There is lots of talk around the street about a generational shift in growth stocks. As new firms IPO and skyrocket, and perhaps even hotter ones now trade on secondary markets, some big name leaders of the past decade are lagging the market. The nature of these firms is changing. As they grow large in size in terms of revenue and subsequently market cap, Darwinist traders begin to shrink the multiple they are willing to assign. This process can be delayed as large firms can still grow quickly, but eventually, a mega cap is rarely assigned the kind of multiple that a fast growing smid cap or newly minted large cap can garner. There is a basic belief that once a firm is battle ship size, it is hard for it to turn and that revenue growth will slow along with earnings. This is a natural progression. Many successful firms go from growth to value. Once this change is recognized, these giant firms experience not only lower margin growth and multiple but also shrinking betas, and begin to take on the trappings of more mature companies such as returning cash to shareholders through buy backs, and more typically dividends. They begin to tap the other side of the capital markets: the debt markets and focus on protecting market share, managing their balance sheets and more deliberate and focused growth.
Google (GOOG) had officially entered two new phases of its life cycle. First is the changing of the guard back to one of its founders as the CEO. This could be a Renaissance a la Jobs return to Apple. Right now, it certainly doesn’t feel that way. Looking at its stock chart YTD, six months and one year versus its sector as represented by XLK and the broader market represented by SPY and Google, and a sad story is illustrated for shareholders. How much sense does this make with a 12 month operating cash flow of over $11 billion, quarterly revenue growth of over 25%, and an operating margin over (TTM) over 34%? Today GOOG is assigned a PE of 20. I remember selling the stock in 2007 when its PE passed 75 as that was our PE limit for growth stocks. Next thing you know the firm will issue debt and announce a dividend! Oh, they did just issue debt. Even though the company borrowed almost at 1%, does this act officially mark the stock as a value play? The market is treating it as such, but with a big change at the top, the next chapter of this story remains unwritten.
The YTD and six month charts don’t look too good for Apple (AAPL) either. Here its revenue growth rate is a staggering >80% year-over-year, its margins are not much thinner than GOOG which is amazing for a hardware/software firm at just over 29%. Operating cash flow is at over $29 billion and this company is assigned a multiple of just under 16.
We sold our shares in GOOG over a year ago and I have trimmed our position in AAPL, but it is still substantial.
Why do I think the market has it wrong on Apple and right on Google? Before I explain, let me provide some quick definitions. Some great businesses provide steady growth in revenue and profits and the stock still may be viewed on a scale ranging from value down to dead. Firms like Research In Motion (NasdaqGS: RIMM) have been the poster child for this phenomena since late 2007. The market has just abandoned the firm despite its continued revenue and earnings growth. Its PE is now just over 6 which is less than half of typical defensive stocks such as General Mills (NYSE: GIS) or Pfizer (NYSE: PFE). These are classic Consumer Staple and Healthcare stocks (respectively) paying hefty dividends. But RIMM, like Google and Apple pay no dividends and can currently only return cash to shareholders indirectly through stock buy-backs. Microsoft (NasdaqGS: MSFT) pays a dividend and has a PE under 10 despite being a software firm and involved with online advertising, social media and other analyst favorite areas. It has struggled to enter new markets and generate enough revenue to make a large enough contribution to move the needle. It has not experienced dominance of an area outside of the desktop. Part of this is due to the size of the firm’s revenues and earnings. It takes a major business unit to make a difference in mega caps.
Google too has struggled to hit a home run outside of search. It has base hits in analytics and Android related sales (Android itself is free), but the needle is still predominantly search.
I still believe in Apple’s stock. Fundamentally, it still has substantial room to grow outside the US. On the product side, as the iPod continues to fade as the iPad is ascending. There are many more markets within China being addressed through carriers and new stores and much of Asia and the Middle East, Africa and parts of Latin America remain untapped. There is even room for more stores domestically, but that will soon hit a saturation point with carriers and other retailers carrying Apple products. The Mac line of computers is also gaining more traction not only in the home but also in the enterprise. As all things Apple mobile proliferate, all of Apple benefits. The iPhone began as an annoyance for the enterprise and now is standard issue at many S&P 500 Companies. The iPad is a totally different story as it is so dominant and about half of all iPads make their way into the office one way or another. The iPad is standard issue at some firms and iOS apps are now being described as a bubble. Apple mobile has sucked the white collar set to have more Macs showing up in homes that require some if not complete support by CTOs and CIOs around the country, Europe and rapidly emerging markets.
The mass affluent and anyone else who can afford to, is purchasing mobile devices from Apple. This in turn is bringing more Macs online. There is room for strong unit growth. Unlike HPQ and DELL, Apple is the cause of laptop erosion and the recipient of the incremental take-away sales. This was highlighted when HPQ reported but AAPL received no love from the market.
Android is doing very well in phones and I am sure will do well eventually with tablets. But as I have written before, there are dozens of versions of Android out there. Yes there are threats to growth. Will Apple’s dollar and unit share rise but market share decrease? If so what will that do to its multiple? Will iPad replace all of iPod revenue and more? Can the pace of iPhone sales continue on its trajectory? It takes a lot of simultaneous wins for a mega cap to increase its multiple.
I may love my devices, but I never love companies or stocks. Growth potential in both revenue and earnings is the calculation I use to determine where to invest capital. When the tide truly turns, the investments simply change from long to short, or to cash.
Disclosure: Corn is chief investment officer of E5A Funds LLC. Through various equity strategies under his supervision, he is currently long AAPL and short XLK and SPY. Short positions can change at any time.
