A Debate Over Apple Computer

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Over and StreetInsight.com, where I write daily commentary, there has been a series of posts debating the value of Apple Computer (AAPL) shares. A StreetInsight colleague got the ball rolling with a cautious post. Another colleague and I took up his challenge and responded. What follows is the exchange as it is currently archived on the website:
We had an exchange on our site (March 29 and March 30) regarding methods for valuating Apple Computer’s stock. Tom Au got the ball rolling when he posed the following open question to AAPL bulls: “Does anyone think that Apple’s return on equity could go as high as 30% in the next year or so, based on a book value today of about $11 a share?” To which Apple bull Jeff Bagley replied that “any valuation method that depends primarily on ROE is mostly meaningless when it comes to Apple Computer.” Jeff admits that it has been a painful few months for AAPL bulls, but he puts his valuation in the company’s positive free cash flow yield of more than 4.0%. The following day, Steve Birenberg also weighed in by agreeing with Jeff. Steve pointed out that an ROE-based valuation doesn’t mean all that much because AAPL is a momentum stock.
Click “Continue Reading” below to see what Tom, Jeff had to say….

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How the Internet is Impacting Traditional Media

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Several interesting tidbits regarding traditional media and the internet were included in the collection of stories in the latest MediaWorks email I received from AdAge.com:
• I’ve recounted how the shift of auto advertising to the internet has really hurt newspapers. AdAge.com reminds us that magazines are taking a serious hit as well. In 2005, auto advertising in magazines fell by $100 million. Magazine advertising totaled over $11 billion last year, so loss of almost 1% of the total really hurts at the margin. The trend is continuing so far in 2006, although February did see a 4% increase in auto advertising, breaking a string of six straight down months that included a drop of over 20% in January 2006. At Ford, the share of total advertising dedicated to magazines fell from 23.5% to 21% last year. Smaller but significant declines were evident at GM and Chrysler. Among the major media stocks, Time Warner (TWX) is the only company with a significant exposure to magazines. Last year the company received 13% of its revenue and 12% of its EBITDA from its publishing division which is primarily magazines including titles such as Time, Sports Illustrated, and People.
• An editorial in MediaWorks took the New York Times to task for eliminating stock tables from the daily paper. The writer was not mad that the company dropped the tables but rather wondered why it took ten years of the internet age for management to see the waste of paper. The Chicago Tribune just announced it would stop carrying stock tables as well. The writer didn’t mention how the launch of Google Finance and the end of stock tables at NYT occurred so close together on the calendar.
• CBS (CBS) made a big splash with its online streaming of the first four rounds of the NCAA basketball tourney. The experiment was a big success with over 1.4 million people signing up for a VIP pass to avoid standing in line. Unfortunately, for the potential viewers, demand overwhelmed CBS’ decision to offer 260,000 simultaneous streams. Advertisers and media buyers were thrilled, however. CBS is already selling advertising for next year’s online streaming coverage. This year, most of the advertising was in the form sponsorship. It is not clear if there will be more CPM based pricing next year but the idea that a big event can be streamed with sufficient demand to underwrite much of the costs received another big boost on the heels of AOL’s success last summer with the streaming of the Live8 concert. One issue that is raised by the success of the hoops streaming is the availability of bandwidth.
A few observations. First, in its fight to hold market share against internet advertising, each form of traditional media needs to remember what it does best. For example, newspapers are local and magazines are niche targeted. Traditional media must capture these advantages and remember that if challenging your own business is necessary it is a risk worth taking. Second, regarding streaming of TV content, as the article notes, hypothetically, bandwidth supply is limitless but there are bottlenecks related to server capacity. Those bottlenecks only go up as more HD TVs are in living rooms and viewers get used to the quality of the picture. Downloading full length TV shows or movies takes a long-time already and without solving the bottlenecks, the download times will stretch to hours in HD format. This is one reason why the internet won’t replace your cable or satellite subscription anytime soon. As Rob Martorana recently pointed out TV downloads will create new stars. With the NCAA tournament, CBS showed us that some of those new stars will be traditional media companies willing to take some risks.

NTL: The Numbers Supporting the New Buy

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Last week, I re-entered NTL Incorporated (NTLI) from the long side after a several month absence. I outlined the rationale behind my decision to buy in this post but failed to provide a lot of numbers. So here goes…
NTLI has 283 million shares outstanding following a 2.5 to 1 split that occurred simultaneous to the closing of the merger with Telewest earlier this month. With the shares closing at $28.29 on Friday, the market cap is $8 billion. Aryeh Bourkoff of UBS is projecting yearend 2006 total debt of $10.4 billion and cash of $1 billion, leading to a total enterprise value of $17.4 billion. Without adjusting for NTLI’s net operating loss carryforward or its content assets, the shares are trading at 7.6 times estimated 2006 EBITDA and 6.9 times estimated 2007 EBITDA.
In 2006, analyst estimates call for EBITDA of almost $2.3 billion at current exchange rates (all of the company’s revenues are generated in British Pounds). Over 90% of EBITDA will come from the from the cable plant via the triple play offering of TV, telephony, and internet and the business and wholesale offerings. Content assets provide the balance of EBITDA. Unlike in the US, the UK cable industry has been a triple play offering since the plant was built out in the 1980s. In fact, telephony is the largest revenue generator for NTLI, producing approximately 30% of revenue. Cable TV is the second largest business at about 20% of revenue, with cable internet next at 15%. The remainder of revenue is generated by business services, content, and sales of network capacity to other carriers….

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Apple and France

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There continues to be a lot of chatter about Apple Computer (AAPL) and the potential French law that would force the company to open up its iTunes digital rights protection. One thing that I think is misunderstood is that the law will only really impact AAPL by forcing it to withdraw iTunes from the French market. The company can continue to sell iPods in France if it chose to do so.
The issue that is bugging the French lawmakers is that music which is downloaded from iTunes can not be transferred to a digital music device other than iPod. The lawmakers note that when a consumer buys a physical CD they can load the music onto any device. Therefore, the lawmakers wonder why shouldn’t music purchased online from iTunes store be transferable to any other device?
The problem with the French lawmakers is that they are totaling misunderstanding the music market and how iPods +iTunes fit in. Today, most of the music that is stored on iPods or within iTunes on Macs and PCs has come from one of two places: illegal free downloads and uploads of physical CDs. For example, the Birenberg family iTunes library has over 8,000 songs. Roughly 6,000 songs have come from uploading physical CDs which we already owned or have purchased since we started using iTunes. I added about 1,000 songs by attaching a hard drive full of MP3s owned by a friend and just dragging what I wanted into iTunes. Another 500 or so have come from purchases via iTunes. The balance have come from non-iTunes downloads (overwhelmingly legal), borrowing CDs from friends, or copies of CDs friends burned for us.
Most importantly, I can load anything I want into iTunes. It doesn’t have to be digitally encrypted to Apple’s proprietary digital rights management software. So the iPod is already encryption free. Only the music that comes from iTunes is digitally encrypted and non-transferable….

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NTL Incorporated: New Purchase For All Clients

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Last Friday, I purchased a new position in NTL Incorporated (NTLID – the D will be dropped shortly) across all Northlake client accounts. I think the stock has potential upside to at least $40 per share based on a successful merger with Telewest. The merger closed at the beginning of March. I define success as (1) the ability to produce several years of revenue growth in 3-5% range beginning in 2006 with growth at the high end of that range, and (2) the realization of cost synergies that will drive pro forma operating cash flow (EBITDA) margins from 35% in 2006 to 40% in 2008. If these goals are met, the company will produce about $2.4 billion, or $8 per share, in free cash flow over the next three years. With NTLI trading at $28.40 and debt at 4.6 times EBITDA, the free cash flow generation provides big upside to shareholders, and even if it falls short by $500 million still provides a cushion on the downside….

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The Internet Won’t Be Replacing Your Cable TV Anytime Soon

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One of the blogs I read regularly belongs to Mark Cuban. In a post last week, Mark discusses his view that lack of capacity in the final mile to the home will limit the ability of consumers to bypass the traditional distributors of TV, cable and satellite companies, any time in the near future. Mark’s article borrows heavily from research written by Sanford Bernstein analyst Craig Moffett and testimony that Craig gave before a Congressional Committee. I like the basic concept – the internet is not going to replace TV anytime soon. As I have repeated as nauseum since last summer, the near-term threat to cable EBITDA growth rates is being way overestimated leaving sentiment toward Comcast way too negative, and providing an opportunity for good profits as sentiment shifts to a more realistic view of the company’s EBITDA and free cash flow growth over the next few years….

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Central European Media Enterprises Announces Equity Offering

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Last week, Central European Media Enterprises (CETV) announced an equity offering. The company appears to be raising cash for future investments as the SEC filing document indicates the proceeds of the offering will go in the bank. I doubt it will stay there for long but assuming the interest earned will 4%, I see the deal as about 5 cents additive to EPS and 10 cents additive to free cash flow per share assuming the money stays in the bank. CETV should earn around $2.25 in 2005 and almost $3.00 in 2007.
I exchanged several emails with the CFO about the ultimate use of the money. He indicated that there are several small projects on the horizon in the internet and TV production/distribution areas that could consume some cash. Additionally, the company wants to build some reserves to increase its stake in its operating companies if the opportunity arises. As a reminder, CETV has spent about $50 million already this year to increase its stakes in Romania and Slovakia. Importantly, in Slovakia, CETV was able to obtain control of its broadcasting license….

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A Colleague’s Perspective on Motorola

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A fellow contributor to StreetInsight.com recently wrote a good piece on Motorola (MOT). Jeff Bagley and I share a similar view of stock market investments and own several of the same stocks for our clients. Since you are probalby getting bored with my commentary, please click “Continue Reading” to read Jeff’s insightful thoughts on MOT.

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Sears Holdings Moves Higher on Good Earnings Report

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(SHLD) responded very positively last week to a better than expected quarterly earnings report. Since Northlake clients all own SHLD, I am obviously quite pleased with the stock action, even if much of its was driven by short-covering when many bears threw in the towel. I am also quite pleased with quarterly results and with Eddie Lampert’s letter to shareholders. Bears and retailing experts have noted that SHLD can’t shrink its way to success. However, I’d qualify that statement by saying that SHLD can have shrinking sales for another year or so without offsetting the upside for SHLD stock. I see the stock as a race between expense savings and gross margin expansion on one side and softening sales on the other side. Eventually, expense savings and gross margin opportunities will run out. At that point, without top line growth, EBITDA will flatten out or decline. But, over the next year, EBITDA should expand as the “shrink sales to grow profits” strategy continues to work.
Take a look at 4Q05 operating numbers. Revenues fell 5% on a pro forma basis but operating income rose almost $300 million, or 30%, because gross margins rose 130 basis points and SG&A as a percentage of sales fell 90 basis points. Lampert’s shareholder letter spent a lot of time explaining how profits can rise when same store sales decline. Along with a comment that merger integration was largely complete, I think the unwritten message is that the financial model in 4Q is sustainable at least through 2006….

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Another Trip To The Apple Store Reinforces Confidence

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It’s been a rotten year so far for shareholders of Apple Computer (AAPL). AAPL shares have fallen almost 10% against a gain of close to 6% for the S&P 500. I’ve felt the pain as all clients of Northlake and my own accounts own AAPL. My pain was lessened a bit this weekend when I made a trip to my local Apple Store at Old Orchard Mall in Skokie, IL. The store caters to the well-to-do North Shore of Chicago where I’d make an educated guess that Macs enjoy a much better than average market share and every kid has an iPod. In other words, this store ought to be crowded with long lines at the registers if momentum in iPods and interest in Macs is continuing.
That was definitely the case on Sunday. I got in line to buy a Mac Mini as an upgrade for my daughter’s computer. There were at least a dozen folks in line when I started and when I finally checked out. An unscientific survey showed people buying Macs, iPods, and accessories. Furthermore, the store was crowded with people looking at all the products on display. If I had to choose one area of particular customer interest it would be iPod accessories, with lots of people looking at the new iPod Hi-Fi boom box. The product was displayed right next to the hot selling Bose iPod boom box. AAPL was asking $350, a $75 premium to Bose. I was glad to see the big premium because while I see accessories as an area of big upside for AAPL in 2006, I have a mild concern that as AAPL introduces more of its own accessories it could lose the support of some of its partners. These partners have been critical in developing the dominant market share for iPod + iTunes….

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