Thursday, December 8, 2011

Profitless Prosperity

The future for Research in Motion (RIMM) seems, at least for now, less bright by the day but as this Barron's article points out, they're certainly not the only business struggling to profit in areas with a dynamic future.

The article makes the case that competing these days for some companies is leading to "profitless prosperity" and cites some examples.

The High Cost of Buying the Future

Slow-growth technology stocks remain relatively and, in some cases, absolutely cheap while faster growing, yet unproven technology franchises sell at huge speculative premiums. What the article calls "growth at any price".

"...Investors are still willing to pay for what I call GAAP, or growth at any price. They're dumping companies that aren't growing and paying up for those that are. But at some point, the high price of the future will bring diminishing investment returns, and investors will start growing impatient.

And when that happens, look out below."

Neither "growth at any price" nor "profitless prosperity" sound like a brilliant way to invest to me. I'll skip the ride and, instead, stick to buying the proven high quality businesses.

Paying a high multiple of earnings can work out occasionally*, but consider how quickly the earning outlook has changed for something like Netflix. With the profitability picture changing that rapidly, it's very tough to know what Netflix is or will be worth.

Before putting capital at risk, I'd need more certainty or, at least, what's an obvious and substantial discount to likely value.

Now I could reasonably argue, contrary to norms, that the relative economic certainty provided by a proven business like Coca-Cola (KO) actually deserves a higher earnings multiple than many of the more exciting fast growing yet unproven businesses.
(Though I'd certainly prefer if market participants don't draw that same conclusion about Coca-Cola for quite some time...a couple more decades would be nice!)

Some may dismiss this way of thinking but, before doing so, just think about it a bit.

It's not quite as crazy as it may initially sound.

The Barron's article makes the point that Amazon's (AMZN) Kindle Fire has a cost per unit of $202 but is being sold for $199.

Amazon's decision to sell the device for less than it costs to make was covered in this previous post. So, for now, it is a money-losing proposition unless the company can make up the money on sales of e-books, music, videos, etc. They just might but that's pure speculation at this point.

In contrast, according to the article, Apple (AAPL) should make roughly a 50% profit on the 19 million iPad tablets it may sell this quarter.

While Amazon's stock certainly seems expensive, the situation is, to me, very different from Netflix and even more so from RIM.  In fact, Amazon seems to be building quite a franchise. It's willingness to patiently create its business over the long haul is, in many ways, very impressive.

Yet, that doesn't mean shareholders will do well on a risk-adjusted basis in the long run. I'm guessing they will not, even if Amazon succeeds as a business, but who knows (of course trading it may work just fine).

Amazon is expected to earn less than $ 1 billion next year (though the estimates are all over the map). So at that earnings run rate if there were no growth Amazon would earn, in total, by 2041 or so (30 years @ ~$ 1 billion/year) the roughly $ 30 billion Apple will earn this year alone.

Apple's enterprise value is only ~3x that of Amazon's enterprise value.

So investors are paying plenty for Amazon's promise. The company has quite the earnings mountain to climb to even justify its current valuation never mind actually making an acceptable risk-adjusted return for investors.
(By eventually creating a business with intrinsic per share value well above the current share price. Obviously, no investor puts capital at risk for the privilege of eventually just getting their money back.)

In contrast, investors these days are paying less than ten dollars for every dollar of Apple earnings. To produce a nice return for investors, the company has to grow little, if at all, at that kind of valuation.

Of course, using the current earnings run rate isn't really fair because Amazon will eventually grow those earnings substantially over that time, right?

Well, that might be true. All I know is it had better be true considering the valuation.

I mean, it's not like Apple exactly has unattractive prospects at this point.

So we have two businesses, each with unique risks and strengths and lots of promise. Yet, with one stock, investors are willing to pay 100 dollars for every dollar of current earnings while the other stock gets one tenth that valuation multiple.

Growth at any price, indeed.

Most of Amazon's valuation is based upon the promise of what it may do someday. Apple's valuation, assuming its current business is reasonably durable**, in contrast seems completely backed up by what it already is doing.

Apple is certainly not a favorite of mine as a long-term investment but the contrast with Amazon's valuation is really rather amazing.

As I've explained previously here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment.

Adam

Established long positions in KO and AAPL at much lower than recent market prices

Related posts:
Netflix: Buys High, Sells Low
Amazon Sells Kindle Fire Below Cost
Technology Stocks

* Give or take, when the speculative premium that's implicit in a high multiple stock disappears, only what's of more explicit value, if anything, will be there to support the stock price. Yet, if no speculative premium is paid in the first place, one doesn't have to worry about whether that premium will be sustainable.
**As far as I'm concerned, durability is never a given with any technology business. I'll never be as comfortable with most technology businesses as some others. In my view, just about all tech businesses fail this test: "What happens to cash flows long-term if they stopped innovating?" Try that test on Wrigley or Coca-Cola. Also, the potential for a disruptive technology shift is often around the corner so tech businesses will never be my favorite and always have a shorter leash.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
Site Meter