The Popping of the Silver Bubble: Still Too Early to Buy

Silver has been on a tear for the past year.  If you haven't followed it, SLV, the underlying ETF, has traded from $19.50 an oz (or per share) as of just last August, to a high of $49.50 an oz just last Friday.  Then, over the weekend, the bubble popped.  In a mere four trading days this week, silver fell an astonishing 32%! Crushed.  Today its rebounding a little and trading around $34 an oz.  I find this subject endlessly fascinating, and apologize if this gets too long, but there is a conclusion you can skip to at the bottom.

HISTORY & THE HUNT BROTHERS
I admit to following the silver market longer than any other market.  Being a kid in Texas in the early 1980s, I still remember when the Hunt brothers tried to corner the silver market.  In 1979, the Hunt brothers, Herbert and Bunker (names of kids you would beat up in elementary school), began buying massive amounts of silver futures.  They of course only needed a certain margin level to enter into the contracts (ie they levered to the hilt).  Eventually they controlled, via futures and their own physical holdings, almost 1/3 of the entire world's deliverable supply of silver, some 200mm ounces. 

Silver traded between $3 and 4 an ounce for most of the 1970s.  However, by fall 1979, it had reached $11 an ounce.  Markets were in a frenzy.  Then, over the next few months, continued Hunt buying in conjunction with a Middle Eastern partner, drove silver to over $50 an ounce!  Sometime during this ordeal, my older brother gleefully doled out his life savings ($750, he was in high school), and loaded up on silver coins.  I think he paid $40 an ounce. 

It was very shortly after when disaster struck:  the COMEX,  the futures exchange governing silver, changed the rules on silver margin requirements, forcing the Hunt brothers to stop buying.  When they stopped, silver began to fall, and fall hard.  When the Hunts received a $100mm margin call that they could not meet, silver  went into a free fall.  In its darkest day, silver fell by 50% on March 20, 1980.  Nobody wanted anything to do with silver for a long time.

After the collapse, my brother never forgave himself, and silver continued to fall for the next 20 years.  The Hunt brothers eventually went bankruptcy in 1988, losing some $1.7BB on their silver fiasco.  Today in fact,  Bunker Hunt lives just a few houses down from my parents in Dallas.  (Its nice, but quite modest for someone who was at one time perhaps the wealthiest person on the planet).  Personally I owned some physical silver starting in the late 1980s, and really loading up in the late 1990s in the $5-7 range.  I missed all the Internet millions, but couldn't resist buying silver eagles.

As an aside, I highly recommend the book, Bryan Burrough's The Big Rich, which details the Hunts, the Murchisons, the Basses (via Sid Richardson), and the Cullen's family histories and how they came to their wealth.  Hint, starts with O, ends in L.  Great stuff.

SILVER SUPPLY & DEMAND
First of all, its not exactly clear, but a variety of estimates seem to converge on one level of total silver in the world today:  45BB ounces.  That is, the world to date has produced 45BB ounces of silver give or take.  What is more interesting however, is to examine silver supply and demand over the past 10 years.  New production has been remarkably stable throughout the 2000s, averaging a steady 900mm ounces per year of new mined silver.  That means we add about 2.5% to the world's supply of silver every year. 

The general consensus on silver vs gold is the following:  Gold has very little in the way of industrial uses, 50% of its production goes into jewelry, and the rest into world central banks and people's closets.  Silver on the other hand, actually has numerous industrial uses.  Of the 900mm or so ounces of silver mined per year, 700-800 gets used up every year in industrial applications, photographic applications, and in jewelry & silverware.  However, last year silver took a big upturn in turns of total supply.  While the world produced 920mm oz of silver in 2009, it jumped to 1,060mm ounces in 2010, up 15%.  The net increase was naturally due to the price increases that we saw.  More importantly, the net incremental demand came entirely from investment silver buyers. More on this in a sec.

Now, one problem I have with silver is that its demand is declining in 2 key categories:  Photography and Silverware.  Clearly digital photography has impacted silver demand, so much so that in the past 10 years, annual demand has fallen from 214mm oz to a mere 73mm oz in 2010.  Same with silverware, with demand falling from 105mm ounces to 50mm ounces last year.  People just don't buy silver wedding forks like they used to.  That decline, combined nearly 200mm ounces per year, is a LOT of silver relative to supply of 1060mm ounces per year.

To make up for these losses in demand, the implied net investment demand, has risen dramatically in the past 2 years.  The average annual investment demand was a mere 22mm ounces from 2000 to 2008.  Then in 2009, I assume with QE1, investment demand jumped to 120mm ounces, up sixfold!  Then in 2010 it was 178mm ounces!  I have no way of knowing what this number will look like over the next 5 years, but based on trends for supply and demand, we will need to see investment demand AVERAGE over 195mm ounces per year, just to absorb new mined supply! 

This demand can only come from new investment buyers.  I honestly don't know if investment demand goes to 300mm ounces, or back to 22mm ounces per year.  But HIGHER levels than 2010 are required now just to equalize supply & demand, and at significantly higher prices of silver.  I doubt how much much higher demand can go. 

Looked at another way, there are 425mm total ounces of physical silver via the 3 traded ETFs in the market.  That number in 2 years has to almost double just to absorb new mining supplies.  To put that in dollar terms, that implies $12BB in new buyers of silver (at 35/oz) over 2 years.  Compare that the 2000-2008 time frame.  Cumulative silver investment demand was a mere $1.7BB over that 8 year period.  That is a massive increase.

CYCLICALITY
While the industrial applications category makes up about 50% of annual mined silver, it should be noted that this is heavily cyclical.   Silver goes into hundreds of devices, including electrical components, catalytic converters in cars, etc.  So in 2009, demand was especially hit hard during the recession.  (demand fell 19%, from 493mm oz to 404mm in 2009).  So, I think its important to realize that silver prices will likely be fairly correlated to the economic cycle, and cyclical stocks.  The time to buy clearly is at the end of recessions, as likely it will get hit hard during a downturn.  Silver has historically been more volatile than gold, I suspect this will continue.  The problem with volatility is, when prices fall by 32%, people start to question whether they want to hold too much of it.

Most of all though, I think you want a silver investment thesis that doesn't depend on investment demand, but rather one that depends on increasing industrial demand, which is far more predictable.

THE GOLD-SILVER RATIO

To me, perhaps the best measure of whether or not silver is cheap is to look at the long term ratio of gold to silver prices.  The chart below shows 1971-2009 what this ratio looks like.  (prior periods were not terribly relevant given the Bretton Woods partial gold standard for the dollar).

If you drew a trend line on the chart, I think you would find that the average has been around 50.  That is, gold typically trades 50x higher than silver.  When gold is $1000/oz, silver historically has traded around $20 an ounce.  You can see the silver price-spikes in the late 1979 time frame, when the Hunt brother tried to corner the market.

It wasn't long ago at all, however, 2009 to be exact, when the ratio got to as high as 86.  That is, gold got pretty expensive, and silver was a great buy.  What this chart fails to show however, is the spike in silver in just the last 18 months.  The ratio today, even after a 32% fall, is an astonishingly low level of 41.  That is still 20% below the historical average, meaning that silver is still perhaps 20% overvalued.  History suggests buying silver when it hits a 65 or higher ratio, which today means I don't touch it until its around $22 an ounce.  (I think a long GLD, short SLV trade probably is a good trade, but be careful).

SILVER COSTS
I tried in vain to figure out what it costs to mine silver on a per ounce basis.  However, most silver mined is mined in conjunction with many other minerals, its hard to gauge.  Generally, though, I found that anywhere from $6-12 per ounce in cash costs are what a miner pays to dig more silver out of the ground.  Clearly, when Silver got to be above $15 in 2010, producers jacked up supply by quite a bit.  There is a spigot here, and it got turned on full blast last year and likely this year too. 

CONCLUSION
Don't touch silver now.  I laughed on Tuesday when a guy on Seeking Alpha wrote an article saying he was buying more (at 42), and expected it to go to 62.  You can see my comment there.  Even today watching SLV, it initially rose almost 5% this morning, but has succumbed to more pressure.  Its sits right now at $34, up less than 1%.  I call this a dead cat bounce.  (ie, even a dead cat will bounce a little).  I will probably wait to buy more (physical or SLV, not sure) at $22 or lower.  Fair value is probably the historical gold-silver ratio, which at 50 ratio implies around $29/oz.  I don't know silver falls below $30, we might get one more run back to $40, but I think the bubble has popped, and we are due to continue correcting, or at least languishing where we are.

Some Thoughts on Apple Stock AAPL

If you read this blog, then you have probably seen me allude to the fact that everyone should own Apple in their PA. There has been a bit of news on the stock in the past 2 days, and I thought it would be helpful to revisit the name.

First of all, on Monday Apple announced that CEO Steve Jobs is taking a leave of absence for unspecified medical reasons. Further, there was no mention of how long he would be gone. Steve Jobs, who founded Apple in 1976, is considered by many to be the best product development manager ever. CEO of the decade, you name it, he single-handedly poured his life into designing their computers, the iPod, the iPhone, etc etc. He could be considered the most important CEO to any company out there. Without Jobs, there is great risk that product development languishes. And the world of mobile computing is notoriously cut throat. Motorola was the king of mobile phones in the early to mid 1990s, and eventually lost out to better designs. That stock has only gone down in the past 15 years since it peaked.

So, the question is, has AAPL peaked? The stock has rocketed from $75 / share 5 years ago, to $345 today. Jobs' job may be on the line, and competitors like the new Microsoft phone and Android are actually pretty decent. Can Apple continue to grow?

The good news is, the company reported earnings yesterday. I don't think it was a coincidence that they reported good quarterly earnings the day after Jobs took his medical leave. They are managing the newsflow. This is also the 3rd time in 5 years that Steve Jobs has taken a medical leave. None of those episodes were explained either. I find it a little irresponsible of the company not to better explain the management situation, but Apple respects his privacy more than the shareholders' right to know. Enough said.

The first indicent, it turned out Jobs had a pancreatic tumor, and he recovered and was pronounced cancer free. The second time, he told the world after the fact that he had a liver transplant. That was 2 years ago, and he took 6 months off. His COO, Tim Cook, handled the day to day management of the company. Tim Cook is considered an apt manager though, and I have read more and more that Wall Street is comfortable with Cook running the company during Jobs' absence.

So, the question is now, is the stock cheap? Does it discount the risk to losing Jobs? Well, AAPL reported December earnings yesterday after the market closed, and by almost any metric, they were phenomenal. Sales were up 71%. EPS was up 72%. Sales of iPhones were up 88%. iPads generated 4.6BB in sales in the quarter on 7.3mm units sold. They had zero iPads a year ago so you can't measure growth. And so on.

So, in the calender year 2010, Apple generated $76BB in total sales, vs only $46BB the year before. iPhones and iPads and applications and iTune downloads continue to grow at very high growth rates. I asked myself though if growth has peaked. It cannot accelerate, although in the last 5 quarters, EPS growth has been 50%, 89%, 78%, 70%, 72%. Strong. And revenue growth amazingly appears to be accelerating, growing in the last 5 quarters: 32%, 49%, 61%, 67% and 71%. Wow.

So, what is the market saying about Apple. Well based on its Q4 earnings, the company first of all has $59BB in cash. That's $64/share. So I am going to subtract that from the share price and calculate what the business generates in earnings. At 346/share, less $64 leaves me buying the business at $282 per share. And on a TTM basis, they did $18.10 in EPS (excluding interest income which was nil). That means I am paying 15.6x earnings. Compared to the S&P, the market essentially trades at a 15.2x P/E ratio. That is a very negligible premium compared to the market. Furthermore, GS calculates that AAPL has traded on average at 23x earnings over the past decade, much higher than today. I dont quite get it honestly. Perhaps it's just a case of the stock not keeping up with earnings in a volatile world.

Clearly it's also that the law of large numbers has to hamper growth here. But if S&P earnings are expected to grow by 9% in 2011, shouldn't Apple still trade at a much better multiple? Why does it languish at a market multiple when the numbers suggest that AAPL will grow EPS by 40-50% in 2011?

Finally, I did some math to figure out if there really is growth left. Based on guidance for the next quarter, annual revenue through March 2011 will be $85BB. Thats pretty much in the bag. Now everyone knows that finally the iPhone is coming to Verizon. That date is February 10th. Based on some surveys I saw online, an astonishing 26% of Verizon users expect the switch to an iPhone. Count me in that category. We plan to be dialing on an iPhone on the 10th. Further, there are 93mm Verizon wireless subscribers. That means you have a potential of 24mm unit sales of iPhones over the next say 2 years as contracts roll off. Now you could argue that Verizon sales will cannabilize AT&T sales, but really of the 9omm total iPhones sold worldwide, about 15-20mm are US AT&T models, I estimate. 80% of iPhone sales are international.

I have read that VZ expects to sell between 7-13mm iPhones in the first year. I think 10mm is a reasonable number. At $625 a pop, that is 6.25BB more in revenue in 2011 just from the VZ iPhone. We didnt count the AT&T users who plan to switch to Verizon because the network there is notoriously bad. So, if Apple has $85BB in sales pretty much in the bag, and you throw in another 6.25BB from the VZ iPhone, and add a full year of the iPad (add another $3BB), then that gets you to $94BB of annual sales. Translating that to EPS gets me in the $22-23 per share range. That is awfully close to where the street is forecasting EPS for 2011 too.

And then there is China. They only did $3BB of their sales to China last year. The US generated $20BB in sales last year on a $14 Trillion economy. China's economy was $5 Trillion, so it seems there is much room for further growth. This is heavily generalized but, in fact, in December the quarterly numbers show that revenue was up 175% in Asia Pacific compared to the year before. Its just starting to take off there.

Finally their quarterly numbers were hampered by production backlogs. They cannot make enough iPhones and iPads. It appears that the iPad shortages have been resolved, and they now plan to add 15 more countries this month to their existing list of 46 countries where the iPad is available. More sales growth.

I almost hate to agree with the sellside on a valuation. But I think this stock is worth 15-17x its 2011 EPS number. Figure that they'll build another $12 per share in cash, that means you will have 76/share in pure cash, and a business doing between 22-24 in EPS. You are in essence paying $269/share for a business that will do $22 per share in earnings. That is 12x forward earnings! Note that RIMM trades at 10x 2011 earnings, and given that 40% of Apple iPhones are sold to enterprises, that could seriously dampen Blackberry sales.

I am not surprised that GS and JPM just raised their forecast for the stock. They peg value at $450/share, which to me is not crazy. 375/22 in EPS implies that the stock can get to a 17x multiple by year end, still below its historical average. That is 30% upside.

As a final gut check, I always focus on cash earnings. Here I took CF from operations, and subtracted capex. That is REAL cash flow, unmanipulated for the most part. (D&A, depreciation and amortization is the biggest driver of manipulated earnings along with "non-recurring items"). Anyway, here is what I get per year in cash vs GAAP earnings:

Cash EPS GAAP EPS
2008: $9.20 $6.78
2009: $9.94 $9.08
2010: $17.25 $15.15

As you can see, Cash EPS is higher every year. I haven't done the forensic accounting to figure out why, but I note that they deferred a lot of revenue (ie the cash comes in, but not booked until as late as possible). The balance sheet shows almost $4BB of deferred revenue as of the end of September. Probably also some inventory management going on. Doesn't really matter. But this also brings up the point of returns on equity (ROEs). ROEs were around 29% last year, but the company's ROA, if you take out the cash would be an astronomical 58%. And in fact if you used CASH earnings, the number goes even higher. Very impressive. You cannot find a better, cleaner company from a balance sheet and reported earnings perspective.

Now, the negatives to the stock should also be pointed out. I have no idea what they do for growth beyond 2011. Steve Jobs may not come back this time, let's hope he does. But if his health has finally caught up with him, then there is real product development risk. The established base of devices is high, but then always subject to declining market share and cyclicality. Near term the quarter benefitted from a lower tax rate of 25% from 29%. That could go back the other way again impacting earnings.

And finally, sentiment is very high for Apple. I assume you have heard of a short squeeze before, but there is also such a thing as a long squeeze. That is, NOBODY is short apple stock. The short ratio is 0.6%, or about 6.8mm shares short out of 915mm publicly traded. That number is also down from almost 20mm shares short last February. You need a good short base to generate some buy orders when the stock falls. If not, you need to find new buyers of the stock to support it. Long holders keep pushing it down with no support. Feels like its happening now actually. If the short interest ever gets back to 20mm shares again, then probably that would mark a bottom.

So, do you buy here? I don't really know. I already own it, I'll probably look to buy more if it falls 5% from here, which is around $320-325 a share. One study showed that tech companies that get new CEOs, fall on average 10% in the 12 months following the change in management. If Jobs has to fully resign, then history suggests this stock falls to $300 a share. Could be worse though given his importance to the company. If it works and he comes back to work in a few months, then I think $450 is a reasonable upside in 9-12 months.

Shorting Netflix NFLX

I just shorted Netflix, NFLX around $178.50 a share. I have been watching and doing sporadic work on this name for the past month or so. Its been an insane stock to watch. In case you missed it, this traded at just under $50 a share last January, and has gone hyperbolic if you will, reaching a high of $209 a share just last November.


My opinion is that this stock is outrageously overvalued by almost any metric or stretch of the imagination. At $180 a share, its trading at 68x trailing twelve month earnings (TTM earnings), and on a forward basis, is trading at 46x (ie its P/E ratio). On a TTM cash earnings basis, my preferred method of looking at stocks, its a 0.33% FCF yield. Not 33%. 0.33%, less than 1%. I think I can make more with a one year bank CD, but more on that later.


So, to back up for a second, lets discuss the business. Netflix is a very popular DVD by mail rental company. They essentially killed the Blockbuster retail model of distributing rental movies. They have 280 or so distribution centers around the US, so that most of the time you can order a movie online and receive it the next day. You mail it back, pay $16 a month for 3 DVDs at a time, and really its quite brilliant. They reached profitability in 2003, and as you can guess, improved margins as they added subscribers. Its a business model that benefits from economies of scale, and they have gone from a couple million subscribers, to today they have 18mm subscribers.



On a margin basis, between 2005 and 2008 they consisently did 5-6% net income margins. Revenue grew quite nicely from $272mm in 2003 to $1.4BB by year end 2008. Then, their business model evolved. They got into the online business of streaming TV shows & movies. This is different than what Amazon, iTunes are doing, which is offering online movie download rentals. Download time is too long for many people, and at $5 / rental on iTunes, too expensive too. So Netflix came in and offered a deal whereby for $8 a month, you can stream unlimited TV/movie content from their online library. You might have heard of Hulu, which streams TV online, but its an advertising based model that is free.



So, Netflix rolled out its streaming service in 2008, and its been wildly successful. Here's why. To get streaming content, Netflix went to Epix (which owns Paramount, MGM, Lionsgate) and paid them something like $25mm a year fixed for all of their movie content. Then they did the same with Starz paying them something like $30mm a year for all of their titles. Together that got them a good library of movie titles. I believe the company's website lists 2,000 movies available for streaming, and then they have 100,000 in their movie DVD library in total.



Basically it was a major coup, and the guys who cut the deals at Starz and Epix now look like idiots. They didnt realize that movie streaming would be so popular, nor did they realize that this might cut into their market with the cable companies. But now the cat is out of the bag. When the original Epix deal expired last September 1st, they cut a new deal. I could not find the price tag, but reports are that it will cost Netflix $1BB over the next 5 years. Yes, thats a BILLION DOLLARS for 5 yrs, or about $200mm per year. Far higher than the $25mm they paid prior.



The same thing will happen when the Starz contract comes due October 1st of 2011. That deal is $30mm/ year now. Estimates are that it will go to $300mm PER YEAR, up 10 fold.


So what happened to earnings in Q3 with only one month of the new Epix deal? EPS fell from 80c in the June quarter, to 70c in the September quarter. Net income margins which looked great under the prior deals, fell from 8.5% in Q2 2010, to 6.9% in Q3 2010. And that is one month with the new Epix deal.


As for Q4, the company already guided to a very wide range of earnings, from 59c to 74c a share. Recall they did 70c in Q3. Either way, that is a range of margins between 5.5% and 6.7%, still going down.


Now the problem here and the problem with the short is cash vs accrual accounting. You will always hear me refer to CASH based earnings. Cash is all that really matters (unless you like your earnings of the Enron variety, faked). I noted that while Q3 earnings were not great, declining margins, EPS down sequentially, I also noted that D&A didnt change much. However, Capex spending DID. That is, cash went out the door to fund the Epix deal, and yet they havent really starting amortizing it into earnings. (and yet earnings still declined).


So, generally to get to cash earnings, I compare D&A and cash capex spending over time. Netflix has posted D&A of $73mm in Q1, 75mm in Q2, and 86mm in Q3 this year. Capex which should track it reasonably closely, has changed from $101mm in Q1, $92mm in Q2, and $149mm in Q3. So in total they have cash costs of $109mm, that they have YET TO EXPENSE compared to D&A. (ie, total capex less D&A is $109mm).


Well, you should guess that this $109mm of additional capex (movie content mostly), will have to get expensed. D&A will rise next year, and cash costs are going way up (with a new Starz deal). For a company that did a total of $145mm in Net Income in the last 12 months, $109mm of D&A expenses waiting to roll into the Income Statement is a LOT. Hence cash earnings are much lower than real earnings here.


My math is they did $0.60 in CASH EPS in the TTM period, vs reported earnings of $2.65. And with the Starz deal next year hitting them the same way, my basic belief is that they are turning more into a cable company. Yes, Netflix got a 2 year free bye from some major movie programmers to get cheap content and deserves a lot of credit for it. But this business model is very very unsustainable. Costs are going to rise another $270mm per year starting this October probably as the Starz contract is renegotiated too.


Net net, with both new contracts, I calculate EPS will at best be $2.70 per share. That is, you are paying $9.7BB for a company that will do around $150mm in Net income. Thats 67x earnings.


Admittedly I might be early with the short. They might depreciate these cash outlays on a more back end loaded basis. And, since Starz doesnt roll off until next October 1st, earnings until after that date will look decent.


Another item with this stock is internet usage. That is, consumers are in many cases using CABLE company internet service in many cases to get streamed movies/TV, that is Cable type service. The Cable guys dont like this clearly. Some estimates are that Netflix streaming accounts for 20% of all internet traffic in the evening. Networks are getting strained, and there is a high likelihood that within a year or two, Internet Service Providers (ISPs) will start rolling out tiered pricing. Cisco (I like that stock) predicts internet traffic will triple by 2014. Tiered pricing will mean that the $8/ month model cannot continue. Programming costs will have to get passed on to subscribers, and perhaps their internet usage fees will go up as well. ISPs will put up with only so much free riding, especially to the extent that it eats away at their own business (cable co's).


Net net though, I finally assumed that the downside to this stock is that margins stay flat at 7% (although I think they'll normalize at 5-6%). Further I assume that over the next 3 years, they grow 30% per year. That would take the company from 18mm subscribers today to 37mm by 2014. To put that in perspective, there are 99mm total cable/satellite subscribers in the US, and 73mm homes in the US with internet service AND a DVD player. 37mm subs would be over 50% market share of the available market, which is just enormous, and not terribly likely. I am quite sure AOL, Amazon, Apple, and a dozen other big smart companies are going to figure out a way to stream movies over the internet. Barriers to entry are not high. Nobody has this kind of market share.


But even if they achieve this, at 7% Net margins, the company would be generating about $6.25 in EPS. And at $180 per share, still equates to a very high P/E multiple of 29x. Wow, even today, Apple trades at 15x, GOOG trades at 18x, and mature cable companies like TWC around 15x. I estimate that this stock could trade within a range of $240 down to $75. Its hard to guess an upper limit, because irrational stocks like this can continue to trade irrationally. However, I personally would value this stock at 30x 2011 earnings at most, which is around $95, using a more reasonable $3.15 in EPS for 2011. (vs the Street at $3.86 in EPS).


There isnt accounting fraud here, but unrealized expenses on the balance sheet are going to come back to haunt them. Management is very solid here. Their marketing is phenomenal, by all accounts people LOVE their service. The CEO it should be noted though, has sold piles of stock. I couldn't even add it all up, it was many many 10,000+ share blocks every single month last year. He's a smart guy, he knows when to sell too.