Some thoughts on Apple

Apple released their q1 earnings for 2019 on Jan 29, 2019. Approximately 10% of my portfolio is in Apple. I also have more exposure to Apple through Berkshire, another 10% position for me.

Apple’s Moat

Moat based on privacy

Apple is optically trying to sell itself as a privacy first company. This separates them from companies like Google & Facebook which are ultimately using user data to provide value to the users, as well as advertisers. Apple gets to price their products aggressively and does not need to worry about monetising the  user data.

Because Facebook and Google are ultimately funded through ads, it s difficult for them to compete with Apple on privacy.

And so much of your personal information — information you have a right to keep private — lives on your Apple devices.

Your heart rate after a run. Which news stories you read first. Where you bought your last coffee. What websites you visit. Who you call, email, or message.

— Apple on privacy

This provides Apple a built in moat that none of the existing smartphone makers can compete with. There will always be a market for a privacy sensitive hardware manufacturers. It may grow and shrink depending on the tides of customer sensitivity.

Moat based on a well rounded product that works

Apple devices have a significant resale value, unlike say Samsung. They are built to last a while.

Toni Sacconaghi

Okay. Tim, at your September event Lisa Jackson an Apple VP stated the company needed to quote design products to last as long as possible. And Apple’s clearly doing that by helping with the battery replacement program, iOS working on an older range of products et cetera. But I guess the question is why doesn’t that mean that replacement or upgrade cycles for iPhones should continue to extend going forward in part because that’s almost one of your objectives?

…..

Tim Cook

We do design our products to last as long as possible. Some people hold onto those for the life of the product and some people trade them in. And then that phone is then redistributed to someone else. And so it doesn’t necessarily follow that one leads to the other. The cycles — the average cycle has extended. There’s no doubt about that. We’ve said several times I think on this call and before that the upgrades for the quarter were less than we anticipated due to the — all the reasons that we had mentioned. So, where it goes in the future, I don’t know, but I’m convinced that making a great product that is high quality, that is the best thing for the customer and we work for the user. And so that’s the way that we look at it.

Standing by your product by replacing battery for free is something which only Apple does. I remember having an iPhone 4 whose battery used to run out in 4 hours. I went to the Apple store and even though the product was past warranty (15 months), I walked out with a refurbished iPhone 4s by paying 75 CHF difference!

The latest survey of U.S. consumers from 451 Research indicates customer satisfaction of 99% for iPhone XR, XS and XS Max combined. And among business buyers who plan to purchase smartphones in the March quarter 81% plan to purchase iPhones. Based on the latest information from Kantar, iPhone experienced a 90% customer loyalty rating for iPhone customers in the U.S. 23 points above the next highest brand measured.

— conference call, q1 2019

Apple has a track record of making well rounded, easy to use, well thought out products. They may not have the most cutting edge technology or hardware, but they get there at their own pace and with a great story. For example, Face recognition was a preexisting technology but Apple made it cool.

If you are a customer who does not need to worry about money, which phone do you buy? The answer will probably be Apple.

This gives Apple a disproportionate market share in terms of buying power. Even though Apple has only ~13% of market share in smartphones, Apple owners probably own > 50% of the worlds buying power.

Moat based on wearables

Apple Watch 4 is awesome!

It comes with a great story: FDA cleared heart rate monitor, fall detection for worried adults with old parents and a fast enough processor that is pleasant to use. It is getting rave reviews.

None of the other smartwatches come even close in terms of the eyeballs Watch 4 is getting. Even before Watch 4, Apple was the number 1 watch company in the world by units shipped.

The day is not far when people will consider buying iPhone because they want the watch.

Ideally, I would like to carry my phone in the pocket and do most of the light work on a watch. A watch paired with a bluetooth headset is great for doing quick calls, read notifications, perusing emails/messages etc. I generally run with my android phone for tracking. This is super annoying because it jiggles around in my pockets — if i got one in my running jackets. Most of the time I run with the phone in my hand. A great watch is the only thing I would not be annoyed about taking on a run.

All in all, I am excited about the future of Apple.

Tidbits from the Conference Call

I enjoyed the conference call.

Apple Music

And I’m very proud to say that nearly 16 years after launching the iTunes Store, we generated our highest quarterly music revenue ever thanks to the great popularity of Apple Music now with over 50 million paid subscribers.

Spotify has 87 million paid subscribers (Nov’18). It has a market cap of 24 billion.

Growth in Services

Apple’s service revenue for the year was $41 billion, growing 22% year over year. Apple expects the growth to continue at approximately 20% for the near future (until 2020 at least).

In particular, there is a 20% growth business embedded in Apple with $41 billion revenue and ~ 62% gross margin. Just for fun, we can compare it to AWS — which is a $26b business with 25% gross margin. Obviously, the total addressable market for AWS dwarves that of Apple services. Or maybe Apple pay can become a home run, who knows?

In any case, being conservative with a 40% profit margin for Apple services and paying 20 times earnings, was can easily arrive at a value for Apple services stub i.e., $320b (!) As a reminder, Apple has $130b in net cash and with approximately 4.8 million shares selling at $150 a share, it has an Enterprise Value (EV) of 590 billion. In particular, Apple minus services is selling for only $270 billion (!) This includes the entire hardware segment consisting of iPhones, iPads, Macs, Watches, Beats and so on. Obviously, the success of the hardware and services segment is tied. But, they are both successful businesses in themselves and if conservatively the services stub is worth ~ $320b then the rest of the company is selling very cheaply at $270b.

Buybacks

We repurchased 38 million Apple shares for $8.2 billion through open market transactions …

Apple somehow managed to spend $8.2 billion at the quarterly high of $215 which was the price of Apple shares at the beginning of October. Apple fell precipitously after that got to a low of $146 on Dec 24, 2018. Basically, they went ahead and spent a shit load of money at the beginning of October and then waited out when the stock fell.

it is our plan to reach a net cash neutral position over time.

I hope they are buying their stock hand over fist right now.

As I write this, the Q1 report is out. Happy reading!

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Booking.com

Booking Holdings (BKNG) is an interesting business. They own booking.com, OpenTable, Kayak, & Rentalcars.com. They also have significant exposure to Asia via minority investments in Ctrip, DiDi and outright ownership of Agoda. The management has done a great job of building the business for the long term.

Booking currently trades at a forward PE of ~ 17. This valuation hides a couple of things:

  • Booking has approximately $7b in cash, $8.7b in debt but interestingly they have $8.6b in long term investments. The split of the long term investments is as follows:
    Government securities & corp debt: $5.85b
    Ctrip (China):                                   $2b
    Didi (China):                                    $707m
    In particular, we can easily take out $6b from the market cap for computing EV.
  • Booking had offered three tranches of convertible debt of $1b each
    Mar 2012 $1b@$944 due Mar 2018 ($1.4b cash outflow for settling)
    May 2013 $1b@1315 due June 2020
    Aug 2014  $1b@2055 due Sep 2021
    The cash situation for 2018, hence, suffered by nearly $1.5b because of this outflow. Obviously, the outflow will happen in 2020 and 2021 BUT booking has stopped offering convertible debt now. All their nearly $7b long term debt is senior notes.

It looks like booking is actually cheaper than what the superficial analysis tells us.

Competitive Landscape

The competitive landscape where booking.com operates make me very uncomfortable.

Booking’s strategy is to spend on brand advertising. This will result in a user coming to the booking.com portal directly. Right now, a lot of booking.com customers take one of the following routes (1) they are referred via a meta search engine (Trivago/Tripadvisor), or (2) they click on an ad by Google based on the standard keyword based targeting. Given that booking.com has a large enough inventory, a user coming directly to booking will find a fitting accommodation.

On the other hand, Google has been making significant inroads in the travel space. Their flights offering is great! And they are working very aggressively to get the hotel booking experience right. They do not want to do what booking.com is doing i.e., sign up a lot of inventory and act as a middle man between the guests and the hosts. Google is making progress in the meta search space. If you look for “hotels in <city>” they already have a good meta search where you can see which portal offers you the best price. Maybe, even the portal of the hotel sells it cheaper than booking?

Another source of competition is AirBnB. As a business, I like booking much more than AirBnB. AirBnB has two major disadvantages compared to booking.com

  • You do not get an immediate confirmation. You may need to go back and forth over a couple of hours. This kills the experience for me. I already spent a lot of time getting the accommodation right. I don’t want to start the search all over again if the host does not accept me.
  • AirBnB destroys the neighborhoods. It is hard to find places to rent for locals because tourists pay more. I also think that it makes it very difficult for city officials to enforce and maintain the constant influx of tourists if they can live *anywhere*. A lot of places are struggling to cope with over-tourism and we as a society need to come up with ways to handle it. Because this problem will become worse as more and more people move to middle and upper middle class across the developing nations.

Verdict

I think I can’t make a good call here. Even if I did invest in booking because I like the management and the business, I will not be willing to put more than 5% of my portfolio in it. This is because there are too many people out to get you and you are mostly competing on price.

 

Review: 2018

This is what my portfolio looked like at the beginning of 2018.

chart

This is what it looks like at the end of 2018.

chart (1)

A few changes that immediately jump out are:

  • I am completely invested at the end of 2018. Since I started dabbling with investments, I almost always had ~ 25% cash. I liked to keep cash because I thought of using it when the markets crashed. I was completely invested in 2012. And, crash or not, I am completely invested now.
  • I went from holding 14 stocks to only 7. I like to think that this is a by product of discipline and not buying things I do not understand. A lot of companies that I was holding at the beginning of 2018, I will never invest now. For example: Silverchef, LSL Properties, Rolls-Royce etc.

At the end of the year, I am holding the following companies.

  • GOOG: I can’t add to what has already been said many times about the significant moat Google has. In my opinion, YouTube is a significantly undervalued business and cloud/self-driving are some bets which might pay hugely. On top of this, Google sells cheaply for a cash adjusted forward PE multiple of 19 and grows at ~ 20%. If you compare Netflix & YouTube, you can ballpark how much YT is worth. People watch ~ 1b hours of YouTube per day! I estimate the value of YouTube to be at least $200b.
  • Facebook: Lots of bad news this year. The stock got hammered and I was able to correct my mistake of not buying FB at ~ $25. On the plus side, now they have a proven business model, make a lot of money, have $40b in cash and grow at ~ 40% YoY. Currently, FB sells at cash adjusted 18 times forwards PE. This is even cheaper than Google & FB grows more quickly.
  • Hikma Pharmaceuticals: I bought Hikma in March after it got kicked out of FTSE250. This is an owner operator and the family owns ~ 25% of the shares. They have three equal sized businesses: Branded Generics, Generics & Injectables. The bad news coming from the Generic segment drowned out the performance/moat they have in Injectables. The company just became too cheap to pass up. I invested big and luckily the stock appreciated by over 50% in the next few months.
  • Apple: Started buying again when the stock sold off in December. I bought it one day before the China sales warning. The thinking here is simple. They have a great eco-system. Their position wrt privacy is a source of moat which no other Software/Hardware companies offer and the products they design & sell are well thought out and a joy to use. The Watch 4 is getting rave reviews and I am not going to pass off a company like this selling for < 12 times earnings.
  • Booking: Booking has built an OK moat in hotel bookings in Europe. I started with AirBnB but have found myself using Booking more and more. One of the major reasons is that you get an immediate confirmation of your booking. Furthermore, the app/website is quite intuitive and easy to use. Unfortunately, Booking still competes on price and face significant competition from Google/AirBnB and also meta search engines like Trivago. This will never be a > 5% position for me.
  • BRK: Berkshire should be able to return 10% a year. And, I plan to keep this position as a safe holding.
  • DNOW: A well run company selling cheaply. This is the only company in the portfolio that I understand the least. But, I like the management and I like the numbers. It is a marvel to see how they manage working capital during downturns!

In order of things I would sell, if push came to shove, are: BRK, DNOW, BKNG.