Apple's Future May Not Be Its Five Year Past

Steve Jobs' tenure produced a almost eight-fold increase in Apple's stock price, something which will likely not be duplicated in the next five years, no matter who is at the helm of Apple. In the nineties, Apple was a generator of mediocre products that were neither innovative nor priced to deliver value to their customers. The list includes corporate gaffes like Newton, Pippin, Lisa ($9,995 in 1993), the 20th anniversary Mac, portable Mac ($6,500), and the G4 Mac cube ($1,600). Hand picked CEO John Sculley from PepsiCo grew revenues but disastrously chose to have the company sell against IBM in corporate markets, which led to declining profitability.

Technology companies have growth cycles, with the attendant valuation cycles. As we've written before, Apple has become a cult stock. The recent explosion of revenue, returns, and valuation metrics was generated, in our opinion, from the ability of Steve Jobs to cut through the thicket of product development projects to identify the iTunes and iPhone projects as the "must haves" for the company's success. The troops at Apple all rallied to his call, and for such a large organization to focus with great energy and deliver is a testament to executive management, leadership and organizational depth.

The Wall Street Journal asks, "How can ordinary companies turn themselves into Apples?" The answer is easy, "They can't." As framed, it's a vacuous question.

Apple's adolescence, was exemplified by lousy products and a failed strategy, as discussed above. These describe an ordinary company. However, it grew out of adolescence into the young adulthood of the digital era with ideas that revitalized music publishing and enjoyment, as well as giving consumers the iPhone which converged entertainment, information, music, video, and computing in a great package. This is not an ordinary company by any stretch.

As Chairman of the Board, Mr. Jobs has the chance to interact with his hand-picked CEO Tim Cook and form a partnership which will guide Apple through another decade of adding value, but probably not at the rate of the recent past.

Bank of America: The Godfather Comes Calling

The Godfather of American investing, Warren Buffett, came calling on Bank of America's CEO Brian Moynihan, who apparently told Godfather that his company didn't need the capital. Perhaps after some espresso and biscotti, Moynihan reconsidered and accepted the offer that couldn't be refused. The offer, a whited out rewriting of the Goldman Sachs proposition, was for 50,000 shares of cumulative 6% preferred shares at $100,000 each, for a total of $5 billion. Rich ten year warrants for 700 million shares at $7.14 were thrown in as a freebee. There was a one-time boost to the closing equity price.

I''m still struggling to see how this makes the case for the common equity. There is definitely a case for investing higher up the food chain, particularly in Bank of America's bonds. Looking at the June 30th, report for Dodge & Cox Income Fund (DODIX), they have long pursued the strategy of overweighting corporates relative to their BCAG index. As an owner of the fund, I liked this strategy and it has really driven their out performance relative their intermediate bond fund peers.

For the most recent period, the weighting of Corporates went to 44.5% of assets versus 19.8% of the BCAG benchmark. Bank of America's bonds are now the largest corporate issuer in the portfolio, at 2.6% of fund assets. Ally Financial weighs in at 2.4%, and Citigroup at 2.1% of assets. Both Bank of America and Citigroup are stocks that may look like values to the risk-loving investor.

Web commentators have suggested that deposits continue to stream into Bank of America, and bulls suggest that there is money to be made in the stock. It's extremely difficult to project what normalized earnings will be in 2-3 years. Without a reliable estimate, how can one project a reasonable target price?

Since the near-term discussion will be dominated by asset sales, additions to reserves, delinquencies, charge-offs and regulatory hurdles, it's impossible to make a fundamental, valuation driven case for the equity. The bonds clearly have been strong performers, and are senior in the capital structure. It seems as if Mr. Buffett's choice to be higher up the capital structure, i.e. above common equity, but with an equity kicker is another, lower risk way to play Bank of America.

A Breath of Spring in Tripoli?

Scenes of exhilaration on the streets of Tripoli abound in the world press today. Fouad Ajami, a respected and knowledgeable commentator on the Middle East, is too hard on the Obama Administration's handling of support to the Libyan rebels. He dismissively calls our strategy, "leadership from the back."

I look at it a bit differently. It appears that the regime of a despotic leader who squandered "four decades of a nation's life," has been brought down through a NATO coordinated support mission, with the most important contributions coming from the U.S., and without the shedding of American blood. However it happened, this is a pretty sensible use of our resources to get a good outcome. It beats our usual, "Ready, fire, reconsider" strategies.

Going forward, probably driven by the desire to take credit for domestic political reasons, we still run the risk of putting out feet in our mouths, backing the wrong horse, and throwing money at problems which are not monetary. Let's wait and see, perhaps leading from the back again.

When Gadhafi is found and captured, let's hope that the rebels don't create an undignified and inhumane spectacle. After some photo opportunity, like pulling down a Gadhafi statue in a Tripoli square, the settlement of old scores and grudges will begin. Also, there will be a struggle for primacy among the segments of the rebels. Who will be the face and voice of the new leadership council?

We have to resist our usual tendency to select that person, perhaps because they studied at Harvard. The oil companies, none of which appear to be American, are already lining up to lead the restoration of production capacity. Our not being a leader in this effort is probably a good thing, as it frees us a bit from the accusation that we're all about the black gold.

Even though Gadhafi has robbed the national patrimony, that's now in the past and the nation has to look forward. It will need institution building, tribal power sharing, and assistance in financing and building infrastructure and supplying essential services. We should look, listen and learn as this situation unfolds, and share in the pride of Libya's setting itself free.

Tax Repatriation Holiday: Bad Deal for Taxpayers

Sure enough, like crabgrass, it's back: calls for a tax holiday on foreign profit repatriation. The argument is being cloaked in desperate tones of a "stimulus." It will provide no relief from the economic slowdown: why would it? The Wall Street Journal wrote, "...a 2009 study from the nonpartisan National Bureau of Economic Research found that for every dollar companies brought back to the U.S., they invested less than one cent more domestically. Businesses that repatriated profits primarily used the funds to reward shareholders, largely through dividends and stock buybacks."

We've written before about a very sensible proposal from Bob Pozen which aims to equalize any profits being repatriated from low tax jurisdictions while raising funds for the Federal government through a 5% administrative fee. Effective tax rates paid by U.S. corporations really don't vary substantially from European rates, and so there's absolutely no need to use this infrequent event as a substitute for meaningful tax reform.

Let's hope that we don't have another unjustified handout to the largest corporations and their shareholders. I tend to hold large capitalization stocks, and I still think it's unwarranted, by the way. If these companies want to spend some money, they are already flush with cash, and yet they are not expanding employment or increasing capital spending. A shortage of cash is not the constraint, but a total aversion to employing risk capital for business expansion. Now, that's a real problem of a lack of "animal spirits," in Keynesian language.

Slouching Towards Duopoly: Is Apple A Casualty?

Google's acquisition of Motorola Mobility quickens the path towards what looks like the classic duopoly in the consumer technology space, namely Google and Microsoft. Much of the discussion in the financial press seems to center on how handset manufacturers feel and if Google wants to be in the handset business.

The Android experience varies substantially on different phones, which is a natural outcome of having an open source OS. (my son has always liked his bargain HTC phone) Before the acquisition, each handset maker had some incentive to innovate and make their version of the OS superior, enriching the customer experience and gaining some transitory market share. Going forward, because of the incentive for Google to work closely with Motorola Mobility, these other manufacturers like Samsung and HTC have less incentive to spend money improving Android on their phones. The suggestion that these manufacturers would automatically start looking at Windows Mobile out of pique seems irrational. If Android continues to gain share, what incentive is there to move to the OS that is less flexible to work with?

Apple seems to be left out in the cold, on first blush. It seems to be able to provide the best customer experience overall on devices from the iPad to the iPhone and the iMac. This is truly a terrific accomplishment, and at the end of the day, providing the best customer experience with innovative products and providing the best service is the best explanation of the stock's valuation. Now, all of this may not be enough to sustain it.

Both Microsoft and Google are looking for a consumer device, which seems now to be the SmartPhone, to be the stalking horse (or Trojan Horse?) into the consumer's home to deliver a variety of technology services, from entertainment to home energy management. The stand alone profitability of the device is a red herring, if the device is a means of entry.

Motorola Mobility also makes set top boxes, along with Cisco/Scientific Atlanta, used by major cable television systems, and this is another device that may continue to be important as a platform for delivering services to the household.

Since Dr. Eric Schmidt's conflict of interest serving on Apple's board was known for several years, and since Steve Jobs got it the instant he saw an Android phone prototype, one would hope that Apple has a strategy to continue to be major player. Duopolies are not good for consumers, so I surely hope that Apple continues to thrive and that it not become a casualty of the "Clash of The Titans." I'm going to go out and purchase an iSomething to support them.

Bank of America: Heavy Clouds, Low Visibility

I finally read through the transcript of Bank of America's conference call, "hosted" by Bruce Berkowitz of the Fairholme Fund. There was really no visibility offered into the very few good questions. There was a discussion about selling "core versus non-core assets." The discussion then turned to Merrill Lynch, at the behest of a questioner.

I was truly flabbergasted by the response of CEO Brian Moynihan, who said that Merrill, to paraphrase, was fully integrated into the culture of Bank of America. No serious institutional investor would have tipped their hand by challenging this assertion, but it is totally implausible.

Ever since the Eighties, when commercial banks first bought asset managers to reduce their earnings cyclicality, the cultures have never meshed, particularly over compensation issues. Over time, the targets for commercial banks became the investment banks, which themselves had wealth management businesses, as well as proprietary trading desks and investment banking. Now, the cultural and compensation issues diverged more sharply from the commercial banks, although bank CEO compensation exploded sharply because they ran bigger balance sheets.

I once worked for Merrill Lynch when they were located in the old US Steel Building on Liberty Street. The idea of costs and internal controls were about as well understood as Mandarin Chinese. There was a complete disconnect between the huge retail brokerage network, "The Thundering Herd," and the institutional business, both of which were totally oblivious to the asset management business located in New Jersey. Fast forward to 2008, Merrill Lynch was being run by a distant, isolated CEO who wasn't excited by either the brokerage business or by the lackluster asset management business. Instead he led it into the world of creating Collateralized Debt Obligations, instruments that the board and the CEO didn't understand. As this out of control empire started to collapse, along came Bank of America to acquire Merrill Lynch.

US Bancorp bought Piper Jaffray in 1997, and dividended it back to shareholders in 2003. USB bought it at the high point of the cycle and divested at the low point, just before the market turn. In the interim, ownership added no value, and Piper subsequently thrived as an independent public company. Citicorp's acquisition of Smith Barney was described as follows by the Wall Street Journal in 2009, "Ever since Smith Barney became part of Citigroup 10 years ago, the brokerage has been whipsawed by integration problems and troubled deals." Smith Barney was eventually disgorged by Citi.

Citi couldn't integrate Smith Barney after ten years, and yet we are to believe that Bank of America has integrated the bigger and more sprawling Merrill Lynch in less than two years? Not likely. I had the misfortune to have some dealings with Merrill Lynch recently, trying to transfer an old account. I ran full tilt into a total lack of communication, record keeping, and computer system issues between Bank of America's systems and those of Merrill Lynch.

Integration in the best possible case might involve computer systems. The cultures can never be integrated. Institutional traders, salespeople, analysts, and capital markets executives are masters of the universe, and brokers are not part of the club. Retail banks can't sell brokerage services effectively. Why did Charles Schwab return to the business he founded? My point is that the Bank of America CEO's assertion about Merrill Lynch's complete integration would represent the first such successful integration in corporate history.

Beyond this point, which is not small, there is the issue of Countrywide Financial. Nothing on the call added any more clarity to the risks associated with this disastrous acquisition. The "see you in court" challenge to AIG was false bravado and would not give me comfort as a shareholder. Bank of America's asking Secretary Geithner for relief against mortgage fraud issues being brought by State Attorneys General has not worked, and this will be a protracted, multi-front battle which probably won't end cheaply.

After all is said and done, Bruce Berkowitz's Fairholme Fund's investment in Bank of America is very hard to understand. In 2009, Forbes Magazine asked Berkowitz why he was avoiding financials. He is quoted as saying, "Well, we don't know how to value them...It's impossible to know what they own...Five years ago, you could read AIG's report on derivatives. Maybe it was a paragraph. It didn't tell you anything. You had to just assume that these people knew what they were doing. Today you can read ten pages on it and still not know what's going on unless you go through the underlying collaterals. Almost impossible."

Fairholme should have followed its own advice, and this conference call shouldn't have made them any more comfortable with their investment.

Housing Still Needs A Big Fix

The New York Times this morning quoted 30 year conforming mortgage rates at 4.22%. The ten year Treasury yield fell after today's trading to 2.24%. The 30 year mortgage spread over the ten year Note is then 198 basis points.

A 2009 paper by Glenn Hubbard and Chris Mayer of the Columbia Business School shows that the normalized spread is 160 basis points. Although the spread has come down from the intra-crisis peaks, it is still above the normalized level. In their paper, the excess spread raised the cost of owning versus renting by 10-17%.

We've noted before that banks have gone from drunken sailors to Scrooges, and mortgages are being denied to even a bank's good customers. Appraisers were complicit in the U.S. housing debacle, and in my state of Minnesota, the ability to fog a mirror can get you an appraiser's license. That industry is still out of whack, and it is complicated by the appearance of Web sites like Zillow which purport to show estimates of residential value which are based on their proprietary models. What I've seen of Zillow has been nonsensical though it has been improving. Their database on individual properties has gaps, inconsistencies and errors.

We have not come up with a solution for the tens of thousands of homeowners with negative equity in their homes. The worst ones are in the mill but the homeowners are staying put, not making payments, while it's unclear who holds the mortgage and who can dictate the new terms. The Obama administration seeking ideas to turn these homeowners into renters seems to be a blunt instrument which leaves lots of implementation questions unanswered.

The Government is still insuring more than $6 trillion in mortgages, and we can't expect anything from this sector for a long, long time unless it gets a pretty big fix, which should involve shared pain for the banks, investors, homeowners, and the taxpayers, unfortunately.