In this week's Technology Industry Focus, Sean O'Reilly and Dylan Lewis answer some listener questions.
Listen in to find out why Apple's (AAPL 2.15%) fiscal year doesn't line up with the calendar year, how the "goodwill" line on Facebook's (FB 3.77%) balance sheet ties into the acquisition of WhatsApp, and how ADR's help make investing in foreign companies easier.
A full transcript follows the video.
This podcast was recorded on Feb. 5, 2016.
Sean O'Reilly: Everything you wanted to know about tech but were afraid to ask, on this tech edition of Industry Focus.
Greetings, Fools! Sean O'Reilly here, joining you from Fool headquarters in Alexandria, Va. It is Friday, Feb. 5, 2016, and joining me to drop some tech knowledge is Dylan Lewis. What's up, man?
Dylan Lewis: Not much. Pretty excited to do the show. This is something we've talked about for quite a while.
O'Reilly: You've had this in your back pocket for a while now.
Lewis: Well, what I wanted to do with build up a cache of good ideas to discuss that I think appeals to the wide range of listeners that we have, in terms of investing knowledge. And as they've come in via emails and Twitter responses and things like that, we finally have enough, I think, to do a really awesome show.
O'Reilly: And I've got my pen and paper here so I can take down some notes from all the knowledge you're going to be dropping.
Lewis: School's in session.
O'Reilly: So, basically, the long and short of it is, "On Jan. 26, Apple reported its fiscal first-quarter earnings, at a time when most companies are not only reporting their fourth-quarter earnings, but their full-year results. Why does Apple think that it's a special little snowflake? And why does it get its own calendar?" [laughs]
Lewis: The interesting thing is, Apple isn't all that much of its own special little snowflake. Actually, quite a few companies do this, where they have a fiscal year that does not line up with the calendar year. I saw an estimate ... I don't know how accurate was, but it was something like two-thirds of companies follow it --
O'Reilly: A regular calendar year?
Lewis: Yeah. And about one-third don't. There are a couple different reasons for this. Retail companies' Q4 tends to be a big sales boom for them. Then, of course, after Q4 or in the week or so following the holidays, you have all these refunds coming in or all these exchanges or things like that. So, all the contra accounts for revenue undergo havoc for that session. So they take a little more time to settle out, so you might not see companies wanting to end the fiscal year on Dec. 31 for that reason -- there'll be some settling that'll leak into the next year. Some of the other reasons, on the budget side -- if you're a business with very lumpy revenue streams quarter to quarter, you might prefer to have your busy season at the beginning of the year. This is something we see with Apple.
O'Reilly: To allow for planning, so you know how much money you have.
Lewis: Exactly. So, their fiscal Q1, calendar Q4, is where they make quite a bit of their money. So knowing that early in the fiscal year allows them to forecast out and make investment plans, things like that, and just allows for better budgeting, whereas if you were to wait until later in the fiscal year, or have Q4 as your make-or-break quarter, you're setting yourself up where you make investments early in the year, hoping you'll have the cash on hand to be able to finance all of that at the end.
O'Reilly: Right. And if Vince, my consumer-goods partner in crime were here, he would note and probably highlight the fact that every retailer pretty much ends their fiscal year on, like, Feb. 2 or Jan. 31, because of those returns you're talking about.
Lewis: I think there's also one social element of it, where it's just, you look at the holiday season, and prepping all of your year-end bookkeeping, and making sure that everything is in place operationally, so you can, in the month following the end of the calendar year, put together everything, is kind of difficult. So there's a social element of making it easier for people to be out of the office, you're not putting as much stress on the business.
O'Reilly: My dad is an accounting manager at a Midwestern bank, and they follow a regular calendar year, and he's frequently cranky around Christmas time.
Lewis: Yeah, it's not fun to be working late, trying to tidy things up.
O'Reilly: [laughs] Yeah, "These darn auditors!" [grumbles]
Lewis: Yeah, when you could be out caroling or something like that. OK, so, our second question, this comes from a listener email, and the question is: "I own quite a few ADRs and wondered if there might be a scope for a podcast or service on investing in Europe and EMs through ADRs." It's a great question. It's something we'll get to at some point. But before we really delve into that, obviously, quick shout-out to Ben E. for sending that into us at [email protected]. But before we get into an ADR-specific show, which is something I think we want to do at some point, I think a lot of our listeners might not know what an ADR is.
O'Reilly: In Baidu's case, the translation is "please invest in me," is ADR -- I'm just kidding. [laughs]
Lewis: [laughs] You had me there for a second, I was like, "Oh, OK, I didn't know that, yeah." So, what does the acronym stand for?
O'Reilly: It stands for American depositary receipt. Gesundheit, right?
Lewis: Yes.
O'Reilly: Here's the deal. Basically, Baidu is a Chinese company. It trades on the Shanghai Stock Exchange. The currency it trades in is the Chinese yuan. How open are you to converting your dollars to yuan, going over to China, transferring it to a Hong Kong-based bank ... I mean ...
Lewis: It sounds like a lot of work.
O'Reilly: It is, just to invest in Baidu. On the flip side, Baidu, for all intents and purposes, is basically the Chinese Google. You probably want a little bit of exposure to that if you're a tech investor.
Lewis: Right, and if you don't have these ADRs accessible to you ...
O'Reilly: It's a pain.
Lewis: It's very onerous to invest in foreign companies.
O'Reilly: It's a pain, yeah. So, now I'm going to bore everybody with some basics.
Lewis: Get into it.
O'Reilly: Investors can purchase ADRs from broker-dealers or on major exchanges. I'll mention broker-dealers, but pretty much anything that any of our listeners is going to do is going to be done on an exchange. But to create an ADR, a U.S.-based broker purchases shares of the issuer in question in the issuer's home market. So Merrill Lynch or Goldman Sachs or somebody goes over to China, buys the shares, they then deposit those shares in a bank in China, in Baidu's case. The bank then issues American depositary receipts, or ADRs, representing the shares to the broker-dealer, who then puts them on the exchange and trades them and all that stuff.
Word to the wise -- and this is the real trick -- this makes it easier on U.S.-based investors because they don't have to go through the whole song and dance of converting their currencies and everything. ADRs are issued and paid dividends in U.S. dollars, making them a good way for average investors to invest in foreign shares. This does not mean that ADRs are immune to foreign currency fluctuations. Anytime Baidu pays a dividend, or if the U.N. just depreciated 50% overnight or whatever, you would still take a hit.
Lewis: Because the underlying business is denominated in foreign currency.
O'Reilly: Exactly. Long story short, a company pays dividends in its native currency, and the issuing bank distributes those dividends in dollars, in the case of another dividend-paying share. I know that a lot of, for example, bridge corporations, they have ADRs that trade here, and you'll see, if you go to Google Finance, their dividend history, it'll be all over the place by just a couple of pennies, and the reason is currency fluctuation.
Lewis: Oh, that's interesting, because you're so used to seeing a steady march. I hadn't even thought of that.
O'Reilly: Yeah. Great way to do it for an average investor, but I wouldn't invest in ADRs in, I don't know, Venezuela or something [laughs].
Lewis: Yeah, you would want to be in a relatively stable-currency country.
O'Reilly: For sure.
Lewis: Well, thank you so much for that question, Ben. Like I said, that's something we will dive into in a later episode. Maybe dependent on the industry. We'll talk with the folks who run some of the other shows and see which one makes the most sense.
O'Reilly: Maybe I should do one on the energy and materials, so, there's a bunch of ADRs in ... yeah, anyway. Miners. Before we move on, I wanted to point our listeners to the newly redesigned focus.fool.com. There, they can take advantage of a discount on The Motley Fool's Stock Advisor newsletter. This discount works out to $129 for a full two-year subscription. Once again, that's focus.fool.com.
Moving on to question No. 3 that people are too nervous to ask, but they're super-curious about. Dylan, in tech acquisitions, it's common for companies that are scooped up to be done so at a huge premium to their carrying values on the balance sheets. The question to you, Dylan, is: "I understand this effect has something to do with what's called 'goodwill.'" So, for our listeners, what the heck is goodwill, and why is it such a comical line on the average tech company's balance sheet?
Lewis: Yeah, this is something I think a lot of people don't understand. This is deeper-level accounting stuff. You look at these huge public companies acquiring, generally, smaller private companies. But every now and then, you'll see this huge balloon payment, like with Facebook and WhatsApp. And that's something we'll get into a little bit to illustrate this. But that's where you see it blow up most for investors, and it's something they'd be interested in. So, this is kind of an over-simplification here.
But for an acquisition, you break down the valuation like this. You have your tangible assets -- buildings, inventories, anything you can tie a set dollar value to that's a physical thing. You have your intangible assets -- trademarks, copyrights, brands, things like that. Things that are less tangible but still have some value you can assign to it. Basically, you take the two of those and put them together, then the difference, the delta between them and the final purchase price, is what you would call "goodwill." So, that is itself another intangible asset that goes on the company's financials.
O'Reilly: Do you know what John D. Rockefeller said about goodwill?
Lewis: No.
O'Reilly: He was looking at this balance sheet of another oil refinery he was buying, and he said he wasn't sure about the goodwill, but the liabilities were solid [laughs].
Lewis: [laughs] I like that.
O'Reilly: See?
Lewis: So to give you a little bit more of a concrete example, this is what happened when Facebook acquired WhatsApp. The announced purchase price --
O'Reilly: That was all goodwill, basically, right? [laughs]
Lewis: [laughs] Yeah, a lot of this transaction was goodwill. The final purchase price was $19 billion. If you remember, this actually ballooned up to something like $20 billion --
O'Reilly: Because it was mostly Facebook's stock that went up, right?
Lewis: Yeah. So there was all the share price appreciation, which caused the total purchase price to go up. But we're going to state all of this in terms prior to the appreciation. The original purchase price was $19 billion; $15.3 billion of that total was recorded as goodwill on the company's books. A lot of that other value was intangible assets. From the company's SEC filing, this is what they tied that value to, and what they expect from it -- synergies from future growth from potential monetization opportunities from strategic advantages provided in the mobile ecosystem, and from expansion of our mobile messaging offerings.
O'Reilly: That's their reason for paying this extra $15 billion, OK. All right.
Lewis: Yes. So what that sums up to is, "We think there's a lot of growth opportunity here, and it fits well into the stuff that we're doing already." And so, one of the things that's important with goodwill is; you have this huge budget item, in some cases. The ongoing maintenance is really where companies can take a ding.
So from that SEC filing as well, in accordance with ASC 805, goodwill will not be amortized, but instead will be tested for impairment at least annually and more frequently if certain indicators of impairment are present. In the event that goodwill has become impaired, we will record an expense for the amount impaired during the fiscal quarter in which the determination is made.
And so, that's where the issue with carrying a ton of goodwill comes into play, because you look at tangible assets, there's a relatively solid value there. There can be some fluctuations, but it's generally solid. Intangible assets, there's also value there. But when you get into goodwill, you're banking on growth or some sort of opportunity --
O'Reilly: Or a brand name.
Lewis: -- or some sort of synergy, or something coming to light that doesn't currently exist. So because of that promise and that hope, there's a possibility that you will face an impairment charge down the road, if whatever the expectations are don't manifest into actual, substantive value.
O'Reilly: Didn't one of our writers write a great article on this?
Lewis: Yes. For more on this, there is an awesome article on Fool.com from Evan Niu. I believe it's from 2004, right around when --
O'Reilly: 2014, you mean?
Lewis: Oh, yeah, sorry about that. Jeez. Haven't made it through my first cup of coffee yet. The headline is, "Facebook Now Has a Massive Risk Sitting on Its Balance Sheet."
O'Reilly: That's, of course, the $15 billion you were mentioning.
Lewis: So, what it really comes down to with a company making a large acquisition and accounting for quite a bit of that acquisition with goodwill, meaning that there aren't a ton of tangible and intangible assets other than goodwill, and the underlying acquisition, big risk there.
O'Reilly: All right. So we normally get our listener questions via email at [email protected], but for this next question, as I understand it, we have a question from one of our Twitter followers.
Lewis: Yes. We put out a call on my personal Twitter feed and the Motley Fool Industry Focus --
O'Reilly: @WilyLewis.
Lewis: @WilyLewis, and @MFIndustryFocus. And we got a response, so this comes from Andy Sorensen, @Sorenson_Andy. "If you could only invest in one tech stock and not sell for 20 years, who is it and why?" And first off, awesome Foolish question.
O'Reilly: That's great.
Lewis: That is an extreme long-term view on investing.
O'Reilly: When you sent that over to me, I was like, "Oh, crap."
Lewis: Yeah, it's tough. It's a really hard question.
O'Reilly: It's hard to pick any stock to own for 20 years, let alone a tech stock. The only thing I think could be worse would be a biotech with Kristine Harjes or something. Jeez [laughs].
Lewis: Yeah. So, first off, just looking at the tech space, some things that I see and look for, especially taking a longer-term view, some things I'm a little wary of, it is really tough to persist as a tech hardware manufacturer. Apple has managed to do it so far because they have that iOS stickiness, and it's across all their platforms, and it just works, and people love it.
O'Reilly: But they've got that 40% margin, man. [laughs]
Lewis: Yeah [laughs]. But I think, generally speaking, it's very tough to stay on top as a phone, PC, or tablet manufacturer, and have that be your bread-and-butter business. So by and large, I'm not going to look for a hardware manufacturer for a 20-year horizon. I also personally don't love businesses that are solely ad-supported. I get into this debate with you all the time about Facebook --
O'Reilly: And we've been wrong every time [laughs].
Lewis: We've been wrong every time [laughs]. But I'm always wary of the possibility of consumer habits shifting, or a new medium coming out there and ad dollars shifting over to it. And something that does not have something that underlies the business with, as we talked about, a social utility, like, I worry about that. And a lot of the things that a business like Facebook is doing ... like the expansion with Instagram, or, some of the other stuff is just adding gas to that ad fire.
O'Reilly: I finally signed up for Instagram last week. I'm about to turn 30, and this probably has something to do with it, but I was like, this is really dumb. [laughs]
Lewis: [laughs] My friends love it, and we're 25. So, those two things said -- particularly that last one -- maybe my choice doesn't make a lot of sense, but I will explain it, I'm going to have to say Alphabet (GOOGL 0.42%) (GOOG 0.58%).
O'Reilly: I cannot argue.
Lewis: I know I just said that I don't like ad-reliant businesses, but to me, their ad business is funding a host of other projects. You look at the stuff they're doing with self-driving cars, biotech efforts --
O'Reilly: It's OK to be an ad-based business if you have 95% market share in search engines or whatever. [laughs]
Lewis: Yeah, their market share is insane. But the thing I really love about them is, OK, they have this dominant ad business, and they're using that to funnel money into these lottery-ticket research projects. You have things like self-driving cars, biotech efforts, you have their Calico branch, they're also doing some stuff with connectivity with fiber and Project Loon. There's so many things that, if they take off, they're in business. And they're going to be so far ahead of pretty much anyone else that's working in that space.
O'Reilly: Do you think, in 20 years, they'll be a techie GE or Berkshire Hathaway?
Lewis: They're setting themselves up to do that, with the restructuring.
O'Reilly: And the name change, yeah.
Lewis: Yeah. You have to like that, too. I think, you look at their $480 billion market cap and say, OK, how much room is there for growth? That's the big question. But if you're looking at a 20-year investment horizon, I'm not taking any high-growth stock right now. I'm taking something that's relatively stable right now, and has room to grow into a bunch of other outlets, but is the dominant player in the space. One of the other things I want to mention with them, is, and this kind of comes with the restructuring that we've seen with Alphabet, there's been a lot of maturation there as a business.
They've talked about a share repurchase program, they're entertaining that, and I think they authorized $5 billion or so in share repurchases. So I think the good times are going to continue to roll for shareholders with more programs like that.
O'Reilly: With the dividends, buybacks, whatever.
Lewis: Yeah. Wall Street loves Ruth Porat, their CFO. So I wouldn't be surprised if 10 years from now, they have a dividend, if they decided that they had enough money, they were funding enough of these high growth projects, they can only do so much with it and they wanted to share some of it with their shareholders.
O'Reilly: Cool. To our audience, I swear this is a total coincidence, I agree with you.
Lewis: Yes.
O'Reilly: We completely separately picked the same company. But I'm actually going to back mine up with some valuations.
Lewis: Ooh!
O'Reilly: First and foremost, the first reason I picked Google was because it's a verb in the Merriam-Webster dictionary. Can't go wrong there. Twenty years is a long time, and I'm not 100% sure I have the knowledge to pick any smaller players like CalAmp.
Lewis: You're really subjecting yourself to huge macro-trends if you're picking a small player like that.
O'Reilly: So that, again, leaves us with the big ones. I'm pretty sure Microsoft, Google, Facebook, and Apple will be around in 20 years, but, a lot can happen in 20 years. Where was Apple 20 years ago, Dylan? It was 1996.
Lewis: Yeah. I mean, they were making personal computers.
O'Reilly: Need I say more?
Lewis: Yeah, no. Their whole business was making personal computers back then.
O'Reilly: I rest my case. However, I want to note a few things about the companies I just mentioned. Microsoft is having to work harder and harder to grow profits, as I mentioned a few years ago. Facebook is literally at an all-time high, Mark Zuckerberg is worth $50 billion dollars, and it trades for 49 times forward earnings. By the way, because we're talking about 20 years from now, and this might be a good bull case for Facebook, did you hear how many users Mark Zuckerberg expects Facebook to have in 2030?
Lewis: Five billion. Yeah.
O'Reilly: [groans] Anyway. [laughs]
Lewis: I need to contextualize that with estimated population by 2030, because I don't know what that is.
O'Reilly: It'd be 10 billion, right? He thinks half of mankind will be on. OK.
Lewis: It could happen.
O'Reilly: Apple, as you noted, is mostly hardware and has few avenues for growth going forward that can really move the needle. So, I don't know, cars. Exclamation point there.
Lewis: Yeah, it's hard to know without being totally certain what their car ambitions are. Cars are not the same high-margin business that iPhones are.
O'Reilly: When I think Apple Car, I think one of those little two-person kiddie cars at Disney World that you sit in and go around a track in.
Lewis: That's very similar to what the Google Car looks like. Yeah, it looks like a dinky little thing.
O'Reilly: I just picture this white pod thing. Anyway. Alphabet, on the other hand, currently trades for a very reasonable 25 times forward earnings for fiscal year 2016. And, you're getting, for 25 times earnings, what amounts to an Internet monopoly in the Unites States of America and Europe.
Lewis: Yeah, and I think they're, what, 30, 31 times trailing earnings?
O'Reilly: Yeah. It's very reasonable. I put an asterisk next to this one -- my runner-up, because I wanted to give our listeners a little something extra for their ears, was Checkpoint Systems (CHK +0.00%). They're an Israeli-based company, but they're a competitor to FireEye. They were my pick in a Supernova round two months ago. An Israeli-based company, they've been in the business 20 years doing software for computers.
Lewis: So this is not an upstart business.
O'Reilly: This is not an upstart business. They mint money. Mint. They trade for 20 times earnings and 15 times free cash flow. Cash from operations over the last 12 months was $917 million, and their capex was $17 million, so they have $900 million that just came in the door in the last 12 months that they have no idea what to do with.
Lewis: I'm guessing that part of the investment thesis is the overall macro-trend of cyber security becoming much more important.
O'Reilly: Exactly. And I know FireEye has that accolade from the federal government of the United States or whatever, and that's fine, but when you're doing something with Internet security, I don't necessarily want to go with an upstart. I want somebody with 20 years of experience doing the stuff. They have, like, 140 products to fit every possible security IT need. So, that's my runner-up.
Lewis: For people that might scoff at us for talking only about the big companies for a 20-year horizon, I looked at if you were to put $100 in IBM and Microsoft and DRIP the dividends in 1995. For IBM, you'd be sitting on $900 today, which is an 11% return annualized.
O'Reilly: Not bad.
Lewis: Microsoft, you'd be sitting on $2,000 today -- 15% annualized return. So I think that just underscores that a lot of the big tech names are not going to go anywhere, and if these companies have very shareholder-friendly programs in place, like dividends or share repurchase programs, and you decide to DRIP those dividends, reinvest them rather than take them as cash, that can be a very, very nice way to boost your total returns rather than rely on solely share price appreciation.
O'Reilly: For sure. Well, thank you, Dylan.
Lewis: Always a pleasure.
O'Reilly: You dropped some knowledge. If you're a loyal listener and have questions or comments, we'd love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Dylan Lewis, I'm Sean O'Reilly, thanks for listening and Fool on!
