Warren Buffett Sees Potential In Germany, I See A Moat In Adidas

Warren Buffett (BRK-A) has started to buy in Europe, more specifically in Germany. He stated that Germany is a great country, with a vigorous and productive economy.  Therefore, we shouldn’t be surprised that he bought a German supplier of motorcycle equipment and he may be up for more (Source: Fortune).

I have mixed feelings in relation to the European economy. In my perspective, the current set of European policies is clearly off-mark. However, the QE will be an important driver for equities (as happened in the US case). Therefore, the already depressed EUR and some quality assets at depressed prices might represent the entry point that some investors were waiting for.

Buffett’s stance on Germany should be seen as an indicator that there are interesting opportunities in the old continent. I also have been paying some attention to some European equity markets like Germany and Spain. In Germany, one of the best companies that I have found is Adidas (ADDYY). The last time I wrote about Adidas was in September 2014; since then the stock price in EUR has climbed 29%. Unfortunately, the EUR had a steep decline during the period, completely offsetting the stock price gains (for the US-based investor).

The investment case for Adidas

Adidas is a powerful sports brand that dealt with significant problems during 2014. The Russian crisis, emergent markets’ currency depreciation and oversupply in the golf market marked a year where the earnings were a long way off-track. I interpret this as one of those cases where the company had everything going wrong for them.

Photo Credit: Kick Photo

Thanks to all the scares, the company is making huge efforts to improve its operations in order to have a better cushion for unpredictable events like happened last year. The strategy is divided in two major aspects:

  1. Increasing the sales in Adidas’ own stores: Adidas is looking to sell more items in its own retail channels, either online and brick and mortar stores. The company has been trying different approaches in the retail space and now is setting up a revamped retail strategy to apply until 2020. Obviously, the company is expecting to improve its margins by following this approach.
  2. Improving the feedback loop between sales and supply-chain: Adidas wants to reduce its inventory risk by having better communication channels between its sales points and its supply chain and logistics. This is a clear reaction to the excess of inventories that affected its TaylorMade golf brand last year. One way the company intends to do this is by prioritizing its own stores plus the online channel instead of focusing on third parties. Photo: Kick Photo

The previous two points highlight the biggest worry affecting the Adidas management team: speed-to-market. I think that improvements in this field should be welcomed but it worries me that the company lacks some identity on the marketing side. In this regard, the company needs a clear boost like the one that Robert Louis-Dreyfus gave to Adidas, back in 1994 when he left Saatchi & Saatchi to join the German sports brand.

Final remarks

Adidas is a good company with a great brand. Unfortunately, it is not a great company, it is just a good company. This does not mean, however, that Adidas is a bad investment. It is trading at 28 times 2014 earnings, and investors are expecting a recovery in the near future. If we use as a reference the 2013 earnings, Adidas is trading at a multiple of 20. Therefore, a recovery is pretty much discounted in the current stock price. What it is not discounted is the power and attractiveness of the brand that acts as a safety net for the underlying business. Borrowing Warren Buffet’s mindset of the competitive moat, we can argue that Adidas is a good enough brand to confer a good protection to its business.

Why Apple Has A Shot In The Electrical Vehicle Market But It Won’t Be Overnight

Long term stock picking is not about being right about the next line of products for a given company. In my view, it is about understanding how an organization works and thinks. This way we can measure the organization’s ability to build great products and services. When you look from this perspective, you can understand why the “father” of growth investing, Mr. Philip Fisher, was able to successfully keep Motorola in his portfolio for more than 4 decades which, coincidentally, were the best 4 decades of the company.

Basically, I avoid focusing too much on the next line of products and try to focus on what led the concept team to design that product. What needs were they answering? Who are they targeting? Often, the answer is the company needs to ship X million units this quarter. This is the recipe for long term failure.

Hedgehog concept

I will never forget how former Nokia (NYSE:NOK) execs used to start their quarterly presentations by stating how they had shipped millions of devices during the prior quarter. Obviously the company was focused on the production, not on the consumer’s needs, and therefore they’ve lost their hedgehog concept. Apple (NASDAQ:AAPL) on the other hand, has been focused on removing usability obstacles in its products and services. That has been the hedgehog concept for Apple. Remember the Apple II? Computers used to be complicated boards and wires mounted together by hobbyists in a process that took long hours, was expensive and lacked a standard operating system. Apple solved this problem by putting together a machine that was already built with a ready-to-use OS. This was all about removing user obstacles in order to target the mass market. The Macintosh was an even greater step by bringing the graphical user interface to the computer and reducing even more the learning curve. All this has been Apple’s trademark.

There is one more ingredient, a gift that Steve Jobs left during his 2nd stint at the company: He recruited the best and influenced his staff to do the same. Steve Jobs left Apple with a top notch staff team and that is why 3 years after Steve Jobs has left us, Apple presented the best quarterly earnings that any company has ever been able to deliver.

All in all, these are the reasons why Apple is likely to have a real shot in the car market: Focus on removing usability obstacles and having the best staff to do it properly.

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Photo Credit: Mark Mathosian

Potential for improvement in the Auto Industry

“Always listen to experts. They’ll tell you what can’t be done, and why. Then do it.” – Robert Heinlein

Where is there room to improve in the auto industry and particularly in the EV marketplace? The obvious answer is mileage. This is a good starting point. A recurrent problem when companies are at the crossroads of different technologies aiming to achieve the same end is the struggle to get it right. And the ones who get it right can’t really understand why they succeeded while others failed. This is something Apple has learned to do well. Apple never compromises on what matters: utility to the consumer. If a consumer feels he needs to do 400 miles on a single charge, then you can count on Apple to deliver 600 miles per charge. Just think about the MacBooks and how Apple turned battery life from 1-2 hours to 7-8 hours. Apple has exhibited a clear advantage at the moment of choosing the right technology for its products and services. Additionally, there is the charging time problem; here we are still at a crossroads between technologies. Tesla (NASDAQ:TSLA) has gone all-in with battery swap and fast charging posts, but there are alternatives (hydrogen and other fast charging tech) that might become industry standard, which leaves Tesla pretty much exposed to its current bet.

However, to reduce the whole matter to a proper choice of technology would be an underanalysis of Apple’s potential in the auto industry. Let us think for a second about the “driving interface” of a car. Looking at the way we’ve been driving cars since the first decades of the 20th century, we can see it as a natural antecedent to the way we drive our current machines. Cars have evolved a lot during the last century, but they’ve mostly evolved within the current paradigm of drivability, which is hardly different from the paradigm 50 or 60 years ago. Therefore, it makes sense to talk about self-driving cars. Let me now pause just to say that I love driving: I am going to be one of those old school guys that is going to defend the right to drive until the end of my days. However, I wouldn’t mind the occasional “self-lift” home after a party. Self-driving cars are the answer to huge problems in our day-to-day life; we shouldn’t neglect the potential to have cars wired in smart networks that help to avoid traffic and save energy in the process. Daily problems like finding a parking space could be solved with integration with current Apple services like maps.

The Economics of the Industry

Many things have been written about the fact that the auto industry is thin on margins. I believe this is conventional wisdom getting in the way of seeing the potential ahead. Nowadays, if we use computer industry terms, we would be talking about cars being 90% hardware and 10% software (Source: Morgan Stanley Blue Paper). Apple could change that relationship a lot. This is the critical factor to achieve fatter margins and possibly even cross-sell other Apple content-rich products and services.

Graph 1 – Hardware vs Software in cars in the present and in the future

Additionally, in the near future, the production technology is also going to be under fire. 3D printing might end up being a game changer for many industries, including the auto industry. There are some examples of cars built through 3D printing, and results are encouraging. I am not aware of Apple’s projects in this area, but we may end up seeing Apple developing new production technologies and then licensing it to outsourcers that will do the hard work.

Finally, there is the impact of a revolution this size on the whole US economy:

Graph 2 – Potential impact in the US economy of autonomous cars

These numbers could be a big encouragement for policy makers in order to hasten the pace of regulation in the sector.

Let’s not get ahead of ourselves

Yes, I have just taken a stand defending how Apple has the chance to be a relevant player in the auto industry. EVs are the new hype since companies like Apple and Google joined the new kid in town, Tesla, in the EV race. Obviously, these companies bring much-needed new perspectives to this old fashioned business. However, let’s not get ahead of ourselves. There is one thing they won’t change in the following years: the need to keep researching and developing prototypes. And this is a traditional time consuming activity for the auto producers; each new car model needs on average 5 years to go to market. Tesla took 5 years to bring its Roadster to market and took a further 4 to bring the Model S. More than this, Morgan Stanley Blue Paper estimates 5 to 10 years for complete autonomous capability and up to 2 decades to have close to 100% penetration of the technology (utopic scenario).

Furthermore, since the time to market is very different from smartphones, 5 years against 1.5 years, we are talking about slower changes in consumers’ habits. Folks do not change cars like they change mobile devices or even computers. If we add the fact that there are liability issues regarding accidents involving autonomous cars, we can see that there are many issues to solve before we can have a consolidated industry.

This said, my point with this article is to argue that of all companies outside the auto sector, Apple has the best track record in terms of understanding consumers, developing products and services with a great feel, and revolutionizing business models. If the company keeps being well organized and ambitious, it may very well succeed in this wonderful old business. Just don’t expect it to add much to the bottom line in the next 5 years.

Is Nokia Going To Connect People Again?

Photo credit: Are Sjøberg

The plot

Rumor has it that Sony (SNE) is looking to sell the Xperia unit (original source: Reuters). Tomi Ahonen in his Communities Dominate Blog , argued that Nokia (NOK) could be one of the most suitable buyers for the Sony smartphone unit.

Tomi Ahonen estimated that the Xperia unit could be plausibly valued at 4.5 Billion, given the last deals in the Mobile phones industry (i.e. Motorola to Lenovo and Nokia to Microsoft (MSFT)). Additionally, he stated that the deal blocking Nokia from returning to the smartphone business will run out in the end of the year. Therefore, buying the Sony unit, running it until the end of the year and then rebrand it “Nokia” could be a good solution for Nokia.

Why Sony?

So if Nokia were to return to smartphone market place, why choose Sony Xperia unit as its entering door? First of all, Sony makes wonderful products since ever. Presently, it has serious difficulties in having profits, but this has more to do with marketing than anything else. Additionally, the Xperia unit has worldwide presence, with a portfolio 100% smartphones (no feature phones). It would be a great match for Nokia own heritage as a top mobile phone producer.

Does a return to origins makes sense for Nokia?

I believe that from a business perspective the answer is a clear yes! The Nokia brand is still worth a lot in the mobile space. Even if the Nokia-Microsoft years tarnished the brand, a significant number of consumers would be willingly happy to try phones made by an independent Nokia. A clear indication supporting this argument is the demand for the Nokia N1 tablet. The first Nokia experiment in consumer electronics since selling the mobile phones unit to Microsoft caught the attention of a significant number of consumers, even considering the fact that Nokia was never a top player in the tablet marketplace (source: xda-developers).

From a financial perspective things are not so clear. Nokia has a lot of liquidity with a current ratio around 1.88, almost doubling its current liabilities. However, the company already has a 2.5 leverage ratio. This means that if the company decided to raise, let’s say, 4.5 Billion in the debt market this would bring the leverage to 3. By comparison, we can see that other stable companies in the tech sector have lower leverage ratios.

Table 1 – Balance Sheet selected data and ratios for Nokia and Leverage ratio for Peers (2014)

Basically, this means that the perception that Nokia has lots of dough to spend is not entirely correct. The company does have a liquidity slack, but most likely it won’t be enough to a deal like buying Sony Xperia unit. One alternative could be a joint venture with Sony, which from the financial perspective would be much less demanding, but would be harder to implement.

What about alternatives?

If an acquisition or even a joint-venture with Sony fails to materialize, are there alternative moves for a Nokia comeback? The answer is a definitive yes. There are other low cost solutions. One possible low cost move would be the acquisition of Jolla. This company was founded by the development team behind the Nokia N9 that left Nokia when the previous management team showed little support for the homemade operating systems. On the same note, Jolla is most likely going through some rough times, it has even started financing campaigns for some its products on crowdfunding websites (it might be a cool thing to do, but it reveals that there are cash restrictions).

If Nokia went this way and bought a small producer like Jolla, it could easily leverage its old patents, some of the remaining engineering teams but most of all, it could start leveraging its valuable brand. Obviously, Nokia does not have the same level of human resources it once had but after years financing universities throughout Finland, there is a huge supply of specialized engineers salivating for an opportunity to bring back the old Nokia. In no time Nokia can have a full smartphone business unit ready to start shooting. Additionally, this solution is very interesting since it has lower costs and therefore lower financial risks.

Conclusion

Buying the Xperia unit seems a bit farfetched since Nokia does not seem to have the sufficient liquidity to buy and digest a EUR 4.5 billion acquisition. However, other scenarios are on the table and a possible comeback could materialize through a less demanding option in terms of capital.

With the end of the non-competing agreement with Microsoft, Investors should start contemplating the possibility of a Nokia comeback and its consequences for the company and the whole sector. The company still has lots of resources and competences (patents, people, contacts, experience) in the mobile space, but most of all it still has the Nokia brand.

Let us say that Nokia initiates a strategy aimed at achieving a 3% market share in the next couple of years. Assuming that this would represent around 40 million devices at an average selling price around EUR 150, we would be talking about an additional revenue stream of EUR 6,000 million. Assuming a profit margin around 5%, we could be talking about EUR 300 Million added to the bottom line.

Obviously, this scenario could be worse, especially if the company failed to achieve a profitable operation in smartphones. Nonetheless, Nokia was always capable of producing profitable smartphones before adopting the Windows Phone OS. We will have to wait to see if they are still capable of doing it.

Amazon: Should Investors Sleep Well?

Stocks are often evaluated by how the underlying business might perform in the future rather than how things are going right now. Therefore, companies whose main markets or products are under threat tend to have their stock price depressed. On the other hand, companies in new markets with huge growth potential trade at multiples well beyond what’s recommended in any classic investment book. There is nothing wrong with companies being evaluated based on their underlying business outlook; the real problem relies on the fact that sometimes analysts tend to be wrong about the outlook they attribute to stocks. Clearly, Amazon.com belongs to the group of companies trading at generous multiples due to the optimistic outlook surrounding the company. Let us see what substantiates this optimistic stance:

Innovation process in services and products

Just by looking at common media reports about Amazon (NASDAQ:AMZN) you can conclude that the company is always launching and developing new products and services. The innovation within the company has some interesting characteristics.

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(Photo credits: Sindy)

Just like Google (GOOGL), there is a decentralized approach to the pursuit of innovations. The company incentivizes the pursuit of small scale experiments. This way, the company sets a natural selection in the initial stage of the development of new business ideas. Often, we see Amazon developing some of these small scale ideas. Lately, we have seen several products being developed by Amazon especially in the media content (Kindle). Since in this area differentiation is high, the company has been able to get a positive impact in Gross Margin:

Table 1 – Gross Margin evolution (2013, 2012, 2011) Lean company

Since the ’80s, the US recognized the Japanese superiority in industrial production, and many US companies have pursued the best Japanese practices in efficiency improvement. Presently, many start-ups incorporate lean principles from the very start. Therefore, Amazon’s management soon recognized that the company’s customers wouldn’t be willing to pay for an inefficient retail system. Waste prevention became one of the top priorities.

One example of defect elimination is the implementation of the andon-cord principle. The company allows customer-service agents to cut a line of products once there is evidence of repeated problems. The product is taken from the website until the issue is solved. This allows the elimination of numerous defects.

On the innovation side, the company adopted autonomation, i.e. humans use the help of machines for automating low-value repetitive tasks, while human workers focus on high-value complex tasks. This results in fewer defects and more successfully shipped items.

Additionally, the company leverages its ability to have fast turnover times for inventories, which means the company generates negative working capital.

In the end it’s all about valuation

I have just described a great company, so should you buy it? Not so fast. In the end it’s all about how much you pay for the great company you have just analyzed. A great business paired with an awful price will most likely end up a poor investment. As we have seen, Amazon is pursuing all those wonderful opportunities that make growth investors salivate endlessly. This creates a problem when trying to identify a figure for normalized profits. It is really hard to grasp where Amazon would be right now in terms of profits if it were more focused on generating earnings. The main problem relies on the fact that the company claims to be so focused on investing in growth that it is impossible to have an accurate idea about the company’s real profit potential. Therefore, I suggest a simple benchmark exercise in order to deal with this problem. The next table might help us in our quest:

Table 2: Amazon sales mix for 2013, 2012 and 2011 (Source: Amazon 10K – 2013)

Now, let us make some simple assumptions. Imagine that the Media segment is like DirectTV (NASDAQ:DTV), EGM segment is like Best Buy (NYSE:BBY) and the Other segment (includes the third party sellers marketplace) is like Wal-Mart (NYSE:WMT), in terms of profit margins. If this was the case, we would notice a clear trend towards a Best Buy like profit margin. Additionally, we would have approximately the following margins (I have used the 2014Q4 revenue mix and benchmark adjusted margins):

Table 3: Weighted profit margin for AMZN based on benchmark companies for segments

So, our simplistic exercise lead us to a 4.37% profit margin for Amazon. Using a 10% Revenue growth rate for 2015, we will have around USD 97.887 Billion in sales in the current year. Using the 4.37% profit margin, theoretically, Amazon should have around USD 4.28 Billion in profits.

As you must be noticing, this figure means a PER around 40 times our theoretical earnings (current price: USD 374.28). For a company already valued at USD 172 Billion, projecting a growth interval between 6% and 16% in 2015Q1, it is hard to find a 40 times earnings multiple realistic.

Conclusion

I started this article by showing evidence about how good Amazon’s business organization is. My goal is to provide assurance that the company is solid in terms of business and is not going anywhere. Answering the question in the article title, long-time shareholders can sleep well knowing they own a great business organization.

However, the results of our analysis revealed a very high earnings multiple. The exercise about valuation is a simple rationale made to provide a tangible view of the potential margin profit if Amazon tried to milk its profits. Some might have used other companies as a benchmark, I welcome other ideas and views about it in the commenting section. However, this rough measure should not be that far from reality which, in my opinion, should lead the prospective investor to think twice before buying this stock at the current price level.

I like Amazon’s business organization, but this won’t be enough for me to feel compelled to buy the stock at the current levels. I will, however, maintain some attention to this stock waiting for a steep dip in the stock price. If that day comes and Amazon is still well managed then I will most likely invest in the company.

Game theory: Why Varoufakis is wrong and there won’t be a deal soon.

Yanis Varoufakis have stated several times that soon there will be an agreement between the EU and Greece about the financing matters. He has based his opinion on the fact that both have more to lose if they don’t reach an agreement.  Mr. Varoufakis has even used game theory to support his opinion.

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My opinion is that he might be missing some details in the big picture. This is not an EU versus Greece, it is more an EU Governments led by traditional parties versus Syriza. And let’s be honest if they let Syriza take their way, those traditional parties will most likely face huge troubles in the next elections. Therefore, there is no way that Germany, Spain or Portugal will be in favor of letting Syriza striking a good deal. I believe that the game theory outcomes might be closer to this:

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Obviously, if the Syriza government perceives the outcome for the Grexit as worse than the Good agreement for EU, then they will most likely reject the Grexit and follow the next best scenario which is the Good agreement for EU. However, I am truly convinced that Syriza won’t be an easy negotiator and if they want to negotiate they’ll have to be serious about having alternatives. On the other hand, there is no way the EU status quo parties will be open to a deal that satisfies the Greeks. So my guess is the deal will take a long time, as is usual in European politics and financial markets will be kept bipolar for long weeks before any significant deal is made. But be aware of one thing: this time the two sides on the table have too much loose if they concede too much… There might be a surprise!

Earnings Digested: Coach Inc – The turnaround gains traction

Coach Inc (COH) presented last quarter’s results last week. The market reacted with optimism to the news that heavy discounting was largely stopped and encouraging sales in remodeled stores. Additionally, Stuart Vevers collection represented 90% of the women products on sale during the quarter.

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Photo Credit: gatoreena

On the retail side, the company has already opened 20 stores with the renewed store concept, intends to renovate 150 retail locations and to open approximately 70 new stores in the current fiscal year. In the end of the fiscal year, the painful retail restructuring will be mostly done. The renewed stores provided encouraging results:

“This holiday quarter was the first time that we were able to offer consumers the full modern luxury experience across product, environments and marketing, albeit, in only a few stores. However, it is proving to be a very powerful strategy in terms of changing consumers’ perception and impacting results as these locations posted positive comps that were greatly above the performance of the fleet.” – Victor Luis (CEO) [Source: Seeking Alpha Transcripts]

Overall, Coach presented good progress on its turnaround efforts, especially on the brand repositioning and on the retail refurbishing.

Additionally, Victor Luis offered additional insights about the acquisition of the shoemaker Stuart Weitzman:

“Stuart Weitzman is a complementary brand, with many similar core equities and characteristics to Coach. It’s a brand built on offering innovation, relevance and value to a loyal customer base. It has an increasing global recognition and a presence in 70 countries and is known for its craftsmanship and quality, fusing fashion and fit in a segment where comfort is a major driver of customer loyalty.

While we will develop each brand separately, over the long-term, we will learn from each other driving synergies across our respective businesses. Specifically, we will leverage Coach’s international infrastructure and expertise in handbags and accessories to develop Stuart Weitzman’s handbag and accessories business. In turn, Coach will benefit from the Stuart Weitzman team’s expertise in footwear development, where they are proven leaders in style and comfort.”

Conclusion

Coach offered a set of interesting results this quarter. The restructuring is on track with encouraging indicators on sales in renewed stores. Additionally, inventories might be on a downtrend which might be tranquilizer for investors. Furthermore, the acquisition of Stuart Weitzman was a surprise but it seems that it might be the first step in transforming Coach Inc from a one brand company to a company owning a wider brand portfolio. This might be the new growth spring for Coach. You can read more about my views on Coach here.

Market Outlook: The U-Turn In European Politics

European leaders did not understand the essence of the present crisis. The turbulence was provoked by the failure of the established elite’s political direction. The establishment is rotten but its roots are deep; this is the reason why the turmoil provoked by the 2010 debt crisis didn’t make victims sooner. Most of the traditional parties (left or right in the government arch) were able to maintain leadership.

François Hollande‘s victory was one of those cases. Promising to revoke austerity, he has done the opposite since he took office. The public’s reaction has been dreadful. French Socialists are one of the most unpopular parties in office right now. In my opinion, they risk ending up like the PASOK: completely annihilated. The price to pay for not meeting promises is getting higher by the day.

If Syriza lives up to its promises with a focused strategy for the Greek economy, then I believe the rest of Europe will feel the effects of a “European Spring”. Spain might be next on that list with the “Podemos” movement on top of early polls. Obviously, markets will be scared at first, but if things are done right, investors will have more motives to celebrate than to cry. The current state of affairs and the situation as the whole continent is in stagnation and flirting with deflation is what investors should be worried about. Countries turning deep left or right in legislative elections do not pose that much of a threat, especially if they are successful in reinvigorating economic growth or at least sparking some inflation.

At the end of 2014, I wrote a market outlook for 2015. This outlook included views on the QE from the ECB. My views at the time were optimistic on the sense that a European QE could cause a positive surprise in the European markets. Now, I think that the current dynamic will be harder for the European markets and especially the EUR in the first half of the year but in the 2nd half things might improve significantly. I still believe that the lower prices affecting commodities will be positive for Europe, but this impact will be offset by the EUR at the lowest levels in years.

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(Photo credit: Ian Sane)

Again, the big winner will be the US, more specifically the SPY and USD. The US had the best crisis management of any Western country. They refused to use austerity as their guideline. While European countries were counting pennies in their budget, the US were using printed money to save banks and auto constructors. Moral hazard? Not when they helped the banks just enough so that they could punish them later (example: Bank of America (BAC)).

Finally, Asian countries with debt in USD and emergent countries heavily dependent on commodities, especially oil, will struggle with increasing public debt and shrinking economies. This is the year of the US economy.

(Originally posted on talkmarkets.com)