Category: Equities – long

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Apple’s Asian Experience: What’s going on ?

Background:
On January 14th, 2011, S&P’s European downgrade was the “shot heard round the world.” And still, Apple’s Asian experience managed to climb to the top of the Wall Street Journal’s Business & Finance page.

Apple, Inc.



What’s going on?  
Well, like Google, Apple’s finding itself caught between the promises and perils of doing business in Asia.  Apple had to temporarily halt sales of its new iPhone after a disturbing wrangling outside its flagship store in Beijing.  Migrant workers hired by “scalpers” started pelting the stores with eggs and getting unruly after the company sold out of phones.  (While Google has to deal with Chinese censorship, Apple has its own Chinese problem – the authorities forced it to disable iPhone’s Wi-Fi capabilities.)

Supplier Working Conditions Report:
The other news of the day, was the release of Apple’s Supplier Responsibility Report) after a tad of nudging by activists. The urgency to release the report grew after employees at its Foxconn supplier threatened mass-suicide if working conditions hadn’t improved.

As an American, I think it’s difficult for us to understand just how inhumane these conditions are.  We think in general terms (e.g., “Sweatshops”) and how some factories hire under-aged workers. But these kids aren’t working 10 minutes for ice-cream.  In reality, it’s closer to legalized slavery.

It is in Apple’s best interest to put its “best foot forward” by pointing towards progress at its suppliers.  And they do.  However, after going to the source and reading the Supplier Conditions report, I tell you it’s DISTURBING.  It’s considered a GOOD thing if the average worker spends less than 60 hours a week working (and rec 1 day of rest after 7 days).  Apple identified 110 facilities where this has been a continuing problem.

Source: Apple Inc., WSJ

Workers must also deal with combustible materials, which last year resulted in explosions at Foxconn (making headline news).  Though, overall, the area with the lowest ratings was management information systems.  This may not sound important, however, these systems allow suppliers to execute corrective actions and hold managers accountable.

source: Apple Computer

At what cost is ESG Compliance?
I researched the costs involved with making a company fully “ESG compliant” – from “cradle-to-grave.”  It turns out, there is no comprehensive data on the subject.  However, it’s my sense that there is a more than negligible cost.  Maybe the question really should be, “Is there a Financial Reward for ESG investments?”

Who receives benefits from ESG Compliance?
Apple’s suppliers clearly pay a cost for ESG compliance.  In fact, suppliers that were using indentured labor have already paid nearly $7m to employees after Apple’s audits (Source).  Apple also pays for ESG compliance as the company reports (and reduces) its yearly Carbon Footprint from the design to the recycling stage.  However, it is Apple that receives the benefits because it is its name on the product and due to its strong market position.

Apple’s market position allows it to reap from ESG efforts.
Using Porter’s 5 forces framework of Industry Structure, one can easily see that Apple is in a venerable position as it has huge Bargaining power against its Suppliers, and its sometimes cultish customers (there is only one iPhone).  And despite Android, the threat to its ecosystem is minimal given its closed nature.  According to several white papers, ESG-centric companies receive several benefits including higher valuations, better profit margins (see graph below) and lower costs of capital.  This is because they’re less subject to accounting issues and litigation, and tend to have more capable management.  See link for additional information.

source: SustainabilityAdvantage.com

Conclusion:
Apple’s Steve Jobs has been known for being stingy with philanthropy and the company historically has been somewhat of a laggard as a Green Citizen (Source: ClimateCounts.org).  But it’s not known whether Jobs may have given anonymously or left these decisions to his wife/estate.  What is apparent is that the new CEO Tim Cook (previous COO) knows factories.

Now that Jobs’ powerful personality is gone, Cook will be able to provide a more nurturing face to the world. The Supplier report was a good step in this direction given that Chinese authorities would rather keep such disclosures out of the public eye!

Disclosure: the author is long AAPL, and wrote this article on a Macbook!

Editor’s Note: just to be fair, the supplier issues are an industry-wide problem, and not just an issue between AAPL and Foxconn, etc.

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Nike: At what price is Social Responsibility?

Background:
I remember way back when Nike just made running shoes…their classic waffle-inspired ones.  Now the company produces shoes for all kinds of activities and apparel revenues alone approximate $5Bn!  Nike’s revenues were $20.9Bn in FY 2011.

Historical earnings and revenue growth, and the overall management of the company, has been quite admirable.  Founders Bowerman (deceased) and Knight (a 4:10 miler) left the company in good shape.  One of the last, but most powerful accomplishments Knight left the company with was its leading position in Corporate Social Responsibility (“CSR”).

CSR Efforts did not come naturally to Nike…
CSR did not come easy for Nike.  For years, the company was criticized by Human Rights Groups for using sweatshops.  The company has been subject to much critical coverage of the often poor working conditions and exploitation of cheap overseas labor employed in the free trade zones where their goods are typically manufactured (link). Sources for this criticism include Naomi Klein‘s book No Logo and Michael Moore documentaries.  As of 2011, Nike has made great strides in monitoring most of its factories so that workers are not abused in any way.

But there’s still work to be done…

On Dec’11, Nike released its latest iteration of the (Michael) Jordan sneaker.  Retailing at $180, this shoe has an iPhone cult following bringing the company about $1Bn in revenues.  However, we’re not talking about “Bobos” and “Yuppies” buying these shoes.  Instead, its lower-income earners (mostly guys living paycheck to paycheck) that Nike’s marketing to. In fact, shoe launches are usually 
timed perfectly to the exact day customers receive their paychecks. (Source story: WSJ). Surely, this should give socially responsible investors pause.  It just ain’t right, It ain’t Right!

AP Photo/Marcio Jose Sanchez

So what’s Nike worth?
Presently, Nike’s shares are overvalued, or are they?  Nike’s shares are either fairly, or overvalued using several metrics including Prices/Earnings and Discounted Cash Flow.  According to a Fidelity StarMine report, Nike’s P/E (trailing 12mos) is 20.8x versus 14.2x for the shoe/apparel industry.  Over the last 5 years, Nike’s median P/E was 16.7x, with a peak of 19.0x, according to Stifel Nicolaus (whom uses forwards estimates).

According to Jefferies research (which provides forward earnings estimates on each member of the peer group) Nike has the highest P/E ratio (See below).

What’s Nike worth using Free Cash Flows?
I calculated the intrinsic value of Nike’s shares using a 3-Stage DCF model.  Short-term growth (< 5years) was estimated at 16% and attributed to the strong orders book and several upcoming events (e.g., Summer Olympics, World Cup).  I discounted cash flow at a weighted average cost of capital of 10%.  The somewhat lower number (than we usually use) was attributed to the company’s CSR efforts, high credit rating (Moody’s: A2), low share beta (GoogleFinance beta: 0.9) and consistent earnings.  Our Calculated value of $93 is actually below the current share price of $97.

<click to enlarge>
Source: Socially Responsible Investing

So then, what’s the extra-value of CSR worth?
Clearly, Nike’s shares are worth more than others.  Using the data sources cited above, it’s shares trade at a premium between 10% and 45%.  We can assume that its CSR efforts awards it a higher value.  Its higher valuation is also attributed to a:

  • Strong global brand name
  • Innovative products
  • Consistent earnings growth and value creation
  • Strong financial metrics 

In this link readers will be able to read Moskowitz Prize winning articles including the most recent, which notes that costs of capital are lower for companies utilizing CSR efforts. The Moskowitz Prize is awarded every year to those researchers that have done “outstanding work in Social Responsible Investing.”

      Conclusion:
      Nike is clearly a track-star and its above-average valuation shows it.  I believe the higher valuation is partially attributed to its leadership in CSR as well as the company’s strong track record of earnings growth.  2011 was a tough year for the company given higher raw material costs that cut into gross profit margins (SA article), but global commodity costs have already started declining sharply.  On the demand side, 2012-13 will show improvements given an upcoming product cycle (e.g, NFL deal) and the 2012 London Summer Olympics.

      The only threat to Nike’s improving outlook is that we’re expecting a Euro-Crises during 1H’12.  This could slow EU demand given that over 20% of revenues are from the area (incl Eastern Europe).

      Disclosure:  The author’s long NKE and enjoys taking long jogs with a pair of his favorite Nike Free Runs.

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      SodaStream: Drink this Tonic instead of worrying about Competition

      Last June, rumors swirled that SodaStream was about to face a head-on collision with the globe’s most powerful beverage company, Coca-Cola Inc.  Upon further investigation, it appears these rumors were false.  These particular ones were broadcast via Twitter.  But there will be more… The Coke rumor alluded to a similar type machine from Coca-Cola, when in fact, it’s just a commercial soda machine used by restaurants.   Please read Firstadopter.com’s and Seeking Alpha’s article for additional information link.

      However, the question is not if, but when…And what will be the implications of competition. In my experience, new competition will be a good thing for SodaStream, especially if the competition is from a well-known brand.   (Coke is considered the highest rated brand in the world.)

      More recently (October 2011) rumors have turned into real competition.  But, not from the Big 3 soda companies.  Instead, a small publicly-owned company called Primowater introduced a product called Primoflavorstation.  Several Bloggers including commentators to seekingalpha.com imply this is a small, inexperienced, scrappy company.  Small…well that’s true, inexperienced…not at all!
      Primowater’s already innovated before with its well known Blue Rhino propane exchange program at 29,000 retail locations. (It was later sold in 2004 to a large gas company).  For this upcoming holiday season, the company is retailing two carbonating machines, one will be single serve, the other will be nearly identical to SodaStream’s.  What I don’t understand and challenge readers to question is, How can such a small company introduce such a machine when 1) SODA has patents for this and 2) the Single-Serve does not seem viable from a cost perspective?  Well, for one thing, Primo Water Corporation is currently a money-losing business (earnings release & forecast).  Secondly, the Soda business was recently purchased for just $13 million, so it may be weakly patented,  infringing on SODA’s patents or it may be an inferior product.  Hence, Primo is not viewed as a viable competitor in my view.

      SodaStream (SODA) Background:

      SodaStream is a historic company with roots dating back to 1903.  The company uses the razor-razorblade business model used by HP and Lexmark printers for example.  SODA makes some money by selling home beverage makers, but the bulk of its profits come from selling “razors” (i.e, carbon-dioxide bottles, flavored syrups).  Readers may wish to view this fairly objective online video review of the company’s products.

      Regardless, my business experience leads me to believe that SodaStream would Benefit during the short-to-intermediate term if the Big 3 (e.g. Coke) entered the personal soda-maker market.   This is attributed to:

      • Increased consumer awareness that would be generated.
      • Entrance of a large, well respected company would legitimize the new market segment.
      • The entrance of such a large, and adroit company such as Coca-Cola may prevent a host of potential competitors from entering the market.  This would likely create an Oligopoly with few large competitors and moderate-to-high profit margins (SodaStream’s LT operating profit margin goal is 25%).
      • Home beverage making is considered environmentally-friendly (no need for PET bottles).  Consumers may find Coke’s marketing strategy of selling both bottles and home beverage systems inauthentic.

        Based on (Harvard University’s) Michael Porter’s framework for competition, we believe SodaStream would utilize two strategies concurrently:

        1. Cost Leadership:  SodaStream says its cheaper for consumers to use their system rather than purchasing soda bottles.  (Though, we believe savings may not be substantial, link)
        2. Differentiation: SodaStream markets itself to consumers that consider themselves socially and environmentally responsible.  Their flavors also have no high-fructose corn-syrup (using sugar instead) and; are thus, also marketed to health-conscious consumers. Also, the company is retailing several high-end models.

        SodaStream is an efficient user of Technology which it leveraged to break into “new” markets (particularly in the United States).   Going forward, it is expected that the company will introduce new products (single-serving, under-the-sink machines).  These innovations will likely rate high under a competitive analysis.  Please review Porter’s writings for additional information.   Porter’s 5-Forces model is summarized below:

        Case Study:  Research in Motion (RIMM) versus Apple (APPL)

        Well then…How about a recent example?  On 6/17/11,  RIMM’s stock declined over 21% on news that competition with Apple (another huge brand name company) is hurting both top-line and bottom line growth.

        The point is that even in the fast-paced telecom/tech industry, it took Apple two years to break the backbone of Research in Motion.  Apple’s iphone was released on June 29, 2007.  However, RIMM’s stock price moved from $56 before the release of the iPhone to $66.5 after the phone’s release.  It then rose 157% peaking over $144 (Chart) a year after the iPhone was released.  Note that RIMM’s gains might have been higher were it not for the Financial Crises.

                                              RIMM Stock Chart:  Click chart to enlarge
        RIMM stock price after the intro of the Apple iPhone 6/07.  Source: GoogleFinance

        RIMM didn’t feel the negative consequences of the iPhone until mid-2009. The chart below shows the percentage moves in Apple shares versus RIMM.   For perspective, RIMM’s North American market share declined from the low 40s% level in 2007 (50% peak in ’08) to 15% this year.  More recently, RIMM has begun suffering from iPhone displacement in Emerging Markets (a previously strong area for RIMM).

        Source: GoogleFinance

        The difference with the above APPL/RIMM case and a SODA/Coke case is that SODA is both the innovator and the “first-mover.”  Therefore, it will take time for potential entrants to play “catch-up” with SodaStream.

        For example, upon first glance, barriers-to-entry appear low as direct competitors do exist globally.  However, not only is SodaStream protected by patents (a portion expire this year) but more importantly, the distribution network required to support SODA’s customers is extensive and would take years for most competitors to duplicate.  Distribution networks (both to sell the machines and via “reverse logistics” to exchange the empty CO2 bottles) and Execution are Sodastream’s key entry barriers to competitors – not the patents!

        CONCLUSION:
        Should SodaStream face new competition, we view this as a net positive for the short-to-intermediate term.

        Disclosure: the author is long SODA.

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