Apple, IBM and Amazon

I used to be a technology executive in the early 2000s. And as a technophile, I still follow that space assiduously both in terms of products and trends as well as companies and strategy. Every quarter that Apple announces, I have made it a habit of commenting on their quarter, because they are the largest technology company in the world. This quarter, I thought I would add IBM and Amazon to the mix because there are important takeaways from their earnings as well. With Apple, the question is innovation and dependence on the iPhone. For IBM, the question is real earnings versus financial engineering. And for Amazon, the question I want to address here is net income versus cash flow.

Apple. Let’s look at Apple first. 

Below are the headline numbers for Q4 2014:

• Revenue:  $42.1 billion vs. $37.5 billion in Q4 2013 and $37.4 billion in Q3 2014
• Profit: $8.5 billion vs. $7.5 billion in Q4 2013 and $7.7 billion in Q3 2014
• EPS: $1.42 per diluted share vs. $1.18 in Q4 2013 and $1.28 in Q3 2014
• Gross margin: 38 percent vs. 37 percent in Q4 2013 and 39.4 percent in Q3 2014. 
• International sales: 60 percent of revenue.

This is the third straight quarter of earnings increases for Apple. But gross margins slipped quarter-on-quarter.

In terms of product sales. Apple’s quarter looked like this:

• iPhone sales: 39.3 million vs. 33.8 million in Q4 2013 and 35.20 million in Q3 2014 and analyst expectations for 38 million 
• iPad sales: 12.3 million vs. 14.08 million iPads in Q4 2013 and 13.27 million in Q3 2014 and analyst expectations for 13 million 
• Mac sales: 5.5 million vs. 4.57 million in Q4 2013 and 4.41 million in Q3 2014 and analyst expectations for 5 million 
• iPod sales: 2.6 million vs. 3.49 million iPods in Q4 2013 and 2.96 million in Q3 2014 and analyst expectations for 2.3 million

Apple is providing the following guidance for its fiscal 2015 first quarter:

• Revenue between $63.5 billion and $66.5 billion
• Gross margin between 37.5 percent and 38.5 percent
• Operating expenses between $5.4 billion and $5.5 billion
• Other income/(expense) of $325 million
• Tax rate of 26.5 percent

This was a good quarter for Apple. And the next quarter will be even better because of the iPhone 6 and iPhone 6 Plus. I think the move up in size for Apple is a win for the company which will translate into incremental sales. But it is a rearguard, reactive response that underlines the lack of innovation at the company. There are no new killer products. The Apple watch is nothing new since many other manufacturers are already getting into the wearables space. And Apple Pay is equally a product in an already crowded payments space. If Apple executes well, they can take share in these spaces. but intrinsically, there is nothing innovative or new about these products.

Tech Crunch’s August article on the tablet market is where Apple needs to be regarding innovation, particularly in the corporate space:

For the tablet category to continue to grow, tablets need to move beyond what Chris Dixon calls the “toy phase” and become more like PCs. The features required for a tablet to evolve into a super tablet are straight from the PC playbook: at least a 13” screen, 64 bit processor, 2GB of RAM, 256GB drive, a real keyboard, an actual file system, and an improved operating system with windowing and true multitasking capability. Super tablets form factors could range from notebooks to all-in-one desktops like the iMac. Small 7” and 9” super tablets could dock into larger screens and keyboards.

The computer industry is littered with the detritus of failed attempts to simplify PCs ranging from Sun Micrososytems’ Sun Ray to Oracle’s Network Computer to Microsoft’s Windows CE. But this time, it’s actually different. The power of mass-produced, 64-bit ARM chips, economies of scale from smartphone and tablet production, and — most importantly — the vast ecosystem of iOS and Android apps have finally made such a “network computer” feasible.

Businesses Need Super Tablets

As the former CIO at CBS Interactive, I would have bought such super tablets in droves for our employees, the vast majority of whom primarily use only a web browser and Microsoft Office. There will of course always be power users such as developers and video editors that require a full-fledged PC. A souped-up tablet would indeed garner corporate sales, as Tim Cook would like for the iPad … but only at the expense of MacBooks.

The cost of managing PCs in an enterprise are enormous, with Gartner estimating that the total cost of ownership for a notebook computer can be as high as $9,000. PCs are expensive, prone to failure, easy to break and magnets for viruses and malware. After just a bit of use, many PCs are susceptible to constant freezes and crashes.

PCs are so prone to failure that ServiceNow — a company devoted to helping IT organizations track help desk tickets — is worth over $8 billion. Some organizations are so fed up with problematic PCs that they are using expensive and cumbersome desktop virtualization, where the PC environment is strongly controlled on servers and streamed to a client.

And while Macs are somewhat better than Windows, I suggest you stand next to any corporate help desk or the Apple genius bar and watch and learn if you think they are not problematic.

The main benefits of super tablets to enterprises are their systems management and replaceability. Smartphones and tablets are so simple and easy to manage that they are typically handled by an IT organization’s cost-effective phone team rather than more expensive PC technicians, who are typically so overwhelmed with small problems that they cannot focus on fixing more complex issues. Apps can be provisioned and updated by both IT and end-users without causing conflicts or problems. If a device is lost, it is easy to remote wipe data and to provision a new device with all of the same settings.

Programs like BYOD (Bring Your Own Device) just accentuate the fact that smartphones and tablets are so easy to manage that enterprises are comfortable letting their employees pick the devices themselves. Users also get great benefits, including instant-on, long battery life, simplicity, and access to legions of apps from the iTunes and Play app stores.

If Apple does not move its tablets into the super-tablet space, Microsoft will and Google will, with its Chromebooks. And both Microsoft and Google are making operating systems there that span from phones to computers and thus give this space a lot of flexibility for users.

Apple is also excessively dependent on the iPhone for success. This is not Blackberry, however. Apple will continue to churn out huge cash flow. Apple generated $59.7 billion in cash from operations in the 2014 fiscal year, which is more than any other US company and more than the revenue of all except 44 US companies. But the dependence on one product for the bulk of its sales does make it vulnerable to a sudden decline in fortunes.

IBM. I have less to say about IBM which reported earnings before the open on Monday. but the news from IBM is related to Apple. IBM reported disappointing earnings, causing the company’s shares to decline. Andrew Ross Sorkin at Dealbook really nails the analysis here and bears quoting at length:

The company’s revenue hasn’t grown in years. Indeed, IBM’s revenue is about the same as it was in 2008.

But all along, IBM has been buying up its own shares as if they were a hot item. Since 2000, IBM spent some $108 billion on its own shares, according to its most recent annual report. It also paid out $30 billion in dividends. To help finance this share-buying spree, IBM loaded up on debt.

While the company spent $138 billion on its shares and dividend payments, it spent just $59 billion on its own business through capital expenditures and $32 billion on acquisitions. (To be fair, Ms. Rometty has been following a goal set by her predecessor, Samuel J. Palmisano, to return $20 a share to stockholders by 2015. Ms. Rometty abandoned it only on Monday.)

All of which is to say that IBM has arguably been spending its money on the wrong things: shareholders, rather than building its own business.

“IBM’s financials make it self-evident that its stock-rigging strategy is not about value creation through ‘investment,’ ” David A. Stockman, the director of the Office of Management and Budget under President Ronald Reagan and a banker on Wall Street, wrote on his website earlier this year. “IBM is a buyback machine on steroids that has been a huge stock-market winner by virtue of massaging, medicating and manipulating” its earnings per share.

The buybacks and dividend payments have managed to keep activists and vocal hedge-fund investors at bay — at least so far. But if IBM’s performance doesn’t turn around, and soon, Ms. Rometty may face a mini-mutiny.

Ms. Rometty is a well-regarded manager who is facing an uphill battle that is not of her own making. Most of the old-line enterprise technology companies, including Hewlett-Packard, are in a challenging environment as their clients become less dependent on traditional services and move into “the cloud.” And the cloud’s profit margins are far slimmer.

Ms. Rometty has signaled that she is trying to reposition IBM for the future, and she has taken substantial steps toward that goal.

But like some of her competitors, she appears to be late. 

Excess cash on the balance sheet is wealth destruction. Companies with large cash piles on their balance sheets are always tempted to make costly and wealth-destroying acquisitions. Look at what Yahoo is doing for example. So it is a good thing that companies like IBM are returning it to shareholders. I had been after Apple to do so for a couple of years before they started to. In the past year, Apple repurchased $40 billion worth of shares. The problem, of course, is that financial engineering is a symptom of larger problems.

As I wrote in the New York Times last month, options-based compensations schemes have increased the desire for executives to engage in financial engineering while the lack of wage and consumer spending growth will mean there are few opportunities for capital investment anyway. Companies like Apple stress that 60% of their sales comes from abroad because that’s where the growth markets are. But for companies like IBM, which are in mature markets, the business opportunities are few and therefore the need to shrink via share buybacks is heightened.

At some point, however, the buybacks, cost-cutting and outsourcing can no longer mask the lack of top line growth and the potentially terminal decline sets in. This seems to be what IBM faces And they have two choices: accept their lot as a mature company and stay disciplined about capital investment or bow to the market’s addiction to growth and gamble on new markets and new capital investment. Let’s see what IBM does.

Amazon. Amazon is a unique company when it comes to capital investment because it is the ultimate growth company on that score. And its strategy bears mentioning here even before its earnings report this Thursday. Amazon makes almost no net income. And it has a price/earnings ratio of almost 780x as a result. Underneath the astronomical price/earnings ratio is a business with huge operating cash flow that ploughs as much money back into the business as possible.

If you look at Amazon’s cash flow statement, you see that it had $5.475 billion in operating cash flow in 2013, up from $4.180 billion in 2012 and $3.903 billion in 2011. But every year, the company makes a huge amount of capital investment, $3.444 billion in  2013, $3.785 billion in 2012 and $1.811 billion in 2011. And this has meant a massive depreciation expense, which cuts the net income to the bone. On one level, this is a huge tax dodge, because the capex and depreciation strategy is effectively delaying taxes to later periods when Amazon ’s capital expenditure slows down. But at the same time, it is a sign that Amazon believes it has massive growth opportunities to invest in. Think of Amazon CEO Jeff Bezos as the tech world’s Warren Buffett because he seems to get a free pass on business practice because investors believe in his asset allocation and investment prowess. The fact that Amazon is valued based on operating cash flow rather than net income tells you that.

For example, Apple had $59.7 billion in operating cash flow in fiscal year 2014. With a market cap of just under $600 billion. That’s a 10x multiple on operating cash flow versus its 16x multiple on net income. Amazon has a market capitalization of $141 billion on cash flow of about $6 billion, giving it a 20x multiple on operating cash flow and a nearly 800x multiple on net income. The difference is immense. For Amazon to actually be worth as much as it is in relative terms, we should expect its growth to be twice that of Apple’s and for non of it’s so-called growth capex to actually turn out to be maintenance capex. If Amazon turns out to require massive capital expenditure irrespective of growth, then a lot of that operating cash flow will never be free cash flow.

From an investing perspective, then, we are faced here with three very different companies. The first company, Apple, while an older tech company has had prodigious growth and is a cash machine.But we should now question its growth going forward. And as a result, it has a low earnings multiple. The second company IBM is the oldest large tech company and has no top line growth to speak of. As a result, it trades at a low multiple of 10x earnings and less than 10x operating cash flow. Amazon, the newest of the three, still has amazing growth potential and is treated as such.

At this point in the economic cycle, paying for growth and being overweight companies like Amazon versus companies like IBM and Apple is folly. Yes, Amazon represents the future of tech, at least in terms of retail and cloud computing. But neither IBM nor Amazon are going anywhere soon. At current prices and this late into a cyclical bull market, I would rather have a defensive play like Apple with some IBM added to the mix, especially after its price decline, rather than the turbo-charged AMazon.