Buying, Fretting and Re-Checking Some Possibilities

by Travis Johnson, Stock Gumshoe | January 25, 2013 6:47 pm

Friday File thoughts about Apple, Agrium, Greenlight and some Frontier Market Investments

I’ve got a few thoughts to share this week — no new teasers have caught my eye as interesting ones to share specifically with the Irregulars this Friday, but we sure have been seeing a lot of the graphite and graphene teases again (like Byron King’s pitch[1], and the Oxford Club’s graphite spiel[2]), and everyone except Apple investors (more on that in s a moment) seems to be feeling so much more peppy this year as fund start slowly to move from money-losing (eventually) bonds into stocks … at least until the next Fiscal Cliff (or whatever they call it this time) crisis hits with the debt ceiling and etc. in a few more weeks or months.

This week I did do a little bit of buying — I picked up some more shares of Greenlight Capital Re (GLRE), which I explained here yesterday[3] and have orders in for more if the stock happens to drop as I suspect it might (Einhorn had a bad fourth quarter for GLRE’s portfolio, and not just because of Apple, though we don’t know how the underwriting half of the business did in that quarter yet).

And Agrium (AGU) has been on a tear since I wrote about them as a top idea for the first half of the year a few weeks ago, and since I picked up some shares and options in November, so I whittled down my option holding by a bit to take some profit off the table. I still hold some call options and shares and don’t think the optimism is done, but it’s been a quick and sharp move up with improved forecasts from the company, more pushing from activist investors Jana, and raised estimates from analysts. It’s still not an expensive stock, but it is quite volatile with all the attention it gets.

But really, this week was all about Apple.

As always, Apple (AAPL) has gotten so much attention for their latest earnings release that it sometimes seems to have sucked all the oxygen out of the market — and since I have a large position in Apple shares and have suggested them for the Irregulars in the past, I feel as though I should chime in, too.

So what happened?

Well, the positive spin is that Apple reported it’s best quarter ever in terms of revenue, with $54.5 billion worth of iPhones, iPads, iPods and Macs (and etc.) going out the door. That’s about 18% sales growth, year over year. They beat an analyst estimates by a hair, unlike the last two quarters when they missed by a hair.

The negative spin is that Apple had substantial margin erosion in the fourth quarter, and the immediate worry is whether that’s just because the product mix has changed and gotten more expensive (the new iPhone 5 and iPad mini have lower margins than previous iPhones and iPads), or because Apple is on the beginning of the long slope down in margins as competitors (largely Samsung, but others too) catch up with their products in the eyes of consumers. If margins are going to depress over time and the days of 80% revenue growth are over, then Apple is an average and maturing tech company — the kind of company that, as we’ve seen with Microsoft in the past, moves to a much lower valuation in the stock market and, thus, a lower share price. Or, if you want to really worry, you can extrapolate into the future and fret that Apple the hit-driven hardware maker may really lose its way without Steve Jobs and become the next Dell or HP, companies that produce commoditized products and are essentially employment operations, keeping a business going but not making any money.

What am I doing? Nothing. Apple is still one of my larger holdings, I have not sold shares. Those who work with a trailing stop loss will use that particular discipline to decide when to offload their holdings as the stock has fallen, but I see a stock that’s now trading at 10X trailing earnings (ie, real earnings — not analyst estimates for the future) and that has flattened out its earnings growth, but I think presuming that the revenue and earnings at AAPL are going to go from a steady slope up to a steady slope down is premature and overly pessimistic.

I expect them to continue to lead innovation in their space, to use their cash balance to create leverage with suppliers, to sell massive volumes of phones and computers, and to be quite profitable and to grow their dividend. If you take their $135+ billion in cash and assume they pay taxes on the foreign cash and bring it home, that’s about $100 billion after tax (I’m making gross generalizations, but I imagine that’s not too far off), so even though they’ve shown no real indication that they’re going to invest that cash profitably or return it rapidly to shareholders, it is real potential value and (and this is important) they’ve shown no particular indication that they’re going to do something foolish with the money. Holding onto it is better than buying something foolish, like Skpe or Dell, and Apple has shown no real skill in large acquisitions in the past. If you take the cash out of the PE ratio, you end up with a company that’s valued at less than 8X trailing earnings, and the EV/EBITDA ratio is down to 6.5.

I could be wrong (it wouldn’t be the first time), but that just seems silly.

There are two major factors at work, I think: Pessimism over Apple’s ability to innovate and create new products that consumers want in the post-Steve Jobs era; and fears of margin compression now that Samsung has a credible product that can threaten Apple’s premium pricing (others are innovating too, to a lesser extent, but Samsung is the big global threat). It has been almost three years since the iPad was released, and the iPad came about three years after the first iPhone, so I don’t know what will be next or if we have to count on incremental improvements in their existing products for a while, but I am quite certain they have been working to develop “one more thing”.

Odds are that the next major consumer product from Apple will have something to do with the television, which will bring on all kinds of new risks and opportunities, but they have reportedly been working on a TV for years so it seems likely that they’ll eventually try to sell one. I don’t think they need to in order to justify a share price of $450, but they probably need something hot to get folks excited about the stock again if they’re to drive to new heights in the $600-700 range in short order. And no, they won’t tell us what they’re doing — that’s part of the mystique, and part of the investor concern. They are working hard enough, and spending enough, to possibly surprise us with their next innovation and restore a growth premium to the shares … but I don’t know what that might be. Steve Jobs isn’t there anymore, but their design chief now has free reign and they have thousands of engineers and innovators pushing through the next great product. Whatever it might be.

In the meantime, despite the fact that there is more competition, Apple sold huge numbers of iPads and iPhones in the quarter, and booked roughly the same earnings and earnings per share as they did in the 2011 calendar Q4 (it’s actually Q1 for Apple, they’re not on a calendar year), even though the 2011 quarter was one week longer than the 2012 quarter and the 2012 products were more expensive to make. Mac sales were down substantially year over year, which does hit the numbers even though Mac and iPad sales are a much larger segment for them … but that’s largely because, we infer, the product refresh cycle hit right in the middle of that quarter and there was a month or so after the new models were announced and before they were widely available.

The most sensible bearish comments I’ve seen on Apple are from Doug Kass, you can see his latest thoughts here[4]. He’s certainly been right over the last six months and I’ve been wrong, I’m holding my shares because I still think the company is inexpensive and a global leader … but I also thought that at $600 a share, so you can make your own call on whether or not I’m making a mistake. I think that if Apple “turns into” a slower growth dinosaur like Microsoft or Intel (I do own Intel, too), that it should do so gradually over a period of many years … I think the abrupt revaluation of the stock from a growth darling to a deep value stock over just a few months is unlikely to be the final word on Apple shares. The pitfall there is that unlike Intel and Microsoft, which have a utility-like aspect to their business from large recurring sales, Apple is all about new consumer products and, as we’ve seen with their growth, demand for those can spike up rapidly … which means it can also hurtle back down. It hasn’t, I’d argue, the problem has been competition and margins and expectations, not actual sales, but it can.

So I continue to hold Apple. I think we’ll find a year from now that they had an excellent year and generated another $40 billion+ in profits, and I wouldn’t bet against them introducing something else that triggers the “cool” switch. Perception of the stock changed very fast to the downside, leaving no one left to buy the stock, but that can change back, in probably a moderated fashion, as real business is conducted and real products introduced and real profits booked.

Checking in on some Frontiers

I wrote back in May last year, while musing about frontier markets in general, that Thailand was emerging as a pretty compelling play on Myanmar, and with a substantially more advanced economy than Mongolia, the previous flavor-of-the-month in frontier investing, it looked like a much safer play. I mentioned three funds for exposure to Thailand, since it’s difficult and expensive for individuals to invest there independently — two closed-end funds, TTF and TF, and the iShares ETF for the full investable index, THD. I was interested in TTF because I thought the discount would start to narrow and I liked the relatively low expense ratio, but now if I were investing in Thailand to get exposure both to the growing consumer economy there and to their investment in Myanmar I’d go with the THD ETF (Thai companies have an edge in Myanmar, thanks to a long history and a shared border).

Over the past year TTF has handily beaten the other two funds, and over five years TTF and THD are essentially neck-and-neck (TF is far worse over that time, and has a much higher expense ratio). I’d switch my interest to THD now because I think the portfolio is better positioned for infrastructure growth and energy investment (it looks like THD has good exposure to cement, and more importantly to the giant state-controlled energy company PTT that’s very active in Myanmar, and TTF does not to the same degree), and it’s significantly cheaper. TTF might still outperform, particularly if they do something dramatic with their structure to close that discount (they’ve said they continue to explore options — including open-ending and buybacks, but other than some buybacks there’s been no big change, and it hasn’t altered the discount much). The discount, if you’re not familiar with closed-end fund valuations, is the price difference between the actual assets of the fund and the price of the fund’s shares — open ended funds trade at net asset value, closed end funds can trade at a premium or discount depending on investor sentiment.

And while we’re on it, I do like to keep an eye on Mongolia from time to time — we’ve written about that country fairly recently, when Turquoise Hill Resources (TRQ) was teased … that’s the new version of Ivanhoe Mines (formerly IVN), following the takeover of control of their major Oyu Tolgoi mine in Mongolia by Rio Tinto (RIO). And I can’t get my head around what that one should be worth, though it is certainly a “trophy asset” in the world of copper and gold mining, and will be a major part of the Mongolian economy for decades to come — it’s just so much of a political football that you have to guess whether the taxes, permits, ownership or whatever else will be changed by the government … after all, revenue that flows indirectly or directly from Oyu Tolgoi will be the major input for the government, so tinkering with those deals is a huge temptation, as long as they can avoid having RIO actually walk away or stop investing in the project, or going far enough toward nationalization to cause international outrage. My guess is that growth and corruption will win out over time and the mine will be huge and profitable for TRQ and RIO, but I could be wrong and there could easily be some huge hiccups along that road.

The Mongolian investment that keeps coming up in questions from readers, and in teasers or commentary from a few of the newsletter guys we keep an eye on, is Mongolian Growth Group, the creation of a hedge fund guy and some other investors a few years ago who built an investment company to buy Mongolian real estate and build a Mongolian insurance company. It has almost always traded at a huge premium to any possible guess about the value of their assets, so I’ve never waded into the shares myself, but I do like the logic: Create needed businesses (insurance) in growing markets, and own income-producing real estate that benefits from the people and money that are flowing into the country, but don’t buy the actual mining projects themselves.

So what’s the valuation look like for Mongolia Growth Group now? Their ticker is YAK.V, (they recently moved to the Venture exchange from the CNSX, which is a micro-cap exchange in Canada), if you can’t trade directly in Canada it’s most easily traded on the pink sheets at MNGGF. Volume has recently been about the same, though both are pretty low volume… but I do think it’s a pretty big deal that they’re at least on the venture exchange now, the reporting and volume should both improve.

The shares are just over $4 now, with a market cap of just under $140 million. That uplisting to the venture exchange cost them a lot of money ($300,000 and much of management’s attention, we’re told) and was part of the reason for their weak performance in recent quarters, when other than the revaluing of their real estate assets they haven’t been able to generate income (and revaluing properties doesn’t create cash flow, though they did earn some cash from selling properties as well).

The current run rate for net premiums earned by their Mandal Insurance unit and rental income from their real estate unit (those are their two businesses, there isn’t really anything else) is about $2 million a year. If you exclude share-based payments, their operating expenses look like they run at about $3.5 million a year (their most recent quarterly report is here[5] if you want to see the details). I assume that earned premiums will ramp up fairly slowly at Mandal, since it’s a new business and they’ve so far incurred some losses that have cut into early performance. Current leases should get them to almost $2 million a year of just rental income this year, and they have slides in their presentations indicating the potential for more like $3-3.5 million a year in rental income from redevelopment and releasing. Most of the big redevelopment is still apparently theoretical — projects they envision but have not yet designed or permitted, but some (some offices and apartments renovated) seems to have already been done or is now in the works, so I think that number must include only the stuff that’s actually happening, since they include the prospective numbers in 2013 charts. Not particularly promising for valuing the company based on cash flow or earnings, but they have been cash flow positive at least from time to time over the past year, and at that level of revenues they could conceivably reach sustainable cash flow positivity soon.

If we want to value them instead based on some assessment of net asset value or book value, the reported book value is around $50 million — $39 million in property, plant and equipment (mostly investment property) and $11 million that’s mostly in cash and other investments. The idea is that their investment property is going to become considerably more valuable because it has redevelopment potential over the coming years — creating hundreds of new residential units that are in high demand, and thousands of square feet of office and retail space. The purchase price of this investment property they’ve acquired over the last few years has been roughly $33 million at current exchange rates. Property prices have been rising in Ulan Bator, but that still means we’re paying a hefty management premium for the company — the fair real estate valuation is probably fairly close to the value it carries on the books still, since it’s been acquired in recent years (though they haven’t bought anything of substance for a couple quarters), so you’re paying effectively almost three times the book value for a real estate and insurance company that is close to breaking even on cash flow. That’s maybe not bad compared to other ways you could invest in Mongolia, but it certainly wouldn’t fly for investment in a developed market — so the question is how fast you think they can turn that property into either cash flow, or how quickly the mining rampup at Oyu Tolgoi will juice the Mongolian economy and get asset prices rising rapidly again.

I’m left still thinking that it’s a bit too expensive, but you can certainly make the argument that this is a worthwhile gamble on Mongolia’s breakout — if they do indeed see incomes rise rapidly and rents follow, they could actually become a profitable company fairly soon (a year or two, if you want to put on a smiley face), and partner some of their redevelopment property to get their asset portfolio built up quite a bit more quickly. In the end I look at it fairly simplistically: They’ve raised about $50 million to build the company over the last two years, the assets they’ve bought or built are currently worth about $50 million, and I don’t feel comfortable paying $140 million for that. I’ll pay a premium for on-the-ground management in a frontier market with big growth potential, but that premium seems to big for me. I will continue to keep an eye on them, though.

If you’d like the most recent assessment from management, there was a good interview of CEO Harris Kupperman by Jon Springer here[6] (Springer follows the company closely, writes often about Mongolia, and owns shares). He says they’re on track to start investing more again now and emphasizes the value of their Mongolian team and their expertise in leasing and renovation, and they do have some cash to put to work so I may be being too cautious. We’ll see.

I do, for what it’s worth, still hold shares in the blank check company that’s been looking for a Mongolian investment (Blue Wolf Mongolia, MNGL, which will be either dissolving and returning cash to shareholders or making a deal by April, their two-year deadline). I think there’s little downside in that one, since the dissolution price should be pretty close to the current share price depending on what their allowable expenses have been, but they may well not find anything reasonable to buy for $80-90 million over the next few months in Mongolia. I have heard absolutely no news out of this company at all.

Those are my thoughts for this chilly week — have a wonderful weekend!

  1. Byron King’s pitch:
  2. Oxford Club’s graphite spiel:
  3. picked up some more shares of Greenlight Capital Re (GLRE), which I explained here yesterday:
  4. Doug Kass, you can see his latest thoughts here:
  5. most recent quarterly report is here:
  6. good interview of CEO Harris Kupperman by Jon Springer here:

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