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The Friday Five

Thu, 24 Jan 2013

Five stats from the market and the stories behind them. This week: Apple's steep 12% drop, Netflix's 2 million subscribers, and more.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five.

We've got a different format for you this week, five stats from the market and the stories behind them.

Joining me here with the numbers is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: Jason, my pleasure.

Stipp: What do you have for The Friday Five this week?

Glaser: We're going to look at a steep 12%, a surprising 2 million, a respectable 4.2%, a manageable 5%, and finally a scant 0.1%.

Stipp: That steep 12% refers to Apple's really bad day in the market on Thursday after they reported on Wednesday. What's the story with the stock?

Glaser: Not a good day for Apple investors. After the firm reported their fiscal first-quarter results on Wednesday night, on Thursday, the stock tumbled over 12%, as investors were starting to get very nervous about their iPhone business and about their projections of what that business is going to look like in the future.

And a lot of the concerns stem with the growth of lower-end smartphones, of cheaper smartphones, and of those with bigger screens, and worries that Apple just doesn't have the products to compete in those areas and that they are not planning on introducing products to compete in those areas--that they want to just go after those premium customers, even though the market is moving in a different direction.

Tim Cook even said on the earnings call that they are happy with the 4-inch screen on the iPhone 5. They think that's the right screen size. They are not looking at others.

I would say that you should take everything that Apple says often with a grain of salt. They said that 3.5-inches was the perfect screen until 4 was. Awhile back they said PowerPC processors are the best thing in the world, until they weren't and Intel was. They said they weren't interested in tablets until they were.

The company has a history of … talking about how happy they are with their current decisions until they very suddenly reverse course.

So, it wouldn't be shocking to see them come out with a larger format phone or a cheaper phone sometime in the future. The question mark is if they come out with those products, if they will be able to maintain the incredible level of profitability they have now.

They are seeing those gross margins already shrink. They are projecting an even bigger decline in those gross margins over the next couple of quarters. A lot of that is a product shift as people buy more iPad minis versus full-sized iPads. That really hurts the gross margin. And if you think that profitability is going to continue to shrink, that puts a lot of pressure on the valuation of the company, and could put some pressure on the shares.

I think it's going to be an interesting story for Apple to see if they are able to adapt to the changing smartphone market, particularly outside of the United States.

Stipp: If Apple was in the doghouse with shareholders, a former cellar-dweller or troubled child Netflix got a real boost with that 2 million number. How impressive was that?

<TRANSCRIPT>

Glaser: It was unexpected. Netflix added a lot more subscribers, 2 million, than most analysts had expected, and it sent the stock soaring over 40% after that news came out. People see Netflix again as a growth story and that they will be able to make up some of those missteps they had in separating the DVD rental business from the streaming business that had concerned so many for so long.

However, we don't think the story has really changed here. Our analyst Michael Corty looked at these numbers and said, yes, they are impressive; [it's impressive that] they were able to sign up those new users through the holiday period. But it doesn't take away those long-term pressures that are going to face the company. They need to get content, streaming content, to those consumers, and that's not going to get any cheaper.

So, you look at that Disney deal that they signed that was probably at a very lofty valuation; that's going to be difficult to make the economics of that work.

You could think about them moving into original programming, Arrested Development is coming back on Netflix, and a few other series, but that's hit or miss. When you look at the history of the movie studios, it's challenging to be able to pick what shows are going to be popular, what shows people are going to pay for. We don't know if Netflix will be able to do that, or if that's really a business that we'd want to invest in. Those long-term competitive pressures aren't going away. They are only going to get worse over time.

So, even if you see a little bit of better results here, or a little bit of better results there, and more people sign up, it's not that there was a thought that Netflix won't have a lot of customers or that they don't have a strong brand in the U.S. and Canada. The issue is, will they be able to actually provide that content, will there be profitable growth? And we just don't see that happening.

Stipp: Compared to the kind of moves we saw on Apple and Netflix, a 4.2% year-over-year revenue growth rate for 3M is kind of unexceptional, but it's actually remarkable and its unexceptionableness.

Glaser: It really is a respectable amount. It's easy to look at these more exciting companies in the world, like Apple and Netflix that we just talked about. But it's those wide-moat companies like 3M that really keep churning out year-after-year and produce a lot of shareholder value and really can be great investments over the long haul.

Like we said, they had that 4.2% year-over-year growth in earnings, and that came across a lot of the regions. The U.S. did really well, Asia-Pacific did well, and they are selling everything from Post-its to health-care machines into the healthcare industry. And they are seeing success there. They are seeing their operating margins expand; as that operating leverage kicks in, they can get more sales out of their existing plants and not have to invest a ton more there.

They are seeing great return on invested capital. Our analyst Adam Fleck sees a 20% [return on invested capital] over 2012 compared to an estimated 8.5% cost of capital. That's a real economic profit and one that is really being delivered year-in, year-out. It's a low uncertainty stock, so we can kind of have a pretty good idea of what the business is going to look like. And if you are someone who is worried about volatility, if you're worried about the ins and outs of the stock market, these are the kind of names that look really interesting right now.

Now, 3M looks about fairly valued. It's not a huge deal when it comes to cheapness. It's not a screaming buy by any stretch of imagination. But if there were a pullback in the broader market, if 3M looked really cheap, it could be a great place to put some money to work.

Stipp: Microsoft had some interest in Dell, purchasing a stake in Dell. It created some buzz in the headlines this week, but there is a 5% number there that's worth keeping in mind.

Glaser: This Dell buyout has been rumored for a little bit, but it really picked up this week, when there were talks that Microsoft was going to invest somewhere between $1 billion and $3 billion in mezzanine financing in order to get a deal by Silver Lake and Evercore--who are going to come with Michael Dell--to bring Dell private in order to be able to work out some of the problems the company is having outside of the public eye.

And this is a deal that it wasn't clear if they would be able to raise the money to do. It's going to be a big buyout; it would be in the approximately $22 billion range, one of the larger deals we've seen in quite some time, and I think the idea is that Microsoft--even though they'd be taking a small stake--their financial heft would lend some credibility to the buyer group--they already had a lot of credibility having the founder of the company in there as well--and would make it possible for this to actually get done.

The real question for Microsoft investors is, what does this really mean? What is this telling us about the potential strategy of Microsoft? And Norman Young, who is our Microsoft analyst, thinks this could just mean that Microsoft sees that one of their key partners needs some help, and they're willing to take some of that 5% of their cash-on-hand to invest that. It's not a huge, betting the entire house on Dell, but just helping them out there. It could be that they're looking to help accelerate some of their hardware initiatives--you look at Surface Tablet, you look at other places that they are starting to get into the hardware business--it helps them there. And maybe they are interested in the services part of Dell and want to work with a better relationship on that front.

So, it will be interesting to see what Microsoft gets out of this if this deal does get done, but given that it's a relatively small size for them, for the future of the company in lot of ways it doesn't matter as much.

Stipp: 0.1% is such a scant number; why is it notable for McDonald's?

Glaser: For McDonald's, they were able to get that global same-store sales growth, and even if it was really small, a lot of analyst had thought that it could turn negative, and they could really succumb to a lot of these big pressures that are facing the business.

And I think that small number shows that these pressures are very much weighing on them. For a long time, a lot of their quick-service competitors were shooting themselves in the foot a lot; they didn't have very competitive offerings, maybe they hadn't remodeled their stores, they weren't really a credible competitors, and McDonald's was able to take a lot of share during that time. But that's starting to turnaround as Burger King, Wendy's and Yum Brands continue to invest and continue to do better than they were, and this isn't a huge surprise there. And McDonald's is also getting pushed out from the upper end with chains like Panera and others and Chipotle, that people are maybe trading up a little bit.

But the fact that they were able to get something out of there shows the value of their brand, the value of their scale. They are looking to introduce a lot of new products in 2013 to continue to mine that international growth, particularly in Asia-Pacific in an effort to keep that business going.

And R.J. Hottovy who covers McDonald's for us really sees them as having the wide economic moat--that their scale is just so unprecedented, that they will be able to continue to do well. Even if they are not able to take share from the other players in the fast-food industry forever, they will be able to introduce enough new products and be compelling enough to get people into their stores.

Again, their shares look … pretty fairly valued, but with a 3% dividend yield potentially for people who are more income-focused, it could be interesting and again another more stable name out there in a turbulent market.

Stipp: Jeremy, thanks for the insightful details behind the data this week and for joining me again.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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