May 04/15 – Apple vs. Microsoft (and the winner won’t be who you expect)

2015-05-04 9am EDT  |  #AAPL #Ballmer #DELL #MSFT #Steve Jobs

I don’t usually write much about individual stocks, but today I will make an exception. I am sure when you read my post, you will think that I am a clueless idiot. But I am going to put it out there nonetheless.

Microsoft will outperform Apple by a significant margin the coming years. There, I said it. It feels good to get that off my chest. I know, I know… Microsoft is about as cool as a SONY walkman. I also know the future is portable devices and wearables – which Microsoft stinks at. Yes, I am aware that Apple is eating Microsoft’s lunch in almost every category out there.

Yet if there is one thing I have learned over the years it is the market always underestimates the potential for change.

Remember 1997 when the coolest thing out there was a DELL computer?

The stock market was so enamoured with “Dude you’re getting a DELL” that the CEO felt confident enough to opine that Apple should just “shut down and give the money back to the shareholders.” At that time if you would have suggested that Apple would become the world’s largest company and that DELL would struggle to survive in a commoditized shrinking PC market, you would have been told you were complete baffoon.

Fast forward to today. Even though Apple has become the world’s largest company, the market is completely convinced that Apple can continue gaining market share without reaching a saturation point. Just like they thought Michael Dell could do no wrong in 1997, today Tim Cook is equally “infallible.”

When Steve Jobs passed away, the price of Apple stock dipped over concerns that the company would not be able to continue its success without their unique leader. I remember arguing that Jobs was sick for a long time, and he spent considerable effort leaving behind a culture that would survive his passing. Market sentiment eventually shifted and accepted this thesis. Within six months the price of Apple stock was hitting new all time highs.

But do you know how long ago that was? I looked it up because I couldn’t remember. Steve Jobs passed away October 5th, 2011. On that day, Apple stock closed at $54.03.

Last week it hit a new high of $127.88. Not a bad return for a company missing their instrumental founder.

Yet I can’t shake the feeling that the market is over estimating Apple’s ability to continue to lead without Steve. Jobs was the key to that company. Although he left behind a great product pipeline, eventually his influence will be missed.

The first post Steve Jobs era product has recently hit the shelves. The Apple Watch was developed completely after Jobs. And it shows…

Jobs would have never let this product out the door in its current form. I don’t want to rehash all my misgivings about the watch, but the poor execution of the product launch is indicative of Apple’s struggle to replicate Steve’s success.

Even the production was botched. From WSJ:

A key component of the Apple Watch made by one of two suppliers was found to be defective, prompting Apple Inc. to limit the availability of the highly anticipated new product, according to people familiar with the matter.

The part involved is the so-called taptic engine, designed by Apple to produce the sensation of being tapped on the wrist. After mass production began in February, reliability testing revealed that some taptic engines supplied by AAC Technologies Holdings Inc., of Shenzhen, China, started to break down over time, the people familiar with the matter said. One of those people said Apple scrapped some completed watches as a result.

Apple last week told some watch suppliers to slow production until June, without explaining why, according to people familiar with Apple's supply chain. Suppliers were surprised because Apple recently said that Watch inventory was insufficient, these people said.

The design is also sorely lacking. In a blow that strikes Apple hard, it was recently reported that the watch does not work if the user has tattoos. Do you know how many millennials have tattoos? I am pretty sure that getting a “sleeve” is something they automatically do when they turn eighteen. This “tattoogate” is going to make it tough for anyone under the age of 31 to ever wear an Apple Watch. From CNET:

If you have tattoos, you may have one less feature to count on in the Apple Watch. Apple has updated a support page on its website to say that some people who have tattoos may find that the wearable’s heart rate monitoring doesn’t work as expected, confirming user reports over the last week who reported errors in the device’s readings.

“Permanent or temporary changes to your skin, such as some tattoos, can also impact heart rate sensor performance,” Apple wrote. “The ink, pattern, and saturation of some tattoos can block light from the sensor, making it difficult to get reliable readings.”

This is the first time the company has acknowledged the Apple Watch’s issue with tattoos. Over the last week — the first seven days that the device has been available to consumers — users who have tattoo “sleeves” have reported that the heart rate monitoring feature would stop working entirely. Until the update, which was spotted today, Apple hadn’t said anything about the issue.

I am a seller of the Apple Watch and think it is only a matter of time before it becomes as cool as “Google Glasses.”

Don’t forget how jazzed up everyone was about Google Glass when it was first launched. Now you are a pariah if you wear it in public. I don’t expect Apple Watch to bomb that badly, but the market will be disappointed with the adoption rate.

So we have the first non-Steve Jobs product launch, which the market will soon realize is a dud, at a time when the stock price is at an all time high. Sentiment is about as bullish on Apple as it gets, with every retail player, hedge fund mope and closet indexer stuffed to the gills with Apple stock. There is absolutely no one calling for an Apple top. No one. Everyone is too scared to look like a lone idiot because the herd is so unanimous in their bullishness. Yet this is precisely why they are going to be disappointed.

This is at a time when risks are increasing. Recently Apple made a filing about the recent developments in the EU regarding their Irish tax shelter strategy. From the FT:

Apple has warned investors that it could face "material" financial penalties from the European Commission's investigation into its tax deals with Ireland the first time it has disclosed the potential consequences of the probe.

Under US securities rules, a material event is usually defined as 5 per cent of a company's average pre-tax earnings for the past three years. For Apple, which reported the highest quarterly profit ever for a US company in January, that could exceed $2.5bn, according to FT calculations.

The warning came in Apple's regular 10-Q filing to the Securities and Exchange Commission on Tuesday, a day after it reported first-quarter revenues of $58bn and net income of $13.6bn.

Brussels has the power to order Dublin to reclaim 10 years of tax advantages granted to Apple if it finds that deals struck in 1991 and 2007 were unlawful.

Both the Irish government and Apple have consistently denied any wrongdoing and declined to comment on the size of any fine. However, some Brussels officials suggest any ruling could set a new record for a state-aid investigation penalty by comfortably topping 1bn.

Apple said in the filing: "If the European Commission were to conclude against Ireland, it could require Ireland to recover from the company past taxes covering a period of up to 10 years reflective of the disallowed state aid, and such amount could be material."

The market quickly glossed over this development, but when the authorities start going after you, it is the beginning of the end.

And it’s not just the authorities that have woken up to Apple’s aggressive tactics. In an interesting shift in tone, I have notice more articles like Andrew Zaitlin’s “When will Apple stop screwing the US economy?”

There's a story I heard about electronics company Sharp. The company was about to go bankrupt and default on some major debt. This put Apple at risk, since Sharp was a major source of Apple's LCD screens. The story goes that rather than come to Sharp's aid, Apple instead approached the bankers and offered to buy the factory assets after bankruptcy - for pennies on the dollar of course. Talk about kicking someone when they're down! True or not, when I share that story with others who have dealt with Apple, they shrug their shoulders and say that they aren't surprised. That's the Apple way.

Business is not a popularity contest, but when the winner-take-all, cripple-the-other-guy approach goes too far and begins to damage the economy, it's time to rein things in.

The issue at hand is the way Apple's relentless greed has undermined the US economy and damaged its future industrial competitiveness. All so Apple can make $5 more per phone.

What is the burden of having Apple be the best it can be? Nine years, a trillion dollars in sales, and almost no taxes paid. And while Apple helps Samsung and TSMC build factories in China, Intel is shuttering factories in the US.

I have no issue with corporate greed per se; more often than not there's a balance with the public good (lower prices, better products and services). When things become imbalanced, it falls on us, as a society, to re-align things. We need to step in here.

It used to be that everyone rooted for Apple’s success. Apple was viewed as the American under dog. No longer. They have become the big huge oppressive corporate machine.

Not only that, but their cool factor is diminishing. It has to. It’s like Yogi Bera said, “nobody goes there anymore. It’s too crowded.” The top is in for Apple. We have hit peak Apple.

The market always under estimates the potential for change. Right now, all everyone can do is imagine Apple continue growing forever. I will take the other side of that trade. Just like no one could imagine Dell not being the dominant technology company in 1997, the market is equally unimaginative about the potential for Apple also losing its supremacy.

But if Apple is going to stumble, who will pick up share?

When my business partner and I left our bank owned dealer jobs in 1999, we wrote our own code for our automated trading strategies. Well, that’s not really true. My business partner wrote all the code and I just traded. But in the mid–2000s we noticed that no longer were our SUN UNIX boxes the epitome of trading tools, and we had to make the move over to PCs. So we hired a super smart computer science engineer right out of University. Although I like to call him “the kid”, I realized the other day he has been with us for ten years, and he is far from a kid.

Over the years he has offered some extremely valuable insight from a technology perspective that most stock market analysts miss. I distinctly remember him throwing cold water over the market’s brief infatuation with the RIM tablet. He told us it would never take off because the developers hated writing code for the whole Blackberry ecosystem. They charged for the SDK, it was buggy and in general, a huge pain in the ass. This might seem obvious in hindsight, but at the time, he was alone with his warnings about the problems with Blackberry. “The kid” was also extremely early in the whole bitcoin excitement. I remember him telling me about bitcoin when it was well under $5. If only I had listened to him and put $10,000 into bitcoin, it would have been worth $2.3 million at the top (not that I would have ever been able to hold it that long – I probably would have sold it at $20,000).

I have learned that when “the kid” starts talking about technology, it often pays to listen. He might be early, but he understand things from the development side that many of us end users miss. And lately he is super excited about all things Microsoft is developing.

Now you are probably rolling your eyes at that suggestion. Microsoft? Vista? Blue screens of death? Steve Ballmer?

Whereas Steve Job’s passing was a true loss for the company, I don’t think you can say the same thing about Ballmer’s retirement. Microsoft has been wandering around aimlessly for the past decade, getting their lunch eaten by smart innovative companies like Google, Apple and Facebook. Ballmer’s mis-steps buying stupid companies at ridiculous valuations only to write the whole thing off years later are legendary.

Yet Ballmer has been gone for a couple of years now, and the new CEO is slowly turning things around. Now Microsoft is one big ship, so it doesn’t happen overnight. But just like the Apple Watch is the first product without Steve Jobs’ influence, this next version of Windows is the first full version under the new Microsoft’s management.

And they are doing all the right things. From finally creating an app store, to making it easier for developers to port over their code from iOS and Android devices to run on Microsoft phones. If you recall back to when Apple was struggling to convert PC users over to the Mac OS, one of the big turning points was when Steve moved the Mac over to the Intel architecture and allowed users to dual boot into Windows. This made many users (myself included) willing to take the leap knowing they would be able still use all their Windows software. This realization by Microsoft that they need to offer this same sort of fall back might be the out of the blue development that helps their mobile system gain traction.

Every time you turn around, Microsoft is showing signs of innovating. No longer are they simply the big behemoth selling Office to Fortune 500 companies. Microsoft is starting to come up with some “cool’ things that are more reminiscent of Google than stodgy Microsoft.

I know it is gimicky, but their recent web page is illustrative of how Microsoft is changing. This web service allows you to upload your photo and their software uses new algorithms to estimate your age. Give a whirl – it’s actually quite neat. I uploaded a photo of myself, and although it did guess my age to be a couple years older than my actual age, I attribute that to the stress of being short Apple in the face of the mad crowd of bulls. I decided to upload a photo of Yoda, and I was quite shocked that the software managed to guess his age bang on.

There are a million other neat things that Microsoft is working on. I could list more, but there is no one “magic bullet.” As “the kid” explained to me, Microsoft are simply doing all the right things they should have been doing ages ago.

They have gotten rid of Ballmer, and they have stopped making mistakes.

Microsoft over Apple

Many market pundits can only envision a Microsoft that can do nothing except barely get out of its own way. At the same time, the market is convinced that Apple can do no wrong.

Yet Microsoft is showing signs of doing everything right, just as Apple is making mistakes.

Here is a chart of the ratio of MSFT vs AAPL.

Earlier this year, the ratio was bumping along the recent lows of 0.30. Although it has moved up, I think that it still has a ways to go. The first stop of 0.60 is as easy as a chip shot.

The market has started to wake up to the change at Microsoft.

I bet you are thinking I don’t know what I am talking about, and that Microsoft stinks, and will continue to stink. But that’s exactly why it might work…

Remember, at one point you probably thought there was nothing cooler than getting a Dell too…