Why Apple Acquiring Tesla Seems an Obvious Step…

…and why the obvious probably won’t happen!

A Look at Apple history

Apple’s progress from a company in trouble to becoming the first company to reach a trillion dollar market cap meant over 400X appreciation in Apple stock. The metamorphosis began when the company hired Fred Anderson as an Executive VP and CFO in 1996. Tim Cook joined the company as senior VP of worldwide operations in 1998. Fred and Tim improved the company operationally, eliminating wasteful spending that preceded their tenure. Of course, as most of you undoubtedly know, bringing back Steve Jobs by acquiring his company, NeXT Computer in early 1997 added a strategic genius and great marketer to an Apple that now had an improved business model. Virtually every successful current Apple product was conceived while Steve was there. After Fred retired in 2004, Tim Cook assumed even more of a leadership role than before and eventually became CEO shortly before Jobs’ death in 2011.  

Apple post Steve Jobs

Tim Cook is a great operator. In the years following the death of Steve Jobs he squeezed every bit of profit that is possible out of the iPad, iPod, iMacs, music content, app store sales and most of all the iPhone. Because great products have a long life cycle they can increase in sales for many years before flattening out and then declining.

Table 1: Illustrative Sales Lifecycle for Great Tech Product

Cook’s limit is that he cannot conceptualize new products in the way Steve Jobs did. After all, who, besides an Elon Musk, could? The problem for Apple is that if it is to return to double digit growth, it needs a really large, successful new product as the iPhone is flattening in sales and the Apple Watch and other new initiatives have not sufficiently moved the needle to offset it. Assuming Q4 revenue growth in FY 2019 is consistent with the first 9 months, then Apple’s compound growth over the 4 years from FY 15 to FY 19 will be 3.0% (see Table 2) including the benefit of acquisitions like Beats.

iPhone sales have flattened

The problem for Apple is that the iPhone is now in the mature part of its sales life cycle. In fact, unit sales appear to be declining (Graph 1) but Apple’s near monopoly pricing power has allowed it to defy the typical price cycle for technology products where average selling prices decline over time. The iPhone has gone from a price range of $99 to $299 in June 2009 to $999 to $1449 for the iPhoneX, while the older iPhone 7 is still available with minimal storage for $449. That’s a 4.5X price increase at the bottom and nearly 5X at the high end! This defies gravity for technology products.

Graph 1: iPhone Unit Sales (2007-2018)

In the many years I followed the PC market, it kept growing until reaching the following set of conditions (which the iPhone now also faces):

  1. Improvements in features were no longer enough to drive rapid replacement cycles
  2. Pricing was under pressure as component costs declined and it became more difficult to convince buyers to add capacity or capability sufficient to hold prices where they were
  3. The number of first time users available to buy product was no longer increasing each year
  4. Competition from lower priced suppliers created pricing pressure

Prior to that time PC pricing could be maintained by convincing buyers that they needed one or more of:

  1. The next generation of processor
  2. A larger or thinner screen
  3. Next generation storage technology

What is interesting when we contrast this with iPhones is that PC manufacturers struggled to maintain average selling prices (ASPs) until they finally began declining in the early 2000s. Similarly, products like DVD players, VCRs, LCD TVs and almost every other technology driven product had to drop dramatically in price to attract a mass market. In contrast to that, Apple has been able to increase average prices at  the same time that the iPhone became a mass market product. This helped Apple postpone the inevitable revenue flattening and subsequent decline due to lengthening replacement cycles and fewer first time buyers. In the past few years, other then the bump in FY 2018 from the launch of the high priced Model X early that fiscal year, iPhone revenue has essentially been flat to down. Since it is well over 50% of Apple revenue, this puts great pressure on overall revenue growth.

To get back to double digit growth Apple needs to enter a really large market

To be clear, Apple is likely to continue to be a successful, highly profitable company for many years even if it does not make any dramatic acquisitions. While its growth may be slow, its after tax profits has been above 20% for each of the past 5 years. Strong cash flow has enabled the company to buy back stock and to support increasing dividends every year since August 2014.

Despite this, I think Apple would be well served by using a portion of their cash to make an acquisition that enables them to enter a very large market with a product that already has a great brand, traction, and superior technology. This could protect them if the iPhone enters the downside of its revenue generating cycle (and it is starting to feel that will happen sometime in the next few years). Further, Apple would benefit if the company they acquired had a visionary leader who could be the new “Steve Jobs” for Apple.

There is no better opportunity than autos

If Apple laid out criteria for what sector to target, they might want to:

  1. Find a sector that is at least hundreds of billions of dollars in size
  2. Find a sector in the midst of major transition
  3. Find a sector where market share is widely spread
  4. Find a sector ripe for disruption where the vast majority of participants are “old school”

The Automobile industry matches every criterion:

Matching 1.  It is well over $3 trillion in size

Matching 2. Cars are transitioning to electric from gas and are becoming the next technology platform

Matching 3. Eight players have between 5% and 11% market share and 7 more between 2% and 5%

Matching 4. The top ten manufacturers all started well over 50 years ago

And no better fit for Apple than Tesla

Tesla reminds me of Apple in the late 1990s. Its advocates are passionate about the company and its products. It can charge a premium versus others because it has the best battery technology coupled with the smartest software technology. The company also designs its cars from the ground up, rather than retrofitting older models, focusing on what the modern buyer would most want. Like Jobs was at Apple, Musk cares about every detail of the product and insists on ease of use wherever possible. The business model includes owning distribution outlets much like Apple Stores have done for Apple. By owning the outlets, Tesla can control its brand image much better than any other auto manufacturer. While there has been much chatter about Google and Uber in terms of self-driving cars, Tesla is the furthest along at putting product into the market to test this technology.

Tesla may have many advantages over others, but it takes time to build up market share and the company is still around 0.5% of the market (in units). It takes several years to bring a new model to market and Tesla has yet to enter several categories. It also takes time and considerable capital to build out efficient manufacturing capability and Tesla has struggled to keep up with demand. But, the two directions that the market is moving towards are all electric cars and smart, autonomous vehicles. Tesla appears to have a multi-year lead in both. What this means is that with enough capital and strong operational direction Tesla seems poised to gain significant market share.

Apple could accelerate Tesla’s growth

If Apple acquired Tesla it could:

  1. Supply capital to accelerate launch of new models
  2. Supply capital for more factories
  3. Increase distribution by offering Tesla products in Apple Stores (this would be done virtually using large computer screens). An extra benefit from this would be adding buzz to Apple stores
  4. Supply operational knowhow that would increase Tesla efficiency
  5. Add to the luster of the Tesla brand by it being part of Apple
  6. Integrate improved entertainment product (and add subscriptions) into Tesla cars

These steps would likely drive continued high growth for Tesla. If, with this type of support, it could get to 5% share in 3-5 years that would put it around $200 billion in revenue which would be higher than the iPhone is currently. Additionally, Elon Musk is possibly the greatest innovator since Steve Jobs. As a result, Tesla would bring to Apple the best battery technology, the strongest power storage technology, and the leading solar energy company. More importantly, Apple would also gain a great innovator.

The Cost of such an acquisition is well within Apple’s means

At the end of fiscal Q3, Apple had about $95 billion in cash and equivalents plus another $116 billion in marketable securities. It also has averaged over $50 billion in after tax profits annually for the past 5 fiscal years (including the current one). Tesla market cap is about $40 billion. I’m guessing Apple could potentially acquire it for less than $60 billion (which would be a large premium over where it is trading). This would be easy for Apple to afford and would create zero dilution for Apple stockholders.

If the Fit is so strong and the means are there, why won’t it happen?

I can sum up the answer in one word – ego.  I’m not sure Tim Cook is willing to admit that Elon would be a far better strategist for Apple than him. I’m not sure he would be willing to give Elon the role of guiding Apple on the product side. I’m not sure Elon Musk is willing to admit he is not the operator that Tim Cook is (remember Steve Jobs had to find out he needed the right operating/financial partners by getting fired by Apple and essentially failing at NeXT). I’m not sure Elon is willing to give up being the CEO and controlling decision-maker for his companies.

So, this probably will never happen but if it did, I believe it would be the greatest business powerhouse in history!

Soundbytes

  1. USA Today just published a story that agreed with our last Soundbytes analysis of why Klay Thompson is underrated.
  2. I expect Zoom Video to beat revenue estimates of $129 million to $130 million for the July Quarter by about $5 million or more

My Crazy Investment Technique for Solid Growth Stocks

You should not try it!

Applying Private Investment Analysis to the Rash of Mega-IPOs Occurring

The first half of 2019 saw a steady stream of technology IPOs. First Lyft, then Uber, then Zoom, all with different business models and revenue structures. As an early investor in technology companies, I spend a lot of time evaluating models for Venture Capital, but as a (recovering) investment analyst, I also like to take a view around how to structure a probability weighted investment once these companies have hit the public markets. The following post outlines a recent approach that I took to manage the volatility and return in these growth stocks.

Question: Which of the Recent technology IPOs Stands out as a Winning Business Model?

Investing in Lyft and Uber, post IPO, had little interest for me. On the positive side, Lyft revenue growth was 95% in Q1, 2019, but it had a negative contribution margin in 2018 and Q1 2019.  Uber’s growth was a much lower 20% in Q1, but it appears to have slightly better contribution margin than Lyft, possibly even as high as 5%. I expect Uber and Lyft to improve their contribution margin, but it is difficult to see either of them delivering a reasonable level of profitability in the near term as scaling revenue does not help profitability until contribution margin improves. Zoom Video, on the other hand, had contribution margin of roughly 25% coupled with over 100% revenue growth. It also seems on the verge of moving to profitability, especially if the company is willing to lower its growth target a bit.

Zoom has a Strong Combination of Winning Attributes

There is certainly risk in Zoom but based on the momentum we’re seeing in its usage (including an increasing number of startups who use Zoom for video pitches to Azure), the company looks to be in the midst of a multi-year escalation of revenue. Users have said that it is the easiest product to work with and I believe the quality of its video is best in class. The reasons for Zoom’s high growth include:

  1. Revenue retention of a cohort is currently 140% – meaning that the same set of customers (including those who churn) spend 40% more a year later. While this growth is probably not sustainable over the long term, its subscription model, based on plans that increase with usage, could keep the retention at over 100% for several years.
  2. It is very efficient in acquiring customers – with a payback period of 7 months, which is highly unusual for a SaaS software company. This is partly because of the viral nature of the product – the host of the Zoom call invites various people to participate (who may not be previous Zoom users). When you participate, you download Zoom software and are now in their network at no cost to Zoom. They then offer you a free service while attempting to upgrade you to paid.
  3. Gross Margins (GMs) are Software GMs – about 82% and increasing, making the long-term model likely to be quite profitable
  4. Currently the product has the reputation of being best in class (see here) for a comparison to Webex.
  5. Zoom’s compression technology is well ahead of any competitor according to my friend Mark Leslie (a superb technologist and former CEO of Veritas).

The Fly in the Ointment: My Valuation Technique shows it to be Over Valued

My valuation technique, published in one of our blog posts, provides a method of valuing companies based on revenue growth and gross margin. It helps parse which sub-scale companies are likely to be good investments before they reach the revenue levels needed to achieve long term profitability. For Zoom Video, the method shows that it is currently ahead of itself on valuation, but if it grows close to 100% (in the January quarter it was up 108%) this year it will catch up to the valuation suggested by my method. What this means is that the revenue multiple of the company is likely to compress over time.

Forward Pricing: Constructing a Way of Winning Big on Appreciation of Even 10%

So instead of just buying the stock, I constructed a complex transaction on May 29. Using it, I only required the stock to appreciate 10% in 20 months for me to earn 140% on my investment. I essentially “pre-bought” the stock for January 2021 (or will have the stock called at a large profit). Here is what I did:

  1. Bought shares of stock at $76.92
  2. Sold the same number of shares of call options at $85 strike price for $19.84/share
  3. Sold the same number of shares of put options at $70 strike for $22.08/share
  4. Both sets of options expire in Jan 2021 (20 months)
  5. Net out of pocket was $35/share

Given the momentum I think there is a high probability (75% or so) that the revenue run rate in January 2021 (when options mature) will be over 2.5x where it was in Q1 2019. If that is the case, it seems unlikely that the stock would be at a lower price per share than the day I made the purchase despite a potential for substantial contraction of Price/Revenue.

In January 2021, when the options expire, I will either own the same shares, or double the number of shares or I will have had my shares “called” at $85/share.

The possibilities are: 

  • If the stock is $85 or more at the call date, the stock would be called, and my profit would be roughly 140% of the net $35 invested
  • If the stock is between $70 and $85, I would net $42 from the options expiring worthless plus or minus the change in value from my purchase price of $76.92. The gain would exceed 100%
  • If the stock is below $70, I’ll own 2x shares at an average price of $52.50/share – which should be a reasonably good price to be at 20 months out.
  •  Of course, the options can be repurchased, and new options sold during the time period resulting in different outcomes.

Break-Even Point for the Transaction Is a 32% Decline in Zoom Video Stock Price

Portfolio Managers that are “Value Oriented” will undoubtedly have a problem with this, but I view this transaction as the equivalent of a value stock purchase (of a high flyer) since the break-even of $52/share should be a great buy in January 2021. Part of my reasoning is the downside protection offered: where my being forced to honor the put option would mean that in January 2021, I would own twice the number of shares at an average price of $52.50/share. If I’m right about the likelihood of 150% revenue growth during the period, it would mean price/revenue had declined about 73% or more. Is there some flaw in my logic or are the premiums on the options so high that the risk reward appears to favor this transaction?

I started writing this before Zoom reported their April quarter earnings, which again showed over 100% revenue growth year/year. As a result, the stock jumped and was about $100/share. I decided to do a similar transaction where my upside is 130% of net dollars invested…but that’s a story for another day.

Estimating the “Probabilistic” Return Using My Performance Estimates

Because I was uncomfortable with the valuation, I created the transaction described above. I believe going almost 2 years out provides protection against volatility and lowers risk. This can apply to other companies that are expected to grow at a high rate. As to my guess at probabilities:

  1. 75% that revenue run rate is 2.5x January 2019 (base) quarter in the quarter ending in January 2021. A 60% compound annual growth (CAG) for 2 years puts the revenue higher (they grew over 100% in the January 2019 quarter to revenue of $105.8M)
  2. 95% that revenue run rate is over 2.0X the base 2 years later (options expire in January of that year). This requires revenue CAG of 42%. Given that the existing customer revenue retention rate averaged 140% last year, this appears highly likely.
  3. 99% that revenue is over 1.5X the base in the January 2021 quarter (requires slightly over 22% CAG)
  4. 1% that revenue is less than 1.5X

Assuming the above is true, I believe that when I did the initial transaction the probabilities for the stock were (they are better today due to a strong April quarter):

  1. 50% that the stock trades over 1.5X today by January 2021 (it is almost there today, but could hit a speed bump)
  2. 80% that the stock is over $85/share (up 10% from when I did the trade) in January 2021
  3. 10% that the stock is between $70 and $85/share in January 2021
  4. 5% that the stock is between $52 and $70 in January 2021
  5. 5% that the stock is below $52

Obviously, probabilities are guesses since they heavily depend on market sentiment, whereas my revenue estimates are more solid as they are based upon analysis, I’m more comfortable with. Putting the guesses on probability together this meant:

  1. 80% probability of 140% profit = 2.4X
  2. 10% probability of 100% profit = 2.0X
  3. 5% probability of 50% profit (this assumes the stock is in the middle at $61/share) = 1.5X
  4. 5% probability of a loss assuming I don’t roll the options and don’t buy them back early. At $35/share, loss would be 100% = (1.0X)

If I’m right on these estimates, then the weighted probability is 120% profit. I’ve been doing something similar with Amazon for almost 2 years and have had great results to date. I also did part of my DocuSign buy this way in early January. Since then, the stock is up 27% and my trade is ahead over 50%. Clearly if DocuSign (or Amazon or Zoom) stock runs I won’t make the same money as a straight stock purchase would yield given that I’m capped out on those DocuSign shares at slightly under 100% profit, but the trade also provides substantial downside protection.

Conclusion: Investing in Newly Minted IPOs of High Growth Companies with Solid Contribution Margins Can be Done in a “Value Oriented” Way  

When deciding whether to invest in a company that IPOs, first consider the business model:

  • Are they growing at a high rate of at least 30%?
  • Experiencing increasing contribution margins already at 20% or more?
  • Is there visibility to profitability without a landscape change?

Next, try to get the stock on the IPO if possible. If you can’t, is there a way of pseudo buying it at a lower price? The transaction I constructed may be to complex for you to try and carries the additional risk that you might wind up owning twice the number of shares. If you decide to do it make sure you are comfortable with the potential future cash outlay.