Quick Thoughts: Great Companies But…

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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April 14, 2020

Quick Thoughts: Great Companies But …

  • Great companies that were badly hit for their exposure to the pandemic are mounting a comeback on the presumption that they will suffer for a few quarters but recover back to the growth and profitability that had been projected before the disruption.
  • However, post-crisis business conditions are unlikely to be the same as they were. We see 5 main areas of concern:
    1. Recovery takes longer than anticipated – Investors lose patience and negative narratives take hold
    2. Customer behavior changes – Shifts already underway pre-pandemic may accelerate, spending priorities may abruptly change
    3. Operations disruptions – The aftermath may require new practices that increase the costs of doing business
    4. Competitive threats – New rivals may emerge, old rivals may be stronger, new technology may disrupt traditional product categories
    5. Government intervention – Crises often prompt significant new regulation and changes to trade policy that could put strategies at risk
  • Even if the general economic recovery is strong, companies facing major challenges in these areas may never return to their previous performance trajectories. Investors must consider these risks.
  • DIS and AAPL stand out as broadly admired companies whose stocks have rallied in recent weeks despite major risks to their recovery in multiple areas of concern.

On Wednesday April 8, after China announced that it was lifting the near total lock down of the city of Wuhan, CNBC’s Jim Cramer had this to say:

“I’m salivating over the idea that people will lap up Apple’s 5G phone when a rejuvenated China lines up for the darned thing,” Cramer said. “With China coming back, and Apple’s service revenue stream getting a big boost from a locked down America, this stock suddenly seems pretty darned attractive, to me.”

Not to bust specifically on Cramer, but his take misses a few important points. First, when will that 5G iPhone actually hit the market? Apple’s supply chain has been shut down for two months just at the time when the company would ordinarily be testing prototypes, sourcing parts and setting up trial production for its new products to be introduced in the fall. It seems unlikely that the product can be in volume production in time for Christmas. Second, while Wuhan may be opening a bit, the rest of the world is largely locked closed and may be for weeks, or months. China revealed that smartphone sales were down 60% YoY in the month of February. It is likely just as bad in Europe and the US now and it is not at all clear when the stores

Exh 1: Post-pandemic recovery could disrupt operations in 5 broad categories

will reopen and, importantly, when people will feel comfortable going out to shop and to buy a $1,000+ smartphone.

Finally, Apple’s services revenues (~20% of revenues) consist largely of commissions on apps distributed through the App Store, on Apple care repair contracts, and Apple subscriptions like Apple Music, Apple News, Apple Arcade or Apple TV Plus (Exhibit 2). A lot of that is still tied to the sale of new iPhones (which are down hard). Moreover, with people confined to home rather than out and about, evidence suggests that the big growth in consumer engagement has been from TVs and PCs rather than from smartphones.

Many pundits have also been bullish on Disney, another great company flattened by the pandemic. Shares are off more than a third YTD but bounced off a relative bottom at $85 before stabilizing around the current $104. Still, the near-term damage will be profound – every major Disney business has been badly affected. The biggest division by revenue is Parks, Experiences and Product (36.7% of FY19 sales and 44.7% of operating profit). The parks are all closed, the cruise ships and hotels are empty, and the theaters are dark. Consumer products may sell in dribs and drabs, but most stores are shut. Someday there will once again by lines for Space Mountain, but for a very long time, even after the gates open again, people will be hesitant to rub shoulder to shoulder with strangers from all over the world (Exhibit 3).

The second biggest and most profitable division is Media Networks (34.7% of sales, 49.3% of profit). By far the biggest contributor from this group is ESPN, which is believed to have delivered $10.2B in revenue for 2018 with greater than 30% cash flow margins. While most linear TV network ratings are up, ESPN, without live sports, is down. In a market where advertising is beyond soft, this is a disaster. Moreover, as contracts with Pay TV outlets come up for negotiation, against a background of accelerating cord cutting, ESPN’s $8.43 per basic cable subscription per month fees will be under intense pressure. The rest of Media Networks will not be as bad as ESPN, but the future is not bright.

Exh 2: Snapshot of AAPL Services Segment Revenue, 1Q13 – 4Q19

Exh 3: DIS Segment-wise Sales and Operating Income Breakdown, FY2019

The other main division is Studio Entertainment (15.5% of sales, 17.7% of profit). 2019 was special, with the gargantuan Avengers: Endgame and the very successful Star Wars: The Rise of Skywalker anchoring a theatrical slate that grabbed $4 from every $10 spent on movie tickets worldwide. 2020 would have been a comedown anyway, with a modest slate of Marvel movies and no other obvious blockbusters, but the global closure of movie theaters for 2 or more months and lingering reticence to visit theaters there after is a punch in the face. Furthermore, with film sets shut, projects slated for late 2020 and 2021 are being rescheduled. Yes, Disney+ is signing on new customers at an incredible pace, but no, even 50M subscribers at $6.99 a month can’t make up for the many billions in lost sales and the resulting cash conflagration at the other divisions (Exhibit 4).

It seems very likely that both Apple and Disney will deliver extremely poor March quarter results and offer little in the way of encouraging guidance for June. Investors will need to draw their own conclusions for the value of the companies thereafter. Here we see five major categories of risk:

Timing Risk – Investors are not known for their patience. The bull cases for Disney and Apple depend on the companies joining the broad world economy in an expeditious recovery. For Disney, it means that global consumers must be willing to travel, to brave the throngs at theme parks and to attend movies in crowded theaters. Even in a world with widespread testing and tracking that gets people back to work, those activities central to the Disney strategy will be perceived as risky. It could be years before Parks etc. and Studio Entertainment get back their mojo. Given that these divisions delivered more than 60% of company operating profits in 2019, the wait may be too much for investors.

Timing should also be a major concern for Apple investors. Supply chains, particularly tightly managed, just-in-time supply chains like Apple’s, do not come back up to speed overnight. This is doubly important in preparation for introducing a new model. Ordinarily, teams of Apple engineers would have been in China over a month ago, making and testing prototypes, tweaking designs, and negotiating component supply contracts. By now, plants would have begun designing their production processes so that manufacturing could ramp to volume by early summer in order to hit store shelves at the end of September. Opening assembly plants near Wuhan doesn’t matter much if even one key supplier continues to have delays. The new 5G iPhones that Cramer pines for are going to be late and may well miss the Christmas season entirely. How will the market react?

Demand Risk – Given the trauma of this pandemic, many consumers may never go on a cruise again. Disney owns 4 cruise ships. Fear of tightly packed crowds may temper attendance at Disney parks. After months without sports and with daily exposure to the wealth of streaming options, cord cutting could accelerate hitting Disney Media Networks on two levels: weakened ad spending for TV and push back from Pay TV operators on network fees. All of this will be painful, and perhaps more so that Disney bulls have presumed.

Apple also faces significant customer issues. The pandemic has already created a global recession and few pundits really believe in a sharp V shaped recovery. A key element of the Apple bull case is that 5G will drive a significant reacceleration of upgrade behavior amongst smartphone users. In many markets, the crisis will have seriously set back 5G network rollout plans, particularly in the wake of declining mobile data traffic as people shelter in place. Moreover, the last major recession happened in the early

Exh 4: Snapshot of estimated subscriber base of streaming platforms in the US

days of the iPhone, making it difficult to extrapolate the impact on replacement demand in 2008-09. Will consumers, shell shocked by months of unemployment and uncertainty, rush to buy a $1,000+ smartphone when the one in their pocket still works fine? If not, the anticipated 2020 iPhone supercycle may not happen in 2021 either (Exhibit 5).

Operations Risk – In the aftermath of COVID-19 and with new CEO Bob Chapek now in charge, Disney may decide to make long term changes to its operating strategy. For example, parks may have tighter limits on total attendance, virtual queuing for attractions in the park and the elimination of pre-ride introduction sequences in tightly crowded rooms, and films that once had their initial runs in theaters may go straight to video and streaming. Actions like these and others may change the revenue trajectory and margin calculus for the company in the long run (Exhibit 6).

Exh 5: AAPL Consensus Estimates for Revenue and Growth

Exh 6: DIS Consensus Estimates for Revenue and Growth

Apple, caught flatfooted with almost all of its most important supply chain elements in China, may choose to diversify its manufacturing, increasing the number of suppliers and opening assembly plants in Vietnam, India or other appropriate countries. This would likely raise the costs of making an iPhone.

Competitive Risk – Time will tell if either Disney or Apple’s competitors rise to the occasion in the wake of COVID-19. Disney has built a stunningly effective machine for wringing value out of the best trove of franchise content in the industry. Still, it has not managed to find an effective approach to gaming, the fastest growing part of the media landscape. This could be a significant Achilles Heel in a future that could be every more dominated by video game content.

Apple’s strategy presumes that the smartphone remains the center of the user’s experience and its services are purposely closed to users who don’t use the company’s hardware. The pandemic has people trapped at home and using applications served from the cloud on computers and TVs, a model more in line with Google, Facebook and Amazon’s conception of the future than Apple’s. It is possible that the pandemic will jar consumer commitment to Apple’s walled garden and device focused ecosystem, raising the potential for Android and cloud-based applications to crack the famously loyal iPhone user base.

Government Risk – Will the US government use alleged Chinese malfeasance around the start of the pandemic to press broad new trade restrictions? Could government restrictions on large gatherings persist in fears of future waves of infection? Will global antitrust inquiries gain or lose momentum in the wake of the crisis? Will a weakened Europe promote a more protectionist agenda? Both Apple and Disney have considerable stakes in the direction of trade policy and regulation around the world. The pandemic creates significantly greater uncertainty as to the eventual outcomes.

Of course, Disney and Apple are not the only companies whose post-crisis risks have been underplayed by analysts and pundits. Other traditional media companies (e.g. CMCSA, T, etc.) and participants in the smartphone ecosystem (e.g. QCOM, SWKS, QRVO, etc.) share many of the same risks as the two bellwethers. We are also pessimistic for suppliers of configured equipment (e.g. DELL, HPE, etc.) and licensed software (e.g. ORCL, SAP, etc.) for enterprise datacenters given the accelerated shift to the cloud. Still, of this group, Disney and Apple are the highest profile and most loved names. There are a lot of other great companies that will gain additional strength in the recovery from the Coronavirus Pandemic. There is no need to chase the ones that are being run over by it.


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