HTC: Open Strategy

In 2006, HTC changed from being another anonymous phone manufacturer to promoting their phones under their own brand, and expensive proposition that dramatically changed the structure of their business.

Like many other companies, HTC has chosen to get in line to try to beat Apple at their own game. This strategy has no hope of success. No other manufacturer can hope to beat the iPhone’s level of integration between hardware, software, and services. Despite their proven success in design and manufacturing, their direct assault on the market is doomed from the start. They need a different approach.

Here are 3 strategies HTC should consider instead:

Alternative Strategy #1: HTC Inside

das antiga by vcheregati

In the early days of PCs, Intel faced a similar challenge to HTC: How can an anonymous component manufacturer build a consumer brand? Their solution was Intel Inside: Give PC manufacturers a discount to co-brand products, which resulted in Intel becoming one of the most recognized brands in the world. Instead of direct advertising, HTC could do the same thing to promote their reputation as a world-class device design firm.

Alternative Strategy #2: Focus on Accessories

What's in my gadget bag by Neil T

HTC could leverage their expertise in hardware and firmware engineering to expand the connectivity of their phones. They could define a common docking standard (like the iPhone has), and a suite of high-quality accessories. This will allow them to establish a reputation for design and quality in a market they are able to dominate, then leverage that for the assault on phones.

Alternative Strategy #3: Focus on road-warriors

Marchard d'abat-jour, rue Lepic by George Eastman House

While everyone is busy trying to copy all aspects of the iPhone, from the touch interface to the App Store, millions of business customers are being ignored. Even RIM has caught iPhone envy and have taken their eyes off the corporate suite spot: Road warriors. For people whose livelihoods depend on high mobility, all-day working battery life, and real-time productivity, there are plenty of opportunities to improve over what the iPhone delivers. Real phone security would be a nice start. Tethering without hacks is another.

While virtually all road warriors depend on both a phone and a notebook PC today, they will be able to do more with just the phone in the future. Today, email is a basic feature, but it’s still difficult to access other corporate data from your phone; That’s slowly improving. Productivity will always be limited on small form factors, but there are opportunities to re-think how we can do more with less. For example, micro projectors allow you to present directly from your phone. What would it take to run a whole meeting with just your phone, with remote participants, notes, and slides? Wouldn’t that be a killer feature?

Taking advantage of iPhone tunnel vision

With everyone overly fixated on Apple, now’s the chance for an agile and innovative company to capture the corporate market. HTC has that opportunity, if they realize it in time.

The Black (Red?) Hole Where Sales Used to Be

According to the S&P, S&P 500 sales are expected to decline by over $1.5 Trillion in Q3 from a year ago. Let’s take a closer look.

 

A Review of Q2 Revenues

First, how bad was Q2? In a word: Very. The overall revenue shortfall in Q2 according to the S&P is close to 20%. The worst in recent history.

Here are the top 10 companies with the greatest revenue declines in Q2 2009:

Most of them are oil and US auto companies (GM would have been on this list too, but doesn’t exist as a public company anymore). Over half of the S&P 500 posted double-digit revenue declines.

Double-Digit Revenue Growth during the Recession?

An interesting question is which companies actually grew revenues during this recession? Quite a number it turns out. Over 1/5 of the S&P companies reported positive revenue growth in Q2 2009. Some (i.e. the banks) were due to a rebound from 2009 lows. Here are the top 10 companies by revenue that posted both double-digit Q2 2009 and annual 2008 revenue growth:

It’s a surprisingly large list (with 31 companies in all).

A Peek at Q3 Revenues

S&P predicts a revenue Q3 shortfall of over 14%. The actual Q3 reports are just starting to come in. Only 11 reports are available so far:

All 11 companies report a shortfall, averaging an 11% decline (based on total revenue). It doesn’t look like the numbers will be far off from the prediction.

 

What To Do?

Since revenues are going to be bad in Q3 (if only less bad than Q2),

a quick and sustainable market recovery is unlikely. However, the numbers show that are are many companies that appear immune to the recession. Any company able to sustain revenue growth should in theory benefit from lower costs. Those are the companies worth investigating further.

Corporate Bond Yield Update: Warning – Sell now!

Here’s an update since the last time we looked at earnings yields vs. corporate bond rates.

Since March 2009, the S&P has made a stunning 57% rise from the bottom. Just look at the sharp v-shape in the long-term graph:

However, this isn’t supported by a similar growth in earnings:

This should be enough cause for concern. When we look at corporate bond yields, the situation starts to look a little scarier.

The good news is that corporate bond spreads have narrowed significantly in the last 6 months. BAA bond yields are back to historically low levels (similar to the 2003-2007 period):

This would indicate that there should be an earning yield ceiling of around 6% (which translates to a P/E floor of 16.7). Recall that corporate bond yields were the major driving factor in market prices over the 2003-2007 bull-run, and since there’s absolutely no other positive force in the market today (if anything, everything is much worse), there’s no rational reason for prices to be higher than this floor other than speculation.

The problem is that P/E ratios are currently off-the-charts because earnings have not yet recovered. Trailing 12-months P/E is 138, but that includes the Q4’08 (AIG -$23.25 EPS) quarter. To work around that, I plotted the projected earnings yield above (which uses current quarter EPS x 4). That gives a projected P/E of around 27.

No matter how you slice it, the current P/E is way above the 16.7 floor. By these calculations, the market has room to easily drop by at least 40% at the first whiff of bad news.

More bad news: Look at Sales

Even worse is that sales are still down. According to the S&P:

In case you missed it, that’s a $1.5 Trillion drop in sales. To put that number in perspective, that’s a $5,000 shortfall for every man, woman, and child in the U.S.

As the S&P analyst puts it:

You can only cut so long - eventually you need to increase the top line in order to increase the bottom line
The $1.52T estimated sales decline is almost as much as the Stimulus ($787B) and proposed Health Care ($829B) COMBINED

The bottom line is that the market is acting as if earnings are going to magically double in a short amount of time. This is nothing short of insanity! There is no real hope that this is going to happen. Even if everything goes perfectly, it will be months before a true economic bottom is reached. The short-term danger is that the fed will be forced to continue raising rates to combat the falling dollar. The moment that fully sinks in, the market will experience a sharp crash.

On the bright side, the crazy market has thrown us all an unexpected life-line. If you were underwater 6 months ago, you have probably recovered a lot of your retirement and investment accounts by now. Here’s your golden opportunity to lock that recovery in.

A Lesson from History

Here’s a final data point to think about. This is the Dow Jones Index over the 1929 crash:

Sure, it was a different time with a different set of circumstances, but notice just how sharp that first jump off the bottom in November 1929 was. The market rose from the bottom of 200 in Nov 1929 to 294 in April 1930 (an almost 50% jump). Boy were people optimistic. That over-optimism lasted all of 6 months, before reality finally set in. It would be 25 years before the index recovered to the post-crash peak again.

Full disclosure: I plan to continue exiting out of US equity positions, and buy strategic puts.

An Update on Unemployment

Since we last looked at the unemployment numbers 10 months ago, things have gotten dramatically worse. According to the official numbers, we are now at a record 9.8% unemployment:

This makes this “recession” the absolute worse in modern history, with an almost 5% swing in unemployment over 2 years. Clearly, not only are millions of people being displaced, but whole industries are dying and being reformed.

The graph of “civilians unemployed 27 weeks or longer” shows that over 5 million people have been out of work for over half a year:

However, there’s hope. A look at the graph for people unemployed for less than 5 weeks shows a sharp drop off in the recently unemployed:

If this trend continues, it’s the best indicator that we might be pulling out of this recession in early 2010.

What jobs do people do?

All the recent talk on employment numbers got me curious as to what exactly people are employed in. A quick visit to the U.S. Census Bureau and some Excel magic reveals this graph:

So much for the myth of being a nation of lawyers, baristas and burger flippers!

If you add up the obvious service industries (excluding health), they add up to less than 14%.

If you add up all the professional and white-collar jobs to this, that comes to 45% of the work force. This includes core I.T. jobs, which is only around 2% of the work force! Legal occupations are only around 1%.

Construction and manufacturing workers make up 23%.

Health-related workers come to around 7%.

Education is 6%.

If you are curious as to what each occupation category means, check out The Standard Occupational Classification.

Here's a more interesting way of looking at it: If the U.S. were a deserted island with 10 people on it:

• Gilligan is a salesperson
• Russell is a doctor
• Mary Ann is a secretary, who teaches part time
• Sue is a call center representative
• Ed is an accountant, who dabbles in law and computer programming on weekends
• Marge is a cook
• Jonas is a carpenter
• His friend Al is a metal worker
• Harry is an aspiring actor, who "daylights" as a policeman,firefighter, farmer, and physical therapist.
• And Thurston is the manager of the other 9 :)

AIG and S&P's First Negative Earnings Quarter, Ever

For those of you who don't know, S&P publishes a free and constantly updated earnings forecast here. Essential reading for every investor. In addition to reporting the numbers, you get an 8-quarter forecast of earnings as well as unvarnished commentary from their house analyst.

Here's a snapshot of the current (3/18) report:   

The S&P as a whole lost money in Q4 2008. In their commentary, S&P points out:

• AIGs record setting Q4,'08 As Reported loss of $-61.7B; -$22.95 per AIG share, $-7.10 index impact (first negative quarter for index ever)
• 28%, 138 of the 486 As Reported EPS are negative; index lost more this quarter than it ever made
• 49 issues with mega-$billon losses
• AIG Operating loss of $-28.2B (record); $-10.49 per AIG share, $-3.24 index impact (first negative quarter for index ever)
• 20%, 99 of 494 Operating EPS are negative
• 18 issues with mega-$billon losses
• $-5.2B loss for the quarter, with $-101.3B from the Financials; Non-Financials therefore positive
• Sales (based on reported current membership) are down -8.78%; 42% higher Y/Y (avg +6.64%), 58% lower (avg -18.12%)
• Massive charges warp P/Es (field H33), forward numbers more important - but many investors have a lack of trust in the estimates
• Cash flow now high priority, dividend cuts to 'preserve cash', ride out the storm->companies are worried (so am I)
• No major shift in estimates yet as stimulus/ TARP/ housing/ budget details come out

All I can say is 'Wow".

Corporate Bond Yields Update

We recently looked at the role of corporate bond yields as a price floor. Here's an updated bond yield chart:

Notice that bond yields have started to creep back up, and so has the earnings yield. The good news is that this indicates prices have begun to stabilize back on the bond floor. The bad news is that floor may be falling.

Note: The S&P earnings yield used here is calculated by dividing the current S&P 500 index ($825.88) by 4 times the current Dec. 2008 EPS estimate ($8.73) to yield 4.2%. This is to be consistent with the previous data used in the chart. However, if you use the forecasted 12 month EPS, the earnings yield is actually higher (4.8%) and pretty close to the current AAA bond yield.

S&P Earnings Forecasts

Standard & Poor's regularly publishes the earnings report on the S&P 500 here. This includes a forecast of upcoming quarterly earnings. Here's a chart of the current (1/22/2009) forecasts:

First, note that during the last recession (.com bubble), it took 3 full years for earnings to recover to the previous peak.

Right now, earnings are at 1999 levels, a 55% drop from the peak in mid-2007. The current forecasts go through the end of 2010, and predict a modest gain, but not a recovery.

Forecasts are, of course, largely backwards looking, and are revised constantly. However, this probably captures as best as anything the prevailing thinking on the economy: i.e. that it's going to be a long hard road for a while.

So, When's The Bottom This Time?

Phew! First the dot-com then the housing bubble. It's been quite a decade, and there is still a whole year left to go!

Take a look at the S&P 500 index since 1990:

Looks like two eerily similar boom and bust periods doesn't it? However, if we dig a little deeper, we'll see that things aren't at all the same, and the market was actually behaving much more rationally for the second bull run compared to during the dot-com bubble. This gives us some useful clues on figuring out when the bottom of this crash will occur.

Let's first consider what happened with earnings over that time. Here is the same index overlaid with aggregate S&P 500 quarterly earnings data:

Notice how price growth in general follows earnings growth. There are distinct periods of earnings growth (1994-2000 and 2003-2007), followed by very abrupt drops (2000-to-2003, and 2007-to-who knows when). Also notice how stock prices grew much faster than earnings from 1997-2000 compared to the 2003-2007 bull run. This shows that investors were much more speculative (or exuberant) in the late 90's than more recently.

We can make the difference easier to see by plotting the earnings data over the extrapolated P/E ratio:

The extrapolated P/E is computed by dividing the closing price for that quarter over 4 times the quarterly EPS. It's a crude and noisy measure, but a simple gauge of what buyer expectations are at that moment.

You'll notice that there are 4 distinct periods of fairly constant P/E ratios (marked by black bars in the chart above). In the earlier dot-com bull run, P/Es hovered around 18 from 1996-1997, then shot up to the 28 range from 1998-2000.

In contrast, P/Es were around 20 in 2003, and went down to below 17 from 2005-2007.

This indicates that buyer sentiment was far more bearish during the most recent bull run. How much more bearish? Well, a P/E of 28 is 65% higher than a P/E of 17, which indicates that investors were expecting at least 65% greater returns from future earnings in the dot-com days.

Earnings Yield

Let's look at this from another perspective. If we invert the P/E, we get earnings/price, or the earnings yield. Think of it this way: If you were to buy an entire company outright, the return in profit for your investment that you would get after tax at the end of the year would be the earnings yield.

Here's the same chart as above, but showing earning yields instead of P/E:

The data is the same, but this view is easier for us to relate to. For example, during the 1998-2000 period, the earnings yield of the S&P 500 was around 3.6% (100/28). To put that number in perspective, you could have instead put your money in a CD for a guaranteed 5.5% return during that time. So on average, investors were choosing to lose money by buying stocks, in anticipation that future earnings growth (and further speculation) would drive prices up.

In contrast, the average (extrapolated) earnings yield of the S&P 500 was between 5% and 6% during 2003-2007. This was also during a time when saving interest rates were at record lows (under 3% until 2005, then under 5.5% through 2007).

This shows that, in contrast to the dot-com boom which was fueled by speculation, the recent bull run was actually largely governed by fundamentals - meaning that stock market investors behaved fairly soberly and rationally (well, it could be that all the irrationally exuberant speculators just shifted their attention to the housing boom during that time!).

The Bond Floor

Looking at corporate bond yields gives us another strong indication that the stock market has largely returned to fundamental valuation.

First some quick background:

There are two main ways large corporations can raise large sums of money: by selling stocks or selling bonds. A bond is pretty much an IOU to pay a certain interest rate over a period of time followed by returning your money for the bond. It's like the company taking a loan from the public market, at a fixed interest rate that's determined by the market.

Now, think about the relationship of earnings yield to bond yields for a moment: If you are the CEO and need to raise money for expansion, you can either sell stocks (which is selling a share of all future profits) or sell bonds (which has a fixed interest rate). Everything else being equal, you would rationally sell whichever has the lower yield.

Moreover, if bond yields drop below earnings yields (or earnings yields rise sufficiently), companies can (and do) borrow money to by back stock - thus lowering the earnings yield until the two equalize. This effect causes bond yields to be a ceiling on earnings yields - and a floor on P/Es.

Just like individuals, companies have credit ratings. Companies such as Moody's and Standard and Poors (S&P) rate the bond issues of companies from AAA (the best, or "prime") all the way down to D ("in default"). A BAA rating is the lowest "investment grade" rating. So the range of yields for companies rated AAA to BAA should generally represent the yields companies in the S&P 500 would have to pay to raise money through bonds.

If we plot the S&P 500 earnings yield chart over a chart of corporate bond yields, this is what it looks like:

Notice that the earnings yield has been below bond yields all the way up to 2003 (in fact, they have been below AAA bond yields since the early 1980s). This means that during that period, other factors (such as speculation) were the primary factors that drove stock prices. However, starting in 2003 and before the crash in 2007, the average S&P 500 earning yield has hovered around the comparative bond yields.

Let's zoom in on that 2004-2008 period to make it more clear:

In effect, bond yields provided a solid floor for stock prices during that time, and were what pushed prices up (or kept them from dropping).

We can also look directly at the stock buyback levels during that time to see the magnitude of their effect. Between 2004 and mid-2007, buybacks increased four-fold, only dropping off after earning yields declined:

Between April 2003 and September 2007 (which was before the market peak), S&P 500 companies bought back a total of $1.5 trillion of stock. Over that same period, the total market cap of the S&P 500 grew by $5.6 trillion, so the buy-backs contributed (very) roughly 28% to the total gain in price over that time. Without them, prices would have been roughly 28% lower (and earnings yields 28% higher) than they were.

Here's a visual of what the index performance would have looked like if we were to remove the investments due to buybacks:

This great article from S&P goes into more depth on buybacks. Of course, there were many other factors at play during this time, but this clearly shows the powerful effect of bond yields on the market.

Money Exit Stage Left: Enter The Credit Crisis

With this in mind, it's easier to understand what's happening during the credit crunch and what the Fed is fundamentally worried about. Look at what happened to bond yields since September 2008:

When the credit crisis hit, there was a sudden shortage of money available to lend and so borrowers, particularly the relatively less credit-worthy, were forced to pay higher rates. The effect on the stock market was that the floor was suddenly dropped from under it, causing prices to crash.

This is primarily why the Fed took such drastic action, including dropping short-term treasury rates down to zero (yes, they are essentially lending money for free) in order to lower downstream lending rates. This is what caused the subsequent drop in bond yields, although you will note that they are still 1-1.5% higher than where they were at the beginning of the year.

So What Does This All Mean?

While there are plenty of other factors at play (a changing U.S. political administration, a continuing global recession, and ever-present global uncertainty), this is what I interpret this data to mean:

1. A lot of speculation had been "wrung" out of the market from the dot.com crash, which shows that overall investor sentiment has been neutral-to-negative on stocks since 2003, which unlikely to improve in the near term.
2. The Fed is aggressively doing everything they can to pull down interest rates, and eventually they will, causing bond yields to fall back to where they were.
3. When that happens, stock earning yields will equalize with bond yields again, and will rise as earnings rise out of the recession.

If you use S&P's current estimate for Q4 2009 earnings, the average earnings yield at today's prices will be 4.4%. This is already close to the AAA bond yield of 4.75%, but still a long way from the BAA yield of 8.12%. Assuming the Fed's actions manage to bring the BAA yield back down to 6.5% where it was before the recession, by S&P's own estimates, prices could still have a ways to drop (to get the earnings yield to go from 4.4% to 6.5% with constant earnings will require a price drop of 32%).

The thing to keep in mind though is that we have been talking about averages - using a single number to represent the entire market. In reality of course, there is a very wide band of earnings yields across all the companies in the S&P 500. For strong (AAA rated) companies with earnings yields above 4.75% (below a P/E of 21), they should already be at their floor price now. Likewise, BAA rated companies below a P/E of 12.3 should be close to their floor.

Ok, So What Should A Savvy Investor Do?

Keep a close eye on corporate bond yields over the next few months. If they keep their current levels or continue to go down, then it means the Fed is doing their job and credit is flowing back into the markets. That's a sign that the bottom is near (assuming earnings stay on track or better).

Even easier, keep an eye on this blog for updates on how all this plays out.

Happy New Year 2009!