(Editor's Note: Today's article is the last installment of the Boring Portfolio. For more information, please click here.)
In two columns last month (Peril and Prospects in Tech and Cisco, Apple & Probabilities), I suggested that investors take a closer look at Apple Computer (Nasdaq: AAPL), a stock I had been buying (and still own). I knew the stock was very unpopular and that I would have to put up with sardonic emails like this one: "You lost ALL credibility when you stated that you bought Apple. hahahahahaha!!!!!" Such reasoned discourse...
But I like buying unpopular stocks when I believe there's a reasonable chance that the company might rebound fairly quickly from its difficulties, yet the stock price reflects a worst-case scenario. This type of bottom fishing is not my preferred long-term buy-and-hold style of investing, but when I see a situation where I think my maximum downside is a 10-20% decline and there's a decent chance of making 50-100% in a year or two, I'll often take it.
I thought Apple represented such an opportunity, but the recent earnings release was truly dismal. I still think the company will rebound, but it will take quite a while and the chance of a meltdown scenario, while unlikely, is now higher than it was when I first invested. Despite this, when I first drafted this column a week ago, my conclusion was that I would hang onto my Apple stock because the valuation was so depressed. But now, with the stock up 27% from its recent bottom, the price is not as attractive and I will sell because I believe there are now better places for my capital.
Though this investment did not materialize as I had hoped, I do not view it as a mistake. It was a good bet that didn't happen to pay off. Though the news from Apple has been awful since my investment, the stock price already reflected that so I am selling at approximately the same price at which I bought.
Apple's Earnings Report
Apple preannounced at the end of September that its Q4 revenues and profits would be lower than anticipated, and reset earnings expectations at $0.30 - $0.33 versus prior expectations of $0.45. The stock was cut in half the next day. I bought a modest position shortly thereafter because, as I discussed in my earlier columns, with an enterprise value equal to a mere 4.6 times trailing free cash flow, I felt that there was little downside and that any good news could send the stock up substantially. In particular, I thought that there was a reasonable chance that Apple would do what Intel did recently: preannounce an earnings shortfall, but then beat the reduced expectations. At the very least, given its cash horde and depressed stock price, I expected Apple to announce a major share buyback.
Unfortunately, Apple's earnings report was truly dismal. Sales and margins were even weaker than expected, so the company committed the unpardonable sin (on Wall Street anyway) of missing estimates that had already been reduced. Apple also guided revenue and profit expectations far below what had been expected: a "slight profit" next quarter (versus expectations of $0.45) and $1.10 - $1.25 for the entire year (versus expectations of $1.73). Finally, the company did not announce a huge share buyback -- CEO Steve Jobs merely said the company might buy back some stock from time to time.
This is inexplicable. Apple has more than $4.0 billion of cash and short-term investments (equal to $11.13/share), $786 million in "non-current debt and equity investments" ($2.17/share), and only $300 million in long-term debt ($0.83/share) -- a net of $12.47/share, equal to 56% of the current share price (all prices as of Friday's close). Thus, Apple could buy back nearly half its outstanding shares and still have plenty of cash left over. In my mind, there can only be three explanations, none of which I like: a) Apple thinks it might need the cash to cover future losses; b) it wants to keep its options open for an acquisition; or c) it's not very concerned about allocating capital to maximize shareholder value.
All of this being said, the stock remains quite cheap. Even if you assume the investments are only worth 1/3 of their carrying cost on the balance sheet, the enterprise value is only $11.23, or about 9-10x EPS estimates over the next year. That's attractive, but at $17.50 less than two weeks ago, Apple's enterprise value was only 5-6x next year's estimated EPS.
Clearly, the market is pricing into Apple's stock today a not insignificant probability that the company continues to decline into unprofitability, as it did during its worst years of 1996 and 1997 when net losses were a combined $1.9 billion. I did some research on these years though, and it's interesting to note that Apple was cash flow positive in both years. Also, in the past five years, there has only been a single quarter when Apple had more debt than cash on its balance sheet (on 3/29/96, Apple had $592 million of cash and short-term investments and $655 million of short- and long-term debt), so contrary to popular myth, it's hard to argue that Apple was on the verge of bankruptcy even during its darkest days.
I have posted on the Apple message board some thoughts on why I think Apple's long-term future might not be as grim as the market currently thinks, as well as my take on Steve Jobs.
Sale of American Power Conversion
I reached a similar conclusion with American Power Conversion (Nasdaq: APCC), which I analyzed in my column last week. At that time, I disclosed that I might sell and did so, partly because I'm always happy to realize a tax loss, especially if I don't think it is likely that a stock will jump during the 30 days in which I can't repurchase it (or else I would forfeit the tax loss). In this case, while I try to avoid making short-term predictions of stock movements, I don't see any catalyst for APC to move up materially in the next 30 days and could easily see it falling further due to negative momentum, tax loss selling, etc.
The key question for me is whether to buy APC back in the first week of December. If the stock price is about where it is today, I think it is unlikely that I will do so. Normally, when the stock of a company I own (and therefore understand well and have confidence in) gets whacked, I'm more interested in buying than selling due to the more attractive valuation. But this assumes that my core investment thesis remains intact, which I'm not sure is the case with APC. I thought that this is a solid growth company, but am questioning this due to the recent decline in margins, profits and cash flow, a weakening balance sheet, and the fact that future growth appears to depend largely on penetrating markets that have significantly lower margins and in which there is entrenched competition.
This is a very different ballgame than the one APC has been playing in (and succeeding in) for the past 10-15 years, so the chances of failure are much higher. There is now a meaningful possibility that APC's growth could stall, margins and returns on capital could continue to decline, and the company's large investments to penetrate new markets could prove fruitless (cap ex so far this year has nearly tripled to $63.5 million vs. $21.6 million in the first three quarters of last year). In this worst-case scenario, the stock would likely continue to fall. I don't think this is likely, but the odds have gone up quite a bit after the latest earnings announcement.
I don't want to own stocks about which I'm ambivalent or even reasonably confident. I only want to own my very best ideas -- in other words, slam dunks. In the cases of Apple and American Power Conversion, with all the question marks from their recent earnings announcements and valuations that, while good, leave more room to fall should the companies continue to disappoint, I believe there are a few investments that represent better bets. That's not to say that I think Apple and APC will do badly or that I recommend anyone else sell -- in fact, should their stocks fall significantly, I might buy them back.
More broadly, bottom fishing among out-of-favor stocks is not an easy game. You must be prepared for unpleasant surprises and have your friends (not to mention, in my case, anonymous emailers) think you've lost your mind. Most importantly, you must have the courage to stay the course if you feel that you're right, but be willing to walk away if the situation changes or you come to realize you made a mistake -- which is often the case with troubled companies.
-- Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous guest columns in the Boring Port and other writings, click here.