Apple Shares Now Nearly As Cheap As Microsoft: Which Would You Rather Have?

That's right. With the recent share price plunge in Apple (AAPL), from over $700 to around $525, the stock is rapidly approaching the valuation of 1990's tech darling Microsoft (MSFT). While clearly facing near-term headwinds, both on the product side (a narrowing of their technological lead over rivals) and the financial side (fiscal cliff, tax-related selling before year-end), among others, I find it hard to make an argument for why Apple should not trade at a premium to Mister Softee. To be fair, Apple still fetches slightly more if you go out to one decimal place, with AAPL trading at 6.4 trailing cash flow, versus 5.7 times for Microsoft. If Apple shares fell another 8% or so, to around $485, and MSFT stayed around $27, both would trade at 5.7x trailing 12 month EBITDA. Still, investors are having a hard time understanding exactly how sentiment on Apple has shifted so much in just a few short months.

Now I know many people come to this blog to discover new investment ideas, and Apple definitely does not qualify. However, since contrarian investing is one of my core tenets, I think it is important to point out that Apple shares are dirt cheap right now. In order to justify a lower stock price, say one or two years from now, you have to think that Apple's sales and earnings have peaked and are headed down from here. While that is not an impossibility, especially in the world of technology, I think it is far more likely that Apple's market share gains slow and level off going forward. Even in that case, the end markets they serve as going to grow nicely over the next few years. As a result, I don't envision their financials petering out from here, though for a company of this size, the hey days of rapid growth are clearly over.

For those who aren't sure such prognostications will prove true, consider again the comparison with Microsoft. Regardless of Apple's position relative to Google, Samsung, and the like in the coming years, is Microsoft really as well positioned? I don't think so. Even a bet that Apple will outperform Microsoft, given their stocks are nearly identically priced, is a bet investors can make in the public market by shorting one and using the proceeds to go long the other. iPod versus Zune? iPad versus Surface? iPhone vs Windows Phone? It's not a bad play.

Although discussing large cap tech titans like AAPL and MSFT hardly uncovers anything new for curious investors, I definitely think today's share price on Apple is worthy of discussion. The recent 200 point decline seems very overdone to me, based on what is happening out in the tech marketplace. The last time I updated my fair value for Apple stock I got a number with a "7" handle on it. Nothing has changed since then, and for the first time in a long time, I am actually looking to add to the stock in client portfolios.

Full Disclosure: Long Apple and no position in Microsoft at the time of writing, but positions may change at any time

Why 6.5% Unemployment Is The Fed's Magic Number

Today Ben Bernanke and the Federal Reserve announced that they would keep the fed funds interest rate near zero as long as the unemployment rate remained above 6.5%. Why pick that number? They did not say for sure in their press release, but I can take an educated guess. Over the last 40 years, the unemployment rate has averaged exactly 6.5% in the United States. So Bernanke and Co. are going to keep rates ultra-low as long as unemployment is above-average.

I would also point out that the 6.5% level as the long-term average is important to keep in mind as we envision what a "normal" U.S. economy looks like. Some people may mistakenly think that 4-5% is typical or common just because we got down to those levels during the dot-com and housing bubbles. That is definitely not the case. A normalized economy is 3% GDP growth (vs 2.7% last quarter) and UE at 6.5% (vs 7.7% last month). So while we are not quite at a normalized level of economic growth and employment right now, we are not as far away as many (especially in the political arena) would have you believe. Perhaps that explains why corporate profits are slated to reach a record high this year, surpassing the prior record attained just last year.

Would Going Over The Fiscal Cliff Really Be That Bad?

Easily the most frustrating thing about being a long-term investor nowadays is how short-term focused Wall Street has become in recent years (or more accurately, the last two decades). Quarterly earnings reports and whether companies slightly beat or slightly miss estimates made by a bunch of number-crunchers in New York result in huge share price volatility. Owners of real businesses would be the first to tell you that small quarter-to-quarterly fluctuations in sales and profits are far less important than the long-term strength, viability, and competitive position of their companies.

Political leaders have the same problem; they are obsessed with the short term because they are up for reelection so frequently. If you listen to the media, or your elected representatives, you would think going over the fiscal cliff would be absolute catastrophe. But is that actually true? Well, it depends on whether you care about the short term or long term outlook for the finances of the United States.

The Congressional Budget Office (CBO), the non-partisan fiscal accountant for Congress, projects that the U.S. would fall into a mild recession if we went over the fiscal cliff, and that the unemployment rate would rise from 8% to 9% in 2013 as a result. In 2014, the economy would return to growth, much like we have today. That is the short-term impact. And yes, that is a bad outcome for politicians currently holding office.

But what about the long-term view? Are there any positive effects that might make it worth it to have a short, mild economic downturn in 2013? This is a question the media and politicians rarely speak about. For instance, did you know that without any actions to blunt the impact of going over the fiscal cliff, the U.S. budget deficit ($1.1 trillion in fiscal year 2012) would fall 43% from 2012 to 2013. In 2014 it would fall another 40%. In 2015 it would fall another 45% (all figures are current CBO estimates). At that point, the U.S. federal budget would essentially be balanced. The deficit problem would vanish within three years, and that is if we do absolutely nothing! Congress could actually accomplish something important by not passing a single piece of legislation!

One could easily argue that the best long-term outcome for the U.S. economy would be to have a balanced budget within three years, even if it meant taking some short-term pain in 2013 as tax rates reset to Bill Clinton-era levels. But nobody is taking a longer term view. Everyone is acting as if they are on Wall Street and care only about the immediate future. There is absolutely no chance that our country's leaders do nothing and balance the budget, even though they would all agree that $1 trillion annual deficits are unsustainable and are easily the biggest problem the U.S. faces in the intermediate term.

Instead, we should expect that politicians will opt to extend most of the Bush tax cuts and postpone or eliminate most of the planned spending cuts. Such a plan would do nothing to reduce our deficits and sets us up for much bigger problems a few years down the road. What people don't seem to understand is that the debt crisis that will arise from $1 trillion annual deficits year after year is many times worse than the relatively mild 2013 recession that inaction on the fiscal cliff would cause. Don't believe that? Just ask Greece or Spain, where unemployment rates are over 25%.

Typical Warren Buffett: Logical, Factual, and Fair

"A Minimum Tax for the Wealthy" - By Warren Buffett (11/26/12 - NYTimes.com) 

A Challenging Global Outlook for the Next 50 Years

The above is never something I would venture to take a stab at, but GMO's Jeremy Grantham has made a name for himself by making bold predictions about the future. His latest quarterly letter, entitled "On the Road to Zero Growth" is one of his best, in my opinion. A highly recommended read if you are interested in a 16-page article characterized by a lot of economic jargon. Granted, it makes a lot of sense and was written by someone who has been right an awful lot over his multi-decade investment career. Just thought I would share the link. Enjoy!

Does Marissa Mayer Make Yahoo Stock A Worthwhile Bet?

Granted, I am a numbers guy, so even asking whether a new CEO is enough to warrant buying a stock is a stretch for me. While quality leadership is certainly important, successful stock market investments require the numbers to work and no matter how great the CEO, they can't magically make the numbers work all by themselves (unless you want the books to be cooked of course). Still, I am intrigued by Marissa Mayer's hire as the new CEO at Yahoo (YHOO), even though the company is clearly not gaining relevancy on the Internet. A 1990's darling, Yahoo has lost its lead in search (thanks to Mayer's former employer, Google) and really only has a stronghold in a few areas of the web, such as email and fantasy sports.

Still, considering who has been occupying the corner office at Yahoo over the last decade, it is compelling that a tech person of Mayer's caliber is now running the show. From 2001 to 2007 the company was headed by a movie studio exec (Terry Semel). From 2009 to 2011, they brought in a Silicon Valley veteran (Carol Bartz), but she previously ran Autodesk, a software company that sells products to help engineers design factories, buildings, and 3D animated characters. Is it really that surprising that Yahoo has been treading water for all these years?

Enter Marissa Mayer, Google's 20th employee (and first woman engineer) who had been leading successful efforts in areas where Yahoo actually competes, like web search. If anyone can help reinvigorate Yahoo, it might just be her. But isn't that taking a big leap of faith? Sure, but there is another factor, other than the CEO, that makes a bet on Yahoo shares at $16 each worth a look. The numbers.

Yahoo's current market value is less than $20 billion. As of September 30th, the company's stake in Yahoo Japan ($7.7 billion) and Alibaba ($8.1 billion) account for the majority of that valuation. Even if you deduct the tax liability that would be incurred if Yahoo were to monetize these stakes, the organic Yahoo operations are priced at just $10 billion. What do investors get for that $10 billion? To start, how about nearly $7 billion of net cash on the balance sheet (plenty for Mayer to begin a transformation)? That leaves a mere $3 billion valuation on Yahoo's core operations, which generated free cash flow of $250 million in 2011. That is a low price even if the company doesn't grow at all going forward.

Yahoo stock today looks to me like a call option on Marissa Mayer. As I said before, a CEO alone is not a good reason to buy a stock. But what if you have a unique change in leadership that could very well pay off in spades, and the meager public market valuation of the company basically affords you limited downside risk? The combination of those two factors makes the stock an interesting opportunity in my view. If Mayer, like her predecessors, fails to reinvigorate the company, then the shares likely stagnate here in the mid teens. However, if she succeeds, as her resume seems to suggest she could, there is a lot of upside to the story. It feels weird for me to say, but Yahoo at $16 with Carol Bartz running the show didn't interest me one bit. With Mayer it's a different story.

Full Disclosure: Long shares of Yahoo at the time of writing, but positions may change at any time 

Chipotle Stock: Rapidly Approaching An Attractive Level

Hedge fund titan David Einhorn has been on fire in recent years with his bearish calls (Lehman Brothers, St Joe, Green Mountain, etc) and his latest presentation at the Value Investing Congress detailed a negative outlook for Mexican fast casual restaurant chain Chipotle Mexican Grill (CMG). Some of his points on CMG were easier to agree with (sky-high valuation, slowing growth, pricing pressures) than others (a strong competitive threat from Taco Bell?) but he nailed another one of his calls. CMG shares are falling $30 today after the company reported a disappointing quarter last night. The stock now sits just above $250, down from a high of $442 hit in April of this year.

Chipotle stock long surpassed any level that I consider a good value, but as its recent descent continues, it makes sense to at least pinpoint a price at which it might warrant consideration on the long side. After all, the company still has a very attractive longer term unit growth outlook, is likely to remain very popular with consumers, and the company sports one of the highest operating margins I have ever seen generated by a restaurant company (27% unit-level operating margins).

The reasons for the stock's decline lately are completely justified even though they don't really impact the long-term business outlook for the company. The valuation was crazy before (at $442 per share it traded at a 50 forward P/E ratio) and comp sales growth of high single digits or more was definitely not sustainable. Yesterday the company offered 2013 guidance of 12% unit growth and indicated comps could be flat. While such an outlook will hurt shares short term, longer term it is not terribly worrisome.

With the stock now down more than 40% from its high, I do not think it is far off from a fair price, though it is not quite there yet. If the shares fell to around the $225 level, which equates to about 12 times cash flow, I would start to get interested. This is definitely one growth company to watch, as negative business momentum short term could very well send the stock down to value territory if investors' disappointment continues.

Kudos to David Einhorn for another timely call. I would never suggest investors' blindly follow any investor, but Einhorn is clearly one of the best around right now and it worth paying attention to when he gives public presentations. We can all learn a lot from him.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time

Investors in Sarepta Therapeutics Should Think About Selling Some

Today's big stock market winner is Sarepta Therapeutics (SRPT), a small biotech company developing Eteplirsen, a novel therapy for Duchenne Muscular Dystrophy. Shares are rocketing higher by a stunning 175% today, from $15 to $41 each, on news that a phase 2 study showed promising results compared with placebo.

There are some red flags though, that should be pointed out. The study was completed on just 12 patients, normally not a large enough sample to get FDA approval. And 4 of those were the placebo group, so only 8 subjects received the drug for the full 48 week trial period. Second, the particular genetic mutation this drug targets is only present in 13% of cases, so the potential patient pool here is only about 2,000 people in the United States.

At a price of $400,000 per year (a typical level for orphan drugs that treat small patient populations), U.S. sales could reach $800 million if the drug is approved and every patient takes it. There are a lot of "ifs" in this scenario, however, and after today's huge stock price jump, Sarepta is being valued at nearly $1 billion already. FDA approval, even if it comes, it not right around the corner.

Long investors would be wise to consider taking some of their gains off of the table. Small cap biotech stocks like this are quite risky, especially after having nearly tripled in a single day. Situations like this can easily go either way longer term.

Full Disclosure: No position in SRPT at the time of writing, but positions may change at any time

An Inside Look at the New Retail Strategy at J.C. Penney (Part 2)

As was discussed yesterday, the much-talked about turnaround strategy at J.C. Penney (JCP), being led by Ron Johnson, is going to take a lot longer than many initially thought. Renovating two-thirds of their store base will take 3-4 years. Getting customers to understand and appreciate their new pricing model will take time, if it happens at all. If you contemplate the finished product in 2015, as Johnson has outlined it, the new JCP is likely to be very unique and intriguing for a large subset of shoppers. One hundred specialty shops, with large well-known brands such as Nike and Martha Stewart, connected by a "street" complete with food and beverage stations, comfy couches, free wi-fi, seasonal services such as Santa and gingerbread cookies for the kids in December or yoga classes and smoothies for moms to kick off the new year... it sounds great in theory. And that's just it, in theory.

The end product won't be completed for three more years. Until then, the stores will constantly have areas being boarded up and redone. With so many other choices in the typical mall, will shoppers leave JCP and have little reason to come back, even if the store in 2015 looks cool? And that's another problem... the cool factor. It was obvious when I was at JCP on Monday that a large chunk of their core customers are women 50 years and over. Is that customer going to care that there is free wi-fi or nice couches in the store? Will they shop for denim fits and dyes at an iPad station? Are they going to warm to the RFID-enabled self-checkout kiosks that Johnson is planning? Sure, placing your shopping bag on the table and having the checkout station automatically read its contents and ring up the purchase is nice (all you have to do is swipe your card, no bar code scanning required), but is that too tech-heavy for the older generation? Can't you envision the line at the cashier backing up pretty quickly if there is only one actual human operating it?

It seems this new prototype JCP store is geared towards a younger audience and I am not sure that crowd will head over to JCP even if it is designed for them. Again, you might have 100 shops in your JCP, but there are at least that many in the mall itself, and that is where most of these people already loyally shop. He won't say it directly, but Ron Johnson probably knows that he really is launching a completely new store here, and will have to market it heavily so people know it exists and will give it a try.

Which brings us to the timing aspect of the investment story for JCP shares. The stock went from the high 20's to the low 40's when Johnson was hired, merely based on his previous retail successes. After Q1 2012 same-store sales dropped nearly 20%, the shares cratered to below $20 each. They have since rebounded to the mid 20's, as investors hope for a rebound as more newly renovated shops are added. Second quarter comps fell by more than 20%. I don't think an IZOD shop and a JCP house brand shop are going to move the needle in Q3, so I would expect similar results again this quarter. Whether they are down 16%, 20%, or 24%, though, is anyone's guess.

When we get to the holiday season, then it really gets interesting. Wall Street analysts are an overly optimistic bunch, and typically project sales improvement slowly over time, regardless of the situation. The same is true of JCP today. Fourth quarter sales estimates right now are for a drop of 11% year-over-year, so the consensus is that revenue losses will be cut in half within a couple of months from now. Possible? Sure, maybe better sell-through of Levi's jeans, from the new, fresh shop design, will offset a lot of the negatives from the older areas of the store.

But what if the holiday season for JCP actually gets worse? After all, they are trying to cut down on sales and offer everyday low prices. If customers balked at buying full priced items (regardless of the actual price level) over Memorial Day, why would their buying patterns change in November and December? In fact, would they not be even more inclined to look for sales over the holidays? JCP cutting back on sales should hurt them the most when everybody else is running Black Friday doorbusters. JCP already had a TV commercial making fun of long lines outside stores at 4am. Now they will be competing against them. How will sales be on Cyber Monday at jcp.com? Probably worse than macys.com and kohls.com, right?

I know it is not the consensus view, but one of the reasons I have not bought a single share of JCP is that I think it is reasonable to think sales could get worse, not better, during the fourth quarter. If the first nine months of 2012 see sales declines of 20%, on average, why couldn't a lack of Black Friday and Cyber Monday doorbuster specials result in a 30% decline during the ever-important holiday shopping season? Seems possible, in which case investors are in for a rude surprise when Q4 sales results come out early in 2013. Another round of selling may very well occur.

At that point, though, maybe it will be a better time to dip one's toe in, if in fact you want to place a wager on the long-term future of JCP. Next year the company will be lapping an absolutely horrible financial performance from 2012. The bar will be low and expectations will be uninspiring. Even if 2013 brings more of the same; more renovations and little in the way of increased customer excitement, it is hard to imagine sales falling another 20% from 2012 levels. While a meaningful turn might be a ways off, 2012 might still mark the bottom for sales losses, and for the stock. And we all know the stock market is forward-looking, so even if we won't see material improvement until 2014 or 2015, investors will bid up the stock ahead of time, just like they have in recent weeks on hopes that things will get better very soon.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time. 

An Inside Look at the New Retail Strategy at J.C. Penney (Part 1)

On September 1st, J.C. Penney (JCP) debuted more new "shops," bringing it about 10% of the way through a transformation plan aimed at having 700 of the chain's 1100 department stores offer shoppers 100 distinct "store within a store" experiences by 2015. My wife and I used part of our Labor Day holiday to do some market research at a local Portland mall and check out the progress at one of these renovated JCP locations.

I have been doing a fair amount of work on JCP lately, trying to figure out if it is a turnaround story I want to play or not. For me, there are three essential questions to ask when making this kind of investment decision. One, do I want to make a bullish bet on a JCP turnaround under new CEO Ron Johnson? Two, at what share price do I feel the risk-reward is attractive enough for the stock? And three, since this is a multi-year turnaround story (renovating 700 stores while they remain open is not easy), at what point in the process would it make the most sense to start buying?

With much of the valuation work done already from my office, my in-person store visit on Monday was more about checking out how the renovations looked and how shoppers were responding to them. I went to one location, in the morning, on a holiday, so this is by no means enough observation to draw strong conclusions about customer traffic, but it was enough to get an idea of where these stores are heading over the next few years.As soon as you walk into the store, you see the original "store within a store" concept, Sephora, that JCP introduced even before Ron Johnson took over as CEO:

The Sephora stores inside J.C. Penney have done very well. They look identical to actual Sephora stores, just with fewer square feet. The successes JCP has seen so far are often cited as a reason why the concept of converting the entire JCP store into dozens of specialty shops has huge potential. I would agree with that assessment, but it completely depends on what products you are selling. Sephora is very popular right now, so it would be hard for it to do poorly. What about other brands? That is the big question mark at this point.

Which brings us to the new shops JCP unveiled this month; IZOD, Liz Claiborne, and JCP (a generic house brand for basics). These are in addition to those already in place; Sephora, iJeans by Buffalo, Levi's, The Original Arizona Jean Co, and MNG by Mango. You may have noticed something odd about that list already, but we'll get to that shortly. For those who have not been in a JCP lately, here is what these new shops look like:

Notice there is nothing earth-shattering or particularly new here in terms of product. What they have essentially done is group product by brand and install upgraded fixtures and displays, so you feel like you are shopping at a smaller Gap or J Crew store within the mall, not at the enormous J.C. Penney anchor location. For instance, here is what most of the store's floor at JCP still looks like:

Obviously, cleaning up the stores by making them less cluttered, adding better lighting, and displaying the clothes more effectively is probably an investment worth making, if you are trying to revamp a department store and position it for long-term survival. Still, the early response by customers has been poor. Making the stores look nicer has not counteracted the negative impact from JCP's decision to reduce the number of sales they run and opt instead for everyday low prices on most items. Rather than paying $25 for a sweater originally marked $75 or $80 (although nobody ever paid that price), JCP has faith that shoppers will make the same purchase, even if it is marked $25 from the start with no discount. Shoppers are balking. The first quarter after the change (Q1 2012), sales dropped 19%. Last quarter they fell by 22%. I don't think there is reason to think the current quarter will be much different.

The pricing issue was something I made a point to watch for during my store visit. Again, it was before noon on Labor Day, so there was not much traffic in the stores. However, you may have noticed that there weren't any shoppers in the photos above. I was not the only one in the store, and I did not ask anyone to get out of the shots. So where were they? Well, look at that, there they are:

The clearance rack. Despite JCP's goal of getting 80%+ of their sales from full price merchandise with their new everyday low price strategy, the store still has product it needs to move quickly, so the clearance racks have not gone away. Interestingly, the signs on these racks do not simply say "clearance" but rather "clearance - $5 and up." Why put "$5" on the sign, which just signals you have really cheap sale merchandise (and gets you thinking that full price may be overpriced)? I don't know. It seems counter-productive. My wife even mentioned that she saw a $20 sweater that she liked, but since it was positioned close to the sale racks, she instinctively looked up to see if it was on sale. When it wasn't, she questioned whether people would think $20 was a good enough price (even though a $20 sweater, on its own, is quite inexpensive). This is what JCP is facing with their new strategy.

Even bigger than pricing strategy is that shoppers are still gravitating to the sale racks, even with these new, upgraded specialty shops. That is where the customers were on Monday, which jives with the trend they have seen so far this year; less traffic, fewer sales, and lower gross margin on each sale. Shoppers are still fixated on sales, and if you don't have as many, they will either leave the store, or only buy the cheaper stuff. Not a good recipe for a retail turnaround (given that JCP is trying to do the exact opposite).

After my in-store visit to JCP this week I was hoping to shed some light on the first of three questions I mentioned at the outset of this post; do I want to make a bullish bet on a JCP turnaround? When you listen to Ron Johnson articulate the ideas he has, they make sense and you can't help but be inclined to think he just might make it work. And he might. However, I had mixed feelings after seeing the store. The shops look nice, but so far customers have not responded, in large part due to pricing. They still flock to the sale racks.

I think JCP can fix this problem to a large degree by offering unique product (like Sephora) in order to differentiate themselves from other stores like Sears, Kohls, and Macys. I am not sure that the Levi's, Arizona Jean Co, and JCP brands do that. Even Liz Claiborne, which is exclusive to JCP, might not be different enough from other similar brands found in competing stores to make people want to go to JCP first.

Not only that, but did you notice the odd choice for the initial set of new specialty shops? Levi's, the Original Arizona Jeans Co, and iJeans by Buffalo are all among the first eight shops. How many choices of jeans does one need? And is that really the best way to use their concept, by duplicating product so much? And you know there are other brands of jeans in the store already (I saw Lee jeans right next to the Levi's shop, for instance). In fact, while we were there my wife overheard a female shopper ask for some help finding a pair of new jeans. The employee walked her over to the Levi's shop, but then told her, unfortunately, that there were jeans scattered around the store, so although this was the best place to start, she would have to walk the entire floor to see everything they had.

That type of shopping experience is exactly what you would expect from a large, disorganized department store; the exact model JCP is trying to get away from. If you are aiming for a wonderful shopping experience (Ron Johnson is aiming low --- trying to becoming "America's favorite store"), you probably don't need three denim brands in your first eight shops. And if you do, at least put them close together and remove the other jeans from the rest of the store. First impressions are everything, as new shops are going to be added periodically over the next three years.

As you can see, this is still very much a work in progress. So, I remain skeptical and will likely want to see some proof of changing customer behavior in future quarters before I take a bullish stance. Right now it is more about the potential for success (if executed better in the future) and less about solid progress thus far.

More thoughts on JCP are coming shortly, so stay tuned.

Full Disclosure: No position in any of the stocks mentioned at the time of writing, but positions may change at any time