earnings-call-transcript?page=3) 4000 stores, that sounds a lot; and tier-1 and tier-2 cities, what does this mean? China cities are commonly segmented into different tiers, normally 4, based on the economic importance. However, there are no definitive standards for how the cities should be categorized. If you google it, you should be able to find two basic versions, one of them categories around 30 top China cities as tier 1 & 2, but obviously, for our case, Nike’s potential market in China won’t be limited to these 30 cities. A second version, a broader one, ‘A common approach is to put the four municipalities (Beijing, Shanghai, Tianjing, Chongqing), 27 provincial capitals, and a handful prosperous prefecture cities such as Shenzhen, Dalian and Ningbo into Tier 1, the more than 300 prefecture cities into Tier 2, the 1,200 city associated districts & county-level cities into Tier 3, and 1,600 counties into Tier 4.’ (http://www.bain.com/bainweb/publications/publications_detail.asp?id=26847&menu_url=publications_results.asp). Let’s not talk about tier 3 and 4, as I don’t think Nike would have the resources to tap into these cities in the next few years. And for tier 1 and 2, estimated around 450 million [note 1] population, we are having 4000 stores, so roughly, we are talking about 12 stores per city, with each one serving around 110,000 people. While in the US, 'We estimate that we sell to more than 25,000 retail accounts in the United States' (2008 10K), which translates to 12000 people per store. Sure the average household income in America is significantly higher than China, but here the comparison is based on a 450 million population from big cities, with more than one billion from tier 3 & 4 cities, as well rural areas filtered out. So here, I see unbeatable growth opportunities for Nike. Maybe across all regions, the economic downturn will cut into people’s spending, and you will see the revenues generated per store flat or declining, but Nike may compensate and turn things around by simply opening more stores in more cities. I won’t be surprised to see Nike continue the growth streak.
2. Nike’s core customer base is affected by the recession not as much as perceived. As I mentioned in another blog, Nike actually has a higher price tag on their products in China than in the US. Using footwear as the example, in the US market, normally the prices are between $50 and $140, and you can easily find sale items below $50, or if you live close to a factor store, the deals may be even cheaper. While in China, most of the shoes are above $100, when on sale, you may see a few items drop to around $60, and factory store? Never heard of. Keep in mind that the average personal income in China is still below $3000, so it is hard to imagine anybody spend 3% of yearly income on a pair of athletic shoes. However, it is just at this price level that NKE sees its double-digit growth year after year. This tells us that the core customers of NKE are not those from tier 3 & 4 cities and rural areas, but the groups from medium or large cities with higher disposable incomes. The immediate question to follow is that how much is this group of consumers affected by the recession? We know that a significant portion of China’s growth was fueled by the export-oriented industries, which simply depend on the economy of the US and the Europe. You see in China the unemployment rate shoot up as American and European economy contracts, but the rate is sort of skewed by the disproportionately high number in these export-oriented industries, as they are labor intensive, hiring a huge number of ‘blue collar’ workers from rural areas. They are the low-income groups in China, might be the very groups that make Nike shoes, but not the group that could afford the shoes. On the other hand, the unemployment rate in organizations that NKE’s customers work for, such as the government, the government controlled enterprises, or privately/collectively owned enterprises, is much lower than the number we see on papers. Another important factor to keep in mind. The social stability is always the top priority for the Chinese government since it has to manage such a gigantic population, therefore it takes firm measures to contain the unemployment rate at an acceptable level, for example, it makes the enterprises reduce employee’s salaries instead of laying them off if cutting cost becomes a have-to. This offers another protection layer of the purchasing power of NKE customers.
3. The money management pattern of Chinese customers makes them not as vulnerable as the customers in the US under the economic pressure. We just witnessed the burst of the Chinese stock market bubble. In the year 2007, it looked like investing in stocks became the single theme of people’s daily life for the entire nation, which pushed the market index almost 5 fold higher in 12 months and eventually reached an unsustainable level. Setting aside all the market manipulations, one interesting yet important fact you can gather from this is the vast savings the Chinese people have in their bank accounts. Actually this reflects a Chinese tradition in money management: no debt, saving for the future. This concept evolved as China society is becoming more open, but is still the mainstream. As a matter of fact, credit cards just started getting acknowledged and gaining some momentum in the past 2 –3 years in a few cities. I won’t elaborate on this topic, as this is more like an indirect and habitual factor. The key is: since the customers, as a group, have descent savings, little or none debt, the pressure from the economic slowdown is much less compared to their counterparts in the US, who normally are constantly haunted by the fear to sell the house and the car once the job is lost. As a result, they may not scale back their spending as steeply as imagined. This is not unique to Nike’s customer, but definitely a positive factor.
So here are the conclusions. First, there is no doubt that China market offers NKE the golden opportunity to thrive through the recession. Then the rest of the story is about NIKE's execution. Up to today, things I read about NKE are pretty positive. Second, everything I described here actually is not unique to NKE, all companies that operates in this 'sub-luxury' consumer products sector may take advantage of China market as well, for example, Apple. We will talk more about it in the next few blogs.
Note 1: not rock solid science, it is my estimation. The same source mentions among the 300 tier-2 cities, 120 of them have populations over one million, so it is 120 millions. For the rest 180 cities, I assigned an arbitrary number, 100 millions (maybe too conservative), based on my readings of China related materials. Then we have the big 4 cities, around 80 millions total, then the 30 other tier-1 cities, 150 millions.
1. Aggressive expansion may offset flat or declining revenue from existing stores. In the F2Q09 earning call, NKE management described China market as, 'China remains a premiere growth opportunity for the Nike brand. Revenue there is up 27% and futures are up 25%. Nothing has softened our enthusiasm for this market, or the Chinese consumers and their passion for sports. We’ve lightened our lead in brand awareness in China and now with more than 4,000 stores in tier-1 and tier-2 cities, we are well-positioned to compete and capitalize on the consumer connections we have built there.' (http://seekingalpha.com/article/111314-nike-f2q09-qtr-end-11-30-08-earnings-call-transcript?page=3) 4000 stores, that sounds a lot; and tier-1 and tier-2 cities, what does this mean? China cities are commonly segmented into different tiers, normally 4, based on the economic importance. However, there are no definitive standards for how the cities should be categorized. If you google it, you should be able to find two basic versions, one of them categories around 30 top China cities as tier 1 & 2, but obviously, for our case, Nike’s potential market in China won’t be limited to these 30 cities. A second version, a broader one, ‘A common approach is to put the four municipalities (Beijing, Shanghai, Tianjing, Chongqing), 27 provincial capitals, and a handful prosperous prefecture cities such as Shenzhen, Dalian and Ningbo into Tier 1, the more than 300 prefecture cities into Tier 2, the 1,200 city associated districts & county-level cities into Tier 3, and 1,600 counties into Tier 4.’ (http://www.bain.com/bainweb/publications/publications_detail.asp?id=26847&menu_url=publications_results.asp). Let’s not talk about tier 3 and 4, as I don’t think Nike would have the resources to tap into these cities in the next few years. And for tier 1 and 2, estimated around 450 million [note 1] population, we are having 4000 stores, so roughly, we are talking about 12 stores per city, with each one serving around 110,000 people. While in the US, 'We estimate that we sell to more than 25,000 retail accounts in the United States' (2008 10K), which translates to 12000 people per store. Sure the average household income in America is significantly higher than China, but here the comparison is based on a 450 million population from big cities, with more than one billion from tier 3 & 4 cities, as well rural areas filtered out. So here, I see unbeatable growth opportunities for Nike. Maybe across all regions, the economic downturn will cut into people’s spending, and you will see the revenues generated per store flat or declining, but Nike may compensate and turn things around by simply opening more stores in more cities. I won’t be surprised to see Nike continue the growth streak.
2. Nike’s core customer base is affected by the recession not as much as perceived. As I mentioned in another blog, Nike actually has a higher price tag on their products in China than in the US. Using footwear as the example, in the US market, normally the prices are between $50 and $140, and you can easily find sale items below $50, or if you live close to a factor store, the deals may be even cheaper. While in China, most of the shoes are above $100, when on sale, you may see a few items drop to around $60, and factory store? Never heard of. Keep in mind that the average personal income in China is still below $3000, so it is hard to imagine anybody spend 3% of yearly income on a pair of athletic shoes. However, it is just at this price level that NKE sees its double-digit growth year after year. This tells us that the core customers of NKE are not those from tier 3 & 4 cities and rural areas, but the groups from medium or large cities with higher disposable incomes. The immediate question to follow is that how much is this group of consumers affected by the recession? We know that a significant portion of China’s growth was fueled by the export-oriented industries, which simply depend on the economy of the US and the Europe. You see in China the unemployment rate shoot up as American and European economy contracts, but the rate is sort of skewed by the disproportionately high number in these export-oriented industries, as they are labor intensive, hiring a huge number of ‘blue collar’ workers from rural areas. They are the low-income groups in China, might be the very groups that make Nike shoes, but not the group that could afford the shoes. On the other hand, the unemployment rate in organizations that NKE’s customers work for, such as the government, the government controlled enterprises, or privately/collectively owned enterprises, is much lower than the number we see on papers. Another important factor to keep in mind. The social stability is always the top priority for the Chinese government since it has to manage such a gigantic population, therefore it takes firm measures to contain the unemployment rate at an acceptable level, for example, it makes the enterprises reduce employee’s salaries instead of laying them off if cutting cost becomes a have-to. This offers another protection layer of the purchasing power of NKE customers.
3. The money management pattern of Chinese customers makes them not as vulnerable as the customers in the US under the economic pressure. We just witnessed the burst of the Chinese stock market bubble. In the year 2007, it looked like investing in stocks became the single theme of people’s daily life for the entire nation, which pushed the market index almost 5 fold higher in 12 months and eventually reached an unsustainable level. Setting aside all the market manipulations, one interesting yet important fact you can gather from this is the vast savings the Chinese people have in their bank accounts. Actually this reflects a Chinese tradition in money management: no debt, saving for the future. This concept evolved as China society is becoming more open, but is still the mainstream. As a matter of fact, credit cards just started getting acknowledged and gaining some momentum in the past 2 –3 years in a few cities. I won’t elaborate on this topic, as this is more like an indirect and habitual factor. The key is: since the customers, as a group, have descent savings, little or none debt, the pressure from the economic slowdown is much less compared to their counterparts in the US, who normally are constantly haunted by the fear to sell the house and the car once the job is lost. As a result, they may not scale back their spending as steeply as imagined. This is not unique to Nike’s customer, but definitely a positive factor.
So here are the conclusions. First, there is no doubt that China market offers NKE the golden opportunity to thrive through the recession. Then the rest of the story is about NIKE's execution. Up to today, things I read about NKE are pretty positive. Second, everything I described here actually is not unique to NKE, all companies that operates in this 'sub-luxury' consumer products sector may take advantage of China market as well, for example, Apple. We will talk more about it in the next few blogs.
Note 1: not rock solid science, it is my estimation. The same source mentions among the 300 tier-2 cities, 120 of them have populations over one million, so it is 120 millions. For the rest 180 cities, I assigned an arbitrary number, 100 millions (maybe too conservative), based on my readings of China related materials. Then we have the big 4 cities, around 80 millions total, then the 30 other tier-1 cities, 150 millions.
Wednesday, March 4, 2009
The Battle Against Psystar: What if Apple Lost?
People following Apple should be familiar with the legal battle it is engaged in with a small start-up company from Miami, Florida called Psystar, which, after Steve Jobs killed the Mac Clone program more than 10 years ago, became the first one openly selling a computer pre-installed with Mac OS but not branded as an Apple product - it is called 'OpenComputer' instead. Lawsuits from Apple soon followed after Psystar made the move. As of Feb 2009, both parties are locked deep in the battle where Apple claimed Psystar infringed the Mac OS copyright - the End User License Agreement (EULA) doesn't allow the system to be installed on any computer other than an Apple-branded machine, while Psystar countered with allegations that Apple's EULA is invalid, the same manner if Microsoft tries to force Windows to be installed on a Dell computer only.
This looks like a one-sided battle and the vast majority of the followers of the story also predict AAPL will win. Nonetheless, very few is bold enough to rule out the chance, though very very slim, that Psystar may emerge as the last one with a smile on the face. It seems to fit into people's logic if Psystar loses. After all, hundreds of companies of this type come and go on a daily basis. At least this one grabbed the headlines for quite a while before diminishing into oblivion. But what if, a giant if, Apple loses? what is the stake here? Actually I was pondering on the competitive advantage of Apple (I will post a new blog on this topic soon), which leads me into the analysis of its business model, then I found I was deep in this topic. I try not to exaggerate things but my conclusion for now is like this: this is a battle for AAPL to protect its business model as well as its competitive advantage; losing this one might turn out to be devastating.
Let's speculate what may happen assuming the verdict rules Psystar as the winner.
1)Now the Mac Clone is legal (actually I have a big question mark here. Maybe even Apple lost the case, it still has the leverage to put a hold to the situation before it spins out of control, similar to what Steve Jobs did in 1997 - killing the clone program by changing the software version number), and OEMs such as DELL and HP will start produce Mac computers with similar or better performance compared to those from Apple, but only a fraction of the price. AAPL sees the revenue from selling Apple branded computers nose dive.
2) Computer operating system development may be the business with the highest entry threshold in human history - the profit only starts flowing in after burning billions of dollars. Now Apple, with an OS that already cost it billions, sees the high margin from bundling it with the hardware vanish, the only option left is to sell more OS licenses, i.e., increase the market share, i.e., a face-off with Microsoft.
3) Nothing depicts the picture of the competition between MSFT and AAPL better than the TV commercials from Apple. Two friendly guys jump on the scene, greeting you with warm and breezy words, 'Hello I am a Mac', and 'Hello I am a PC'. You saw the PC guy got trashed every time but shrug it off and come back with a smile, a little dumb but sure with a big heart. It is wrong if you come to the conclusion that MSFT doesn't take AAPL seriously, the fact is that they play in two different market zones, with MSFT in a broad one and AAPL in a niche one. Now with AAPL forced out of its traditional zone and positioned to fight MSFT in its backyard, there is no reason to expect MSFT to be that big-hearted dude anymore. Remember how it crashed Netscape years ago? That is the exact MSFT that Apple has to fight.
4) AAPL is going to be squeezed from another side. In the sweet old times, their software engineers only need to make sure their code is compatible with a specified range of hardware, which, Apple has absolute control. Now the pressure to increase the market share will force Apple to consider compatibility issues with a range of hardware 10 times wider. Then adding the derivative support and maintenance issues, don't be surprised if you see the cost rocket.
5) You got used to see an Apple that is creative and elegant, but remember nothing comes without a cost. When AAPL has full control over its products and its market, it can afford the luxury to be creative and elegant. However, if it is constantly under the amounting pressure of the competition and the market, can it still sustain this elegance and innovation? I doubt it. More likely, the constant pressure will exhaust their energy and patience to be innovative, drive the change of the company culture, and eventually, lead to the disappearance of their competitive advantage.
It is scary, but no need to panic. What I am painting here is simply the worst of the worst scenario. First of all, you need Apple to lose the case to Psystar. Second of all, even Apple lost, it doesn't necessarily imply that Mac Clone will become legal. Third of all, even Mac Clone becomes legal, it doesn't necessarily mean that Apple has no way to kill it again. Fourth of all, even Apple can't kill it and has to face MSFT, it doesn't necessarily indicate it is going to lose that war. But if it really reaches this far, I will be worried. Honestly, I don't think Apple is ready, yet. So it is better not lose this case at all.
This looks like a one-sided battle and the vast majority of the followers of the story also predict AAPL will win. Nonetheless, very few is bold enough to rule out the chance, though very very slim, that Psystar may emerge as the last one with a smile on the face. It seems to fit into people's logic if Psystar loses. After all, hundreds of companies of this type come and go on a daily basis. At least this one grabbed the headlines for quite a while before diminishing into oblivion. But what if, a giant if, Apple loses? what is the stake here? Actually I was pondering on the competitive advantage of Apple (I will post a new blog on this topic soon), which leads me into the analysis of its business model, then I found I was deep in this topic. I try not to exaggerate things but my conclusion for now is like this: this is a battle for AAPL to protect its business model as well as its competitive advantage; losing this one might turn out to be devastating.
Let's speculate what may happen assuming the verdict rules Psystar as the winner.
1)Now the Mac Clone is legal (actually I have a big question mark here. Maybe even Apple lost the case, it still has the leverage to put a hold to the situation before it spins out of control, similar to what Steve Jobs did in 1997 - killing the clone program by changing the software version number), and OEMs such as DELL and HP will start produce Mac computers with similar or better performance compared to those from Apple, but only a fraction of the price. AAPL sees the revenue from selling Apple branded computers nose dive.
2) Computer operating system development may be the business with the highest entry threshold in human history - the profit only starts flowing in after burning billions of dollars. Now Apple, with an OS that already cost it billions, sees the high margin from bundling it with the hardware vanish, the only option left is to sell more OS licenses, i.e., increase the market share, i.e., a face-off with Microsoft.
3) Nothing depicts the picture of the competition between MSFT and AAPL better than the TV commercials from Apple. Two friendly guys jump on the scene, greeting you with warm and breezy words, 'Hello I am a Mac', and 'Hello I am a PC'. You saw the PC guy got trashed every time but shrug it off and come back with a smile, a little dumb but sure with a big heart. It is wrong if you come to the conclusion that MSFT doesn't take AAPL seriously, the fact is that they play in two different market zones, with MSFT in a broad one and AAPL in a niche one. Now with AAPL forced out of its traditional zone and positioned to fight MSFT in its backyard, there is no reason to expect MSFT to be that big-hearted dude anymore. Remember how it crashed Netscape years ago? That is the exact MSFT that Apple has to fight.
4) AAPL is going to be squeezed from another side. In the sweet old times, their software engineers only need to make sure their code is compatible with a specified range of hardware, which, Apple has absolute control. Now the pressure to increase the market share will force Apple to consider compatibility issues with a range of hardware 10 times wider. Then adding the derivative support and maintenance issues, don't be surprised if you see the cost rocket.
5) You got used to see an Apple that is creative and elegant, but remember nothing comes without a cost. When AAPL has full control over its products and its market, it can afford the luxury to be creative and elegant. However, if it is constantly under the amounting pressure of the competition and the market, can it still sustain this elegance and innovation? I doubt it. More likely, the constant pressure will exhaust their energy and patience to be innovative, drive the change of the company culture, and eventually, lead to the disappearance of their competitive advantage.
It is scary, but no need to panic. What I am painting here is simply the worst of the worst scenario. First of all, you need Apple to lose the case to Psystar. Second of all, even Apple lost, it doesn't necessarily imply that Mac Clone will become legal. Third of all, even Mac Clone becomes legal, it doesn't necessarily mean that Apple has no way to kill it again. Fourth of all, even Apple can't kill it and has to face MSFT, it doesn't necessarily indicate it is going to lose that war. But if it really reaches this far, I will be worried. Honestly, I don't think Apple is ready, yet. So it is better not lose this case at all.
Saturday, February 28, 2009
Stock Deep Dive Analysis - Nike (NKE) in Bear Market
Note from the author: The following is a 7-post series deep analysis of Nike that I completed in the past three weeks. Now I consolidate them into one post with some minor revisions. The writing made me think deeper about Nike's growth in the developing countries especially China. Here are some ideas:
- The huge population in China provides an immense market and NKE is far far from fully tapping it. If Nike moves A LOT more aggressively in this direction, is there a good chance that NKE surprises the investors with impressive numbers even we are deep in recession?
- Sure the layoff is everywhere, including China. But the question is to what an extent does this affect NKE's core customers in that market? They are more like the elite class in that society, the group that should be able to hold onto a job through the difficult times.
- Chinese people have a different spending style from the Americans. Normally they have more savings, little or no debt. The way the recession affects the spending style there must be different from here.
I need investigate further and will post to my blog. Here is the NKE Deep Dive.
Introduction
I am a big tennis fan and I watch a lot of tennis on TV, and as a result, I watch a lot of Roger Federer and Rafael Nadal. If you know even just a little bit about this sport, you know what I am talking about. These two guys battled each other in three of the last four grand slam champion games, and the only one that Nadal failed to reach the final, Federer was the eventual winner. Many people, more or less, have some impression of these unique two, might just from glimpses over the TV, handsome, energetic, elite, stylish, and .... swoosh-y. That famous logo seems to be blending into their images, and it is everywhere, head-bands, wrist-bands, shirts, shorts, shoes, and more importantly, almost every TV scene.
It is very impressive. Nike has been a hot stock since long time back. Now in a bear market, feels like a good time for a deep dive.
About Nike
This part is easy. Basically I copied and pasted from its 2008 10K.
'NIKE, Inc. was incorporated in 1968 under the laws of the state of Oregon'.
'Our principal business activity is the design, development and worldwide marketing of high quality footwear, apparel, equipment, and accessory products. NIKE is the largest seller of athletic footwear and athletic apparel in the world. We sell our products to retail accounts, through NIKE-owned retail including stores and internet sales, and through a mix of independent distributors and licensees, in over 180 countries around the
world. Virtually all of our products are manufactured by independent contractors. Virtually all footwear and apparel products are produced outside the United States, while equipment products are produced both in the United States and abroad.'
'NIKE’s athletic footwear products are designed primarily for specific athletic use, although a large percentage of the products are worn for casual or leisure purposes. We place considerable emphasis on high quality construction and innovation in products designed for men, women and children. Running, training, basketball, soccer, sport-inspired urban shoes, and children’s shoes are currently our top-selling footwear categories and we expect them to continue to lead in product sales in the near future. We also market shoes designed for aquatic activities, baseball, bicycling, cheerleading, football, golf, lacrosse, outdoor activities, skateboarding, tennis, volleyball, walking, wrestling, and other athletic and recreational uses.
We sell sports apparel and accessories covering most of the above categories, sports-inspired lifestyle apparel, as well as athletic bags and accessory items. NIKE apparel and accessories are designed to complement our athletic footwear products, feature the same trademarks and are sold through the same marketing and distribution channels. We often market footwear, apparel and accessories in “collections” of similar design or for specific purposes. We also market apparel with licensed college and professional team and league logos.
We sell a line of performance equipment under the NIKE brand name, including bags, socks, sport balls, eyewear, timepieces, electronic devices, bats, gloves, protective equipment, golf clubs, and other equipment designed for sports activities. We also have agreements for licensees to produce and sell NIKE brand swimwear, team sports apparel, training equipment, children’s clothing, electronic devices, eyewear, golf accessories, and belts. We also sell small amounts of various plastic products to other manufacturers through our wholly-owned subsidiary, NIKE IHM, Inc.
Our wholly-owned subsidiary, Cole Haan ("Cole Haan"), headquartered in Yarmouth, Maine, designs and distributes dress and casual footwear, apparel and accessories for men and women under the brand names Cole Haan® and Bragano®.
Our wholly-owned subsidiary, Converse Inc. ("Converse"), headquartered in North Andover,
Massachusetts, designs, distributes, and licenses athletic and casual footwear, apparel and accessories under the Converse®, Chuck Taylor®, All Star®, One Star®, John Varvatos®, and Jack Purcell® trademarks and footwear under the Hurley® trademark.
Our wholly-owned subsidiary, Hurley International LLC ("Hurley"), headquartered in Costa Mesa, California, designs and distributes a line of action sports apparel for surfing, skateboarding, and snowboarding, youth lifestyle apparel, and accessories under the Hurley® trademark.
On March 3, 2008, we acquired all of the capital stock of Umbro Ltd. ("Umbro"). Headquartered in Manchester, England. Umbro designs, distributes, and licenses athletic and casual footwear, apparel and equipment, primarily for the sport of soccer, under the Umbro trademarks.'
Economic Moat
Obviously NKE enjoys the economic moat - their products, although no much difference from its competitors in cost, are pricier, and have less discount, but they sell better.
Three pillars of NIKE's economic moat:
1) Innovation: this looks like the blood of NKE. Not much needs to be explained here, you get the idea by just looking at the awesome product line history, from the Bowerman's waffle sole about 30 years ago, to the famed "Air" cushioning system to the latest Nike+.
2) Fashion: For the past several years, the sportswear design started to display more and more fashion awareness. But you can perceive the clear differences between competing companies in how they adopt this fashion factor. Visit one Adidas store and one Nike store, you may easily come to the conclusion that Adidas is a more 'traditional' company than NKE. This goes beyond the variances in design ideas, more or less, it reflects the differences in the management philosophy. For me, I read it as Nike's superiority. For most people, sports and fashion share one fundamental aspect: to feel good about yourself. So moving around, breaking a sweat, feeling good inside and at the same time, dressing well to feel good outside, this caters to almost everybody's desire. Nike's capability to better blur the border between sportswear and fashion is a clear advantage here.
3) Branding: this is all about Nike's endorsement strategy. Check the line of stars behind it, Jordan, Tiger, Kobe, Mitchell Wie, and in my favorite sport: Federer, Nadal, Sharopova. First, if not the best in their sports, they are the top talented ones, and second, they are attractive, might be because of the look, or personality or temperament, or all above. Combining these two, you get the most influential athletes. There are controversies regarding Nike's endorsement cost, but for me, I like the overall strategy: pick the best few, yes they are very expensive, but every one counts; and second, these guys give Nike products the elite perception, which justifies its hefty price. Further, and more importantly, the relationship between NKE and these guys goes way more than that Nike pays them to wear clothes embroiled with the swoosh logo and show up in their commercials, actually they themselves become the work of Nike. The flying Jordan, the unyielding Tiger, the timeless classic Federer and the fighting Nadal, sure, they are born to have these characteristics, but can you deny the behind-the-scene Nike's marketing power? Their images are so deeply embedded with Nike's image, and from it, NKE obtains the unique power to define/lead the fashion/trend of its industry. This trend/fashion thing, as exposed to the feelings and sentiments of human being, may shift fast in unpredictable directions. Obviously the best players are not those only passively respond to it, but those anticipate it, influence and best, define/lead it. I don't see any other company enjoying such a position as Nike does in its industry.
Finally let's go a little further deeper to get a little abstract, what is the ultimate force that drives NKE to achieve this type of economic moat? My opinion, everything traces back to the company's culture or management philosophy. It's better that I stop here before this becomes an empty talk. So let me point out one last thing, NKE seems to have a superior culture or philosophy comparing to its competitors. What's more, NKE spent 30 years building a kingdom/system/team upon this philosophy, and this is the very thing guaranteeing that Nike's economic moat is almost insurmountable.
Crunching the numbers
Checked Nike's book for the past several years, nothing is alarming here.
1)Growth
In 2004, Nike generated revenue 12,253.1M and in 2008, 18,627M, the average growth rate is 11.7%; operating income in 2004 is 1,549.7M and in 2008, 2,433.7M, the average growth rate is 14.3%. So historically, a great great company. We will look at the future growth potential in one of the future posts.
2) Return on Asset (ROA)
I put together the numbers from Nike and two of its closest competitors, Under Armour and Adidas.
Observation 1: The number for Nike is very healthy.
Observation 2: In Net Margin, Nike is better than Under Armour, although partially owing to lower tax rate. UA is better in Asset Turn Over. Actually I was surprised by the performance of UA.
Observation 3: Normally Adidas sells cheaper and has deeper discount, somewhat it seems they struggle to find the ingredients in the design that will make people (maybe only me) excited. Also since Adidas acquired Reebok, the latter gradually lost its characteristics, becoming dull and boring. Anyway, it is not perceived to be an excellently run company, and the number confirms it.
3) Return on Equity (ROE)
Observation 1: Again very healthy numbers for Nike, a clear winner here.
Observation 2: The UA 2004 number is skewed by the unusually high debt level. Its average is based on the last four years.
Observation 3: Adidas posted similar numbers as the other two, but was boosted by much higher Financial Leverage (higher debt level).
4) Financial Health
As of 2009, Nike has a Current Ratio at 2.89, Quick Ratio at 1.44, Debt/Equity at 0.05, and around 1 billion cash in hand. Looks like a company well prepared to survive the recession.
(source: www.morningstar.com)
Evaluation and the Three Rules
For the past 10 year, Nike's P/E never dropped below 17, now at 11, price/sales, used to hover around 1.5, now at 1.1. So nothing to elaborate here, its evaluation is at historical low; pretty much it is the same situation for every company still alive today.
Now let's put it in the recession background.
My first article on the blog, click here if you'd like to read, talked about the three rules to screen stocks in today's market. Let's plug it in for the NKE case.
1) Big & Safe: As a company with 20 billion dollar revenue and 20 billion market cap, Nike is big. With almost 1 billion dollar free cash in hand and a current ratio around 3, it is pretty safe. Also NKE is the No. 1 in sportswear. If the entire industry has to go down, Nike may well be the last one.
2) International Revenue: see the table (all numbers in million except percentage).
As of may 2006, around 38% Nike's revenue is from the United States, and in 2008, the number dropped to 34%, and the quarter ended December 2008, 33%. Also you can see NKE is not tied to any single market/area on the globe. Sure we are having a worldwide recession, but it takes different forms in different countries. With the revenue as balanced as NKE, I can't expect any other company could better mitigate the impact.
3) Recover from depression: for me, NKE fits both types of companies I mentioned in the initial blog. I will cover the growth part later. What's more, I think the sportswear industry should be the one recovering earlier and faster from the recession. Nike is not a luxury brand, but their products are not cheap either. The recession forces people to scale back spending, reducing expenses in categories that are not everyday needs. Therefore, you see Walmart thrives but Macy's suffers. The government seems to be trying to put more money into the hands of the ordinary consumers to stimulate the entire economy - seems reasonable to assume people go get a pair of nice sneakers when finally there is some extra cash left in the pocket.
Growth
What is going to drive NKE's growth in the next 5-10 years? The answer is innovation and Asian countries. Let's dig a little deeper.
Innovation is particularly important for Nike in matured markets such as North America and Europe, where the product saturation already reached, price levels were set, brand image/perception was well established, and competition yet fierce, but won't take any new forms unless some of the players have significant missteps. In these markets, we have two levels of innovation. First, some technology progression and innovative marketing ideas seem to be a necessity to retain its current market position. The second level is beyond the first one, referring to the type of innovation that drives up revenue and market share, and we can call it growth innovation. The very last such innovation is Nike+, the marriage between Nike and Apple, which is one of the key drivers of its footwear growth in US region in the past few years. Technically, it is not something that you can count on 100% for sure, nobody could answer questions such as ‘when should we expect the next Nike+?’, further, also a legitimate question, ‘will there be such an innovation at all?’. So you can say nothing is guaranteed. However, given its history, I would like to believe NKE would come up with more growth innovations. And if such ideas do come up, I would also like to believe Nike, as its past illustrated, will execute them well and turn in good numbers on its book.
Compared to innovation, Asian countries are a much more concrete driving force of growth.
Modernization and westernization of the Asian countries created certain form of crave to American culture, and for reasons that we won't dig here, Nike became one of the symbols of American culture. I think partially this is the outcome of Nike's marketing efforts, but also I believe it is something Nike, as a pure business runner, didn't expect. Originating from this is its huge popularity. And Nike never stopped consolidating such popularity with successful marketing moves. In the discussion about the economic moat of NKE, I talked about Nike's branding. In its 10K, NKE stated its strategy as, 'to create long-term revenue growth by creating compelling consumer experiences by creating and delivering innovative, "must have" products; deep personal connections with our brands; and compelling retail presentation'. Nothing interpreted this better than Nike's success in these Asian countries, especially China and India - the fancy sportswear technologies, the fashion sense, the influence of those endorsed sports heroes made Nike not only a "must have" brand, but a "proud-to-have" brand. One more thing to add here, NKE actually put a higher price tag on its products in Asia, adding an extra luxury flavor, which matches perfect with its overall strategy, also results in higher margin.
The other side of the story, economic development in countries such as China and India created a bigger and bigger middle class group. Normally they are the younger generations, growing up in a relative open environment, having higher education, descent income, good sense of fashion and proper knowledge and awareness of health and exercise. Using China as the example, "The number of middle-class consumers on the mainland is expected to nearly triple to 100 million in 10 years from 2006" (source: http://www.chinadaily.com.cn/bizchina/2007-12/08/content_6307152.htm). They are the target consumer of NKE. In other words, NKE already has a huge consumer base and it is growing , and this will be the strongest driving force of Nike's future growth. (Several more words to revisit a previous topic, this explains why the international revenue is so critical for us to screen companies nowadays, especially considering China was hit not nearly as hard as the US by the financial crisis.)
One last contributor is from China. Chinese government is under great pressure from America and Europe to loose its currency policy. For Nike, since virtually all footwear and apparel products are produced outside the United States (a significant portion in China), the appreciation of Chinese currency value against American dollar may translate directly into surging numbers in revenue/profit on Nike's book.
Nike is well aware of the opportunities. One of the indicators, in Feb 2009, Nike broke ground on a distribution center in China, "a further demonstration of our (Nike's) long-term and unwavering commitment to China" (source: http://www.bizjournals.com/portland/stories/2009/02/16/daily28.html).
Risks
Thinking long term, I don't see any major risks with NIKE. Here are some comments on some common concerns.
1. Global Recession: there are two sides of the story. First, if the global recession continues long enough, it will eventually slow down the growth of NKE, or worse, wiping out the profits. Second, the bear market itself simply refuses to reward reasonable/high evaluations even NKE manages to turn in impressive numbers, on the other hand, it punishes harder if the company misses. Thus a good earning from NKE may not boost the price, while a bad one may drive it down big. The positive side, there is nothing specific or unique to NKE only, pretty much the same situation for every company.
2. Design Misstep: if you are familiar with apparel companies such as American Eagle (AEO), Abercrombie and Fitch (ANF), etc... you know the risks internal to this type of fashion player. From time to time, they will have some kind of design missteps, releasing products that deviate from the fashion trend of its targeted customer, thus excessive inventory, deeper discount, a poor quarter and lower stock price, then recalibrate and another round starts. This also applies to NKE. They may release products that the customer totally lack interest. The positive side, they are big, they never rely on one product line or one design concept for one quarter; their mixed product offerings should be able to mitigate the risks well. Further, bottom line, NKE is never a pure fashion player, it is a sportswear company. They can always use the sports stars' influence to offset a poor offering, or a mediocre design.
3. Inventory Pressure: A few days ago, Goldman gave cautious note on athletic apparel, footwear sector, citing the inventory may create near-term headwinds. Overall, it is a valid concern though NKE seems to have some edge over its competitors:
- If you haven't visited nikestore.com, check it once. I was surprised how well it was constructed. Actually more are more revenues are generated from its website, and more importantly, it provides an interface with the end consumers directly, this should give NKE some sort of 'prediction' power, second, they run a lot of secret codes, online coupons, displaying a very flexible pricing schema. Feels they can be very efficient in dealing with inventories.
- Nike runs a "futures" ordering program. From its 10K, "We make substantial use of our "futures" ordering program, which allows retailers to order five to six months in advance of delivery with the commitment that their orders will be delivered within a set time period at a fixed price. In fiscal year 2008, 86 percent of our U.S. wholesale footwear shipments (excluding Cole Haan, Converse, Exeter Brands Group, Hurley, NIKE Golf, Umbro, and NIKE Bauer Hockey) were made under the futures program, compared to 94 percent in fiscal 2007 and 90 percent in fiscal 2006." Five to six months should provide enough buffer time for inventory adjustment. This system sounds very helpful to offset the order volatility.
4. Strategy and Management philosophy: as discussed earlier, innovation, fashion, branding are the cornerstones of Nike's business model, and behind this model, I see the consistent strategy, culture and management philosophy. All these, sounds abstract, but are the ultimate force that drives NKE's success. I'd keep a close eyes on NIKE's management change. The serious deviation from existing strategy and philosophy might be the only thing that may hurt Nike big given the superiority and dominance it has been enjoying today.
Conclusion
Start accumulating shares. As of 2/28/2009, the close price is 41.53, it may go lower below 40, if so, buy more shares.
- The huge population in China provides an immense market and NKE is far far from fully tapping it. If Nike moves A LOT more aggressively in this direction, is there a good chance that NKE surprises the investors with impressive numbers even we are deep in recession?
- Sure the layoff is everywhere, including China. But the question is to what an extent does this affect NKE's core customers in that market? They are more like the elite class in that society, the group that should be able to hold onto a job through the difficult times.
- Chinese people have a different spending style from the Americans. Normally they have more savings, little or no debt. The way the recession affects the spending style there must be different from here.
I need investigate further and will post to my blog. Here is the NKE Deep Dive.
Introduction
I am a big tennis fan and I watch a lot of tennis on TV, and as a result, I watch a lot of Roger Federer and Rafael Nadal. If you know even just a little bit about this sport, you know what I am talking about. These two guys battled each other in three of the last four grand slam champion games, and the only one that Nadal failed to reach the final, Federer was the eventual winner. Many people, more or less, have some impression of these unique two, might just from glimpses over the TV, handsome, energetic, elite, stylish, and .... swoosh-y. That famous logo seems to be blending into their images, and it is everywhere, head-bands, wrist-bands, shirts, shorts, shoes, and more importantly, almost every TV scene.
It is very impressive. Nike has been a hot stock since long time back. Now in a bear market, feels like a good time for a deep dive.
About Nike
This part is easy. Basically I copied and pasted from its 2008 10K.
'NIKE, Inc. was incorporated in 1968 under the laws of the state of Oregon'.
'Our principal business activity is the design, development and worldwide marketing of high quality footwear, apparel, equipment, and accessory products. NIKE is the largest seller of athletic footwear and athletic apparel in the world. We sell our products to retail accounts, through NIKE-owned retail including stores and internet sales, and through a mix of independent distributors and licensees, in over 180 countries around the
world. Virtually all of our products are manufactured by independent contractors. Virtually all footwear and apparel products are produced outside the United States, while equipment products are produced both in the United States and abroad.'
'NIKE’s athletic footwear products are designed primarily for specific athletic use, although a large percentage of the products are worn for casual or leisure purposes. We place considerable emphasis on high quality construction and innovation in products designed for men, women and children. Running, training, basketball, soccer, sport-inspired urban shoes, and children’s shoes are currently our top-selling footwear categories and we expect them to continue to lead in product sales in the near future. We also market shoes designed for aquatic activities, baseball, bicycling, cheerleading, football, golf, lacrosse, outdoor activities, skateboarding, tennis, volleyball, walking, wrestling, and other athletic and recreational uses.
We sell sports apparel and accessories covering most of the above categories, sports-inspired lifestyle apparel, as well as athletic bags and accessory items. NIKE apparel and accessories are designed to complement our athletic footwear products, feature the same trademarks and are sold through the same marketing and distribution channels. We often market footwear, apparel and accessories in “collections” of similar design or for specific purposes. We also market apparel with licensed college and professional team and league logos.
We sell a line of performance equipment under the NIKE brand name, including bags, socks, sport balls, eyewear, timepieces, electronic devices, bats, gloves, protective equipment, golf clubs, and other equipment designed for sports activities. We also have agreements for licensees to produce and sell NIKE brand swimwear, team sports apparel, training equipment, children’s clothing, electronic devices, eyewear, golf accessories, and belts. We also sell small amounts of various plastic products to other manufacturers through our wholly-owned subsidiary, NIKE IHM, Inc.
Our wholly-owned subsidiary, Cole Haan ("Cole Haan"), headquartered in Yarmouth, Maine, designs and distributes dress and casual footwear, apparel and accessories for men and women under the brand names Cole Haan® and Bragano®.
Our wholly-owned subsidiary, Converse Inc. ("Converse"), headquartered in North Andover,
Massachusetts, designs, distributes, and licenses athletic and casual footwear, apparel and accessories under the Converse®, Chuck Taylor®, All Star®, One Star®, John Varvatos®, and Jack Purcell® trademarks and footwear under the Hurley® trademark.
Our wholly-owned subsidiary, Hurley International LLC ("Hurley"), headquartered in Costa Mesa, California, designs and distributes a line of action sports apparel for surfing, skateboarding, and snowboarding, youth lifestyle apparel, and accessories under the Hurley® trademark.
On March 3, 2008, we acquired all of the capital stock of Umbro Ltd. ("Umbro"). Headquartered in Manchester, England. Umbro designs, distributes, and licenses athletic and casual footwear, apparel and equipment, primarily for the sport of soccer, under the Umbro trademarks.'
Economic Moat
Obviously NKE enjoys the economic moat - their products, although no much difference from its competitors in cost, are pricier, and have less discount, but they sell better.
Three pillars of NIKE's economic moat:
1) Innovation: this looks like the blood of NKE. Not much needs to be explained here, you get the idea by just looking at the awesome product line history, from the Bowerman's waffle sole about 30 years ago, to the famed "Air" cushioning system to the latest Nike+.
2) Fashion: For the past several years, the sportswear design started to display more and more fashion awareness. But you can perceive the clear differences between competing companies in how they adopt this fashion factor. Visit one Adidas store and one Nike store, you may easily come to the conclusion that Adidas is a more 'traditional' company than NKE. This goes beyond the variances in design ideas, more or less, it reflects the differences in the management philosophy. For me, I read it as Nike's superiority. For most people, sports and fashion share one fundamental aspect: to feel good about yourself. So moving around, breaking a sweat, feeling good inside and at the same time, dressing well to feel good outside, this caters to almost everybody's desire. Nike's capability to better blur the border between sportswear and fashion is a clear advantage here.
3) Branding: this is all about Nike's endorsement strategy. Check the line of stars behind it, Jordan, Tiger, Kobe, Mitchell Wie, and in my favorite sport: Federer, Nadal, Sharopova. First, if not the best in their sports, they are the top talented ones, and second, they are attractive, might be because of the look, or personality or temperament, or all above. Combining these two, you get the most influential athletes. There are controversies regarding Nike's endorsement cost, but for me, I like the overall strategy: pick the best few, yes they are very expensive, but every one counts; and second, these guys give Nike products the elite perception, which justifies its hefty price. Further, and more importantly, the relationship between NKE and these guys goes way more than that Nike pays them to wear clothes embroiled with the swoosh logo and show up in their commercials, actually they themselves become the work of Nike. The flying Jordan, the unyielding Tiger, the timeless classic Federer and the fighting Nadal, sure, they are born to have these characteristics, but can you deny the behind-the-scene Nike's marketing power? Their images are so deeply embedded with Nike's image, and from it, NKE obtains the unique power to define/lead the fashion/trend of its industry. This trend/fashion thing, as exposed to the feelings and sentiments of human being, may shift fast in unpredictable directions. Obviously the best players are not those only passively respond to it, but those anticipate it, influence and best, define/lead it. I don't see any other company enjoying such a position as Nike does in its industry.
Finally let's go a little further deeper to get a little abstract, what is the ultimate force that drives NKE to achieve this type of economic moat? My opinion, everything traces back to the company's culture or management philosophy. It's better that I stop here before this becomes an empty talk. So let me point out one last thing, NKE seems to have a superior culture or philosophy comparing to its competitors. What's more, NKE spent 30 years building a kingdom/system/team upon this philosophy, and this is the very thing guaranteeing that Nike's economic moat is almost insurmountable.
Crunching the numbers
Checked Nike's book for the past several years, nothing is alarming here.
1)Growth
In 2004, Nike generated revenue 12,253.1M and in 2008, 18,627M, the average growth rate is 11.7%; operating income in 2004 is 1,549.7M and in 2008, 2,433.7M, the average growth rate is 14.3%. So historically, a great great company. We will look at the future growth potential in one of the future posts.
2) Return on Asset (ROA)
I put together the numbers from Nike and two of its closest competitors, Under Armour and Adidas.
| Company | 2008 | 2007 | 2006 | 2005 | 2004 | Average |
| Adidas (ADDYY) | 6.60% | 6.60% | 6.84% | 7.52% | 7.30% | 6.97% |
| Under Armour (UA) | 10.89% | 15.46% | 15.81% | 9.16% | 12.91% | 12.85% |
| NIKE (NKE) | 16.28% | 14.51% | 14.92% | 14.52% | 12.95% | 14.63% |
Observation 1: The number for Nike is very healthy.
Observation 2: In Net Margin, Nike is better than Under Armour, although partially owing to lower tax rate. UA is better in Asset Turn Over. Actually I was surprised by the performance of UA.
Observation 3: Normally Adidas sells cheaper and has deeper discount, somewhat it seems they struggle to find the ingredients in the design that will make people (maybe only me) excited. Also since Adidas acquired Reebok, the latter gradually lost its characteristics, becoming dull and boring. Anyway, it is not perceived to be an excellently run company, and the number confirms it.
3) Return on Equity (ROE)
| Company | 2008 | 2007 | 2006 | 2005 | 2004 | Average |
| Adidas (ADDYY) | 21.06% | 17.75% | 17.53% | 18.83% | 18.83% | 18.8% |
| Under Armour (UA) | 16.12% | 21.24% | 21.35% | 16.75% | 67.47% | 18.87% |
| NIKE (NKE) | 23.78% | 25.37% | 22.41% | 23.34% | 23.24% | 23.63% |
Observation 1: Again very healthy numbers for Nike, a clear winner here.
Observation 2: The UA 2004 number is skewed by the unusually high debt level. Its average is based on the last four years.
Observation 3: Adidas posted similar numbers as the other two, but was boosted by much higher Financial Leverage (higher debt level).
4) Financial Health
As of 2009, Nike has a Current Ratio at 2.89, Quick Ratio at 1.44, Debt/Equity at 0.05, and around 1 billion cash in hand. Looks like a company well prepared to survive the recession.
(source: www.morningstar.com)
Evaluation and the Three Rules
For the past 10 year, Nike's P/E never dropped below 17, now at 11, price/sales, used to hover around 1.5, now at 1.1. So nothing to elaborate here, its evaluation is at historical low; pretty much it is the same situation for every company still alive today.
Now let's put it in the recession background.
My first article on the blog, click here if you'd like to read, talked about the three rules to screen stocks in today's market. Let's plug it in for the NKE case.
1) Big & Safe: As a company with 20 billion dollar revenue and 20 billion market cap, Nike is big. With almost 1 billion dollar free cash in hand and a current ratio around 3, it is pretty safe. Also NKE is the No. 1 in sportswear. If the entire industry has to go down, Nike may well be the last one.
2) International Revenue: see the table (all numbers in million except percentage).
| Areas | 2008 | % | 2007 | % | 2006 | % |
| United States | 6378.00 | 34% | 6107.10 | 37% | 5722.50 | 38% |
| Europe, Middle East and Africa | 5620.40 | 30% | 4723.30 | 29% | 4326.60 | 29% |
| Asia Pacific | 2881.70 | 15% | 2283.40 | 14% | 2053.80 | 14% |
| Americas | 1154.10 | 6% | 952.50 | 6% | 904.90 | 6% |
| Other | 2592.80 | 14% | 2259.60 | 14% | 1947.10 | 13% |
| Total | 18627.00 | 16325.90 | 14954.90 |
As of may 2006, around 38% Nike's revenue is from the United States, and in 2008, the number dropped to 34%, and the quarter ended December 2008, 33%. Also you can see NKE is not tied to any single market/area on the globe. Sure we are having a worldwide recession, but it takes different forms in different countries. With the revenue as balanced as NKE, I can't expect any other company could better mitigate the impact.
3) Recover from depression: for me, NKE fits both types of companies I mentioned in the initial blog. I will cover the growth part later. What's more, I think the sportswear industry should be the one recovering earlier and faster from the recession. Nike is not a luxury brand, but their products are not cheap either. The recession forces people to scale back spending, reducing expenses in categories that are not everyday needs. Therefore, you see Walmart thrives but Macy's suffers. The government seems to be trying to put more money into the hands of the ordinary consumers to stimulate the entire economy - seems reasonable to assume people go get a pair of nice sneakers when finally there is some extra cash left in the pocket.
Growth
What is going to drive NKE's growth in the next 5-10 years? The answer is innovation and Asian countries. Let's dig a little deeper.
Innovation is particularly important for Nike in matured markets such as North America and Europe, where the product saturation already reached, price levels were set, brand image/perception was well established, and competition yet fierce, but won't take any new forms unless some of the players have significant missteps. In these markets, we have two levels of innovation. First, some technology progression and innovative marketing ideas seem to be a necessity to retain its current market position. The second level is beyond the first one, referring to the type of innovation that drives up revenue and market share, and we can call it growth innovation. The very last such innovation is Nike+, the marriage between Nike and Apple, which is one of the key drivers of its footwear growth in US region in the past few years. Technically, it is not something that you can count on 100% for sure, nobody could answer questions such as ‘when should we expect the next Nike+?’, further, also a legitimate question, ‘will there be such an innovation at all?’. So you can say nothing is guaranteed. However, given its history, I would like to believe NKE would come up with more growth innovations. And if such ideas do come up, I would also like to believe Nike, as its past illustrated, will execute them well and turn in good numbers on its book.
Compared to innovation, Asian countries are a much more concrete driving force of growth.
Modernization and westernization of the Asian countries created certain form of crave to American culture, and for reasons that we won't dig here, Nike became one of the symbols of American culture. I think partially this is the outcome of Nike's marketing efforts, but also I believe it is something Nike, as a pure business runner, didn't expect. Originating from this is its huge popularity. And Nike never stopped consolidating such popularity with successful marketing moves. In the discussion about the economic moat of NKE, I talked about Nike's branding. In its 10K, NKE stated its strategy as, 'to create long-term revenue growth by creating compelling consumer experiences by creating and delivering innovative, "must have" products; deep personal connections with our brands; and compelling retail presentation'. Nothing interpreted this better than Nike's success in these Asian countries, especially China and India - the fancy sportswear technologies, the fashion sense, the influence of those endorsed sports heroes made Nike not only a "must have" brand, but a "proud-to-have" brand. One more thing to add here, NKE actually put a higher price tag on its products in Asia, adding an extra luxury flavor, which matches perfect with its overall strategy, also results in higher margin.
The other side of the story, economic development in countries such as China and India created a bigger and bigger middle class group. Normally they are the younger generations, growing up in a relative open environment, having higher education, descent income, good sense of fashion and proper knowledge and awareness of health and exercise. Using China as the example, "The number of middle-class consumers on the mainland is expected to nearly triple to 100 million in 10 years from 2006" (source: http://www.chinadaily.com.cn/bizchina/2007-12/08/content_6307152.htm). They are the target consumer of NKE. In other words, NKE already has a huge consumer base and it is growing , and this will be the strongest driving force of Nike's future growth. (Several more words to revisit a previous topic, this explains why the international revenue is so critical for us to screen companies nowadays, especially considering China was hit not nearly as hard as the US by the financial crisis.)
One last contributor is from China. Chinese government is under great pressure from America and Europe to loose its currency policy. For Nike, since virtually all footwear and apparel products are produced outside the United States (a significant portion in China), the appreciation of Chinese currency value against American dollar may translate directly into surging numbers in revenue/profit on Nike's book.
Nike is well aware of the opportunities. One of the indicators, in Feb 2009, Nike broke ground on a distribution center in China, "a further demonstration of our (Nike's) long-term and unwavering commitment to China" (source: http://www.bizjournals.com/portland/stories/2009/02/16/daily28.html).
Risks
Thinking long term, I don't see any major risks with NIKE. Here are some comments on some common concerns.
1. Global Recession: there are two sides of the story. First, if the global recession continues long enough, it will eventually slow down the growth of NKE, or worse, wiping out the profits. Second, the bear market itself simply refuses to reward reasonable/high evaluations even NKE manages to turn in impressive numbers, on the other hand, it punishes harder if the company misses. Thus a good earning from NKE may not boost the price, while a bad one may drive it down big. The positive side, there is nothing specific or unique to NKE only, pretty much the same situation for every company.
2. Design Misstep: if you are familiar with apparel companies such as American Eagle (AEO), Abercrombie and Fitch (ANF), etc... you know the risks internal to this type of fashion player. From time to time, they will have some kind of design missteps, releasing products that deviate from the fashion trend of its targeted customer, thus excessive inventory, deeper discount, a poor quarter and lower stock price, then recalibrate and another round starts. This also applies to NKE. They may release products that the customer totally lack interest. The positive side, they are big, they never rely on one product line or one design concept for one quarter; their mixed product offerings should be able to mitigate the risks well. Further, bottom line, NKE is never a pure fashion player, it is a sportswear company. They can always use the sports stars' influence to offset a poor offering, or a mediocre design.
3. Inventory Pressure: A few days ago, Goldman gave cautious note on athletic apparel, footwear sector, citing the inventory may create near-term headwinds. Overall, it is a valid concern though NKE seems to have some edge over its competitors:
- If you haven't visited nikestore.com, check it once. I was surprised how well it was constructed. Actually more are more revenues are generated from its website, and more importantly, it provides an interface with the end consumers directly, this should give NKE some sort of 'prediction' power, second, they run a lot of secret codes, online coupons, displaying a very flexible pricing schema. Feels they can be very efficient in dealing with inventories.
- Nike runs a "futures" ordering program. From its 10K, "We make substantial use of our "futures" ordering program, which allows retailers to order five to six months in advance of delivery with the commitment that their orders will be delivered within a set time period at a fixed price. In fiscal year 2008, 86 percent of our U.S. wholesale footwear shipments (excluding Cole Haan, Converse, Exeter Brands Group, Hurley, NIKE Golf, Umbro, and NIKE Bauer Hockey) were made under the futures program, compared to 94 percent in fiscal 2007 and 90 percent in fiscal 2006." Five to six months should provide enough buffer time for inventory adjustment. This system sounds very helpful to offset the order volatility.
4. Strategy and Management philosophy: as discussed earlier, innovation, fashion, branding are the cornerstones of Nike's business model, and behind this model, I see the consistent strategy, culture and management philosophy. All these, sounds abstract, but are the ultimate force that drives NKE's success. I'd keep a close eyes on NIKE's management change. The serious deviation from existing strategy and philosophy might be the only thing that may hurt Nike big given the superiority and dominance it has been enjoying today.
Conclusion
Start accumulating shares. As of 2/28/2009, the close price is 41.53, it may go lower below 40, if so, buy more shares.
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