Please see the Disclaimer associated with this blog. The author owns shares of ROVI at the time of publishing this article. The author may make trades in securities mentioned without notification. The information contained in this article is impersonal and not tailored to the investment needs of any specific person. You should consult with a professional where appropriate. The author shall not be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

ROVI Corp. (ROVI) is a compelling long trading at about 11x forward EPS.  This valuation is very attractive relative to management’s guidance for 20% long term operating profit growth.  ROVI has dominant market positions and a relatively high mix of high margin, recurring revenue.  The company’s growth is tied to several secular trends including growing media consumption on mobile devices such as tablets, smart-phones and laptops and the growth of Over-The-Top (“OTT”) video services such as those offered by Netflix (NFLX), Amazon (AMZN) and Hulu.

Business Description

ROVI is a technology company focused on the discovery, delivery, display and monetization of digital entertainment.  It is best known for its discovery intellectual property which almost all North American pay TV service providers such as Comcast (CMCSA), DirecTV (DTV), EchoStar (DISH) and Time Warner Cable (TWC) license in order to offer their customers an interactive programming guide (“IPG”).  Licensing agreements vary but several sell-side analysts estimate that ROVI receives at least about 20c per month per subscriber for their IPG patents.  The company also sells advertising inventory within these guides and its “metadata” which allows its customers to include cover art and information such as a short blurb about what a specific show is about.  ROVI also does business with consumer electronics companies.  These customers also license ROVI’s IPGs as well as several other technologies such as DivX, a high quality video compression-decompression software library.

Investment Highlights:

1. Increased number of use-cases will drive higher licensing revenue from new and existing customers.  ROVI licenses its technology by use-case.  Pay TV service providers have historically paid ROVI for the TV use-case.  Now that consumers have a desire to be able to watch TV from any device that has a screen, service providers are being forced to pay ROVI more for the “TV Everywhere” use-case.   The increased range of devices for video consumption has also increased the potential number of consumer electronics customers for ROVI.  For example, Apple (AAPL) signed a licensing deal in 2010.  Time Warner Cable has recently been advertising “In any room on any screen.”  In case you missed their Superbowl advertisement, you can see it here: http://www.youtube.com/watch?v=rLgzdnfQej4
2. OTT is a great opportunity.  ROVI recently signed a licensing deal with Hulu.  While Hulu is a relatively small service provider with only about 3 million subscribers, the deal shows the strength of ROVI’s patents and increases the probability of a favorable outcome for  the company’s litigation with Netflix and Amazon.  ROVI also has developed new IPGs that incorporate OTT that it is up-selling to its existing customers.  It calls this “TotalGuide.”  For example, with TotalGuide, you can search for a specific show and get back not only when Comcast may be airing it, but also if it is currently available through your subscription with Hulu.
3. Recent licensing agreements with LG and Hulu in Q1 de-risk 2013 estimates.  When it gave 2013 guidance, the company was not counting on any revenue from Hulu.  Management also guided for the LG licensing agreement to happen in the 2^nd half.  Bears are quick to point out the fact that management reiterated 2013 guidance following the LG deal.  The company also reiterated the fact that 53% of the 2013 revenue will be recognized in the 2^nd half.  While it is possible that there is some deal slippage, I hypothesize that management reiterated guidance in order to have maximum negotiating leverage with customers for upcoming contract renewals and new licensing agreements.  I find it very surprising that Street  revenue estimates for Q1 at $152 million have been left unchanged when the LG agreement will likely represent close to $20 million of sales (since it includes a catch-up payment from previous shipments).
4. Comcast and EchoStar agreements not currently being captured in earnings.  Before it was acquired by ROVI, Gemstar signed a very large 12 year licensing agreement with Comcast and EchoStar for a total of $440 million.  Since Gemstar was desperate for the cash, this was paid up-front and was supposed to be recognized as revenue over 12 years.  However, when Gemstar was acquired, all this deferred revenue was written off.  Consequently, ROVI currently has very large contracts with 2 large customers that it is not recognizing in its income statement.  These deals are up for renewal in 2016 and should be renewed at much higher values because (i) ROVI will not be as financially desperate as Gemstar was in 2004 and will therefore likely not push for an upfront payments, (ii) the ARPU and number of digital subscribers at these customers is up significantly since 2004, and (iii) ROVI’s patent portfolio is stronger.  I estimate that EPS is currently effectively understated by anywhere from 30c to $1 and it is only a matter of time until the earnings from these two important contracts get reflected in ROVI’s price.
5. New management and improved capital allocation.  At the end of 2011, the company replaced its CEO.  A new CFO came on board in Q2 2012.  Previous management significantly overpaid for an acquisition which was one of the main reasons the stock did so poorly in 2011 and 2012.  While the company is still looking for acquisitions, the company appears to be being much more selective and focused.  ROVI is actually in the process of divesting a small, money–losing business.  Management took advantage of the weakness in the stock last year to accelerate a buyback and reduced the share-count by 5%.  The CEO also bought stock in September of 2012.
6. International service provider opportunity. The company has relatively lower penetration into the international service provider market.  As ROVI increasingly goes after monetizing its patents internationally, its penetration in these markets should increase.  Moreover, cross-border mergers can help ROVI’s business.  For example, Liberty Global’s (LBTYA) recent announced acquisition of Virgin Media (VMED) will likely bring in a new customer if Virgin opts-in to Liberty’s existing agreement with ROVI.
7. Growth set to accelerate.  The company has a couple of declining legacy businesses that are offsetting growth in other areas.  The good news is that these legacy businesses are going to be very small this year just in time for revenue from new OTT customers and increased revenue from new products, increased international penetration and new use cases to accelerate growth.  Management is guiding for 2014 revenue growth of 7 to 12% with the Street at the low end of this range.

A dream but not unreasonable scenario is that the stock’s forward EPS multiple rises 50-100% to 15-20x and EPS also grows 60-100% over the next few years for a potential 100-300% return.  At the same time, risk appears relatively limited given (i) the company’s low multiple on EPS that is arguably not even including revenue from 2 of the company’s large customers and (ii) the fact that the LG and Hulu deals were signed earlier than expected.

Please see the Disclaimer associated with this blog.

I believe that ORCL is a great investment for 2013. It can be up 40-50% with very limited downside. Read more about my views on ORCL by clicking here.

See my article exclusively written in November for SeekingAlpha on why I like Facebook as both a long term and short term investment. The popular short thesis on the stock is flawed. I am expecting relatively large upside to consensus expectations.

I also wrote a follow up article on Facebook in Dec in which I reiterate my view after carefully analyzing public statements made by management and board members.

Please see the Disclaimer associated with this blog.  I own shares in Equinix and may trade in and out of it without posting new information.  You should consult with a professional where appropriate.

Those familiar with my work know that with growth stocks, my main concern is about momentum in fundamentals continuing.  Not only do I believe this to be the case with Equinix (EQIX), but I also think fundamentals and positive earnings surprises are now set up to potentially accelerate.

Equinix operates data centers.  The company divides up space in these datacenters into cabinets. Customers effectively pay monthly for space and power.  Customers also pay a monthly fee for each connection they make with other Equinix customers. The beauty of Equinix’s business model lies in the fact that it has the leading position in almost all of its markets.  When Equinix opens a new datacenter in a given market, it makes sure to tether that new building to all of its existing datacenters in that same market.  Because customers prefer to be located close to other customers, they usually are willing to pay a premium to be in an Equinix data center versus the space offered at competitors.  The significant bandwidth savings most customers get from being able to cheaply interconnect to other Equinix customers more than offsets the premium they pay.  Furthermore, once a customer goes through the trouble of placing its servers, storage and Telco equipment in an Equinix data center, the costs and potential disruption involved in switching to a different provider is very high.  All this gives Equinix a strong competitive advantage and pricing power that only grows as the company gains even more scale.

The Company has consistently beaten its guidance.  In early 2011, EQIX said that 2013 revenue would be greater than $2b when the Street was 9% below this figure.  Consensus for 2013 is now at $2.25b and (as I will argue below) is still too low.  EQIX is now guiding for 2015 revenue of at least $3billion.  Like in early 2011, the Street remains skeptical and is well below management’s long term guidance.  Equinix is planning to convert to a REIT in 2015.  REITs are typically valued using Adjusted Funds From Operations (AFFO), which is a proxy for operating cash flow less maintenance capital expenditures.  Other datacenter REITs like Digital Realty (DLR) currently trade at about 16x 2013 AFFO.  Wireless tower companies like American Tower (AMT) trade at over 20x AFFO.  I estimate that at $3b of sales, Equinix can generate AFFO of at least $21 per share in 2015.  At 15x, this would imply an end of 2014 target of at least $315 or over 64% upside from current levels.

The Company guided for Q3 revenue of $492-498m and the Street is currently modeling $494.5m.  This represents a sequential increase of $16.5m versus Q2 excluding the impact of acquisitions.  This compares to the $14m sequential increase in revenue from Q2 versus Q1.  The Street does not appear to be modeling much improvement in new revenue generation in Q3 versus Q2 despite several positive changes:

1)      Lower churn.  Last Q, customer churn was higher than normal at 3.2%. Most of the increase in churn was because of Equinix’s “optimization efforts.”  In hot markets, Equinix tries to proactively churn out older customers who may be less profitable.  It then quickly sells out the newly available space to higher paying customers.  Eqinix’s CFO stated on its last quarterly conference call that churn would “moderate down to between 2.4% and 2.8%” in the 2^nd half of the year.  I estimate that a 0.6% lower churn rate implies at least $2m of incremental revenue in Q3 versus Q2.  Moreover, because some of the vacated space will likely be quickly filled as per the company’s plan, Q3 should have an additional $1m+ or so revenue from new bookings associated with that available inventory.  The Company has done these optimization efforts in the past, and each time the vacated space was sold very quickly to much more profitable customers.   On the Q2 conference call, President of North America Charles Meyers stated, “Typically, we are able to resell capacity quite quickly… these are into high-demand assets with high levels of fill in.”

2)      Significant Capacity Additions and Sales Force Productivity.  Equinix expanded its sales headcount by about 50% over the last 18 months. The Company said that bookings last Q were the 2^nd highest in its history.  Q1 bookings were the highest.  Nevertheless, the sequential growth in recurring revenue was actually higher in past quarters.  I believe the reason for this discrepancy is because some of the bookings in Q1 and Q2 were for pre-sales of space in new datacenters.   On the EQIX’s investor relations page, the company offers a PDF that details its expansion plans. 7 new datacenters were scheduled to open in Q3 making the quarter one of the most important for capacity expansion in the Company’s history.  I don’t remember a time when this many new data centers opened in a single quarter.  To put this into even more context, the same sheet only shows that only 2 new data centers opened in the entire first half of 2012.  It takes time for new sales people to become productive and it appears that Equinix may have perfectly timed productivity increases from new sales people hired over the last 18 months with the significant new capacity.  Even modest assumptions of new sales associated with this new capacity should lead to upside.

3)      Currency.  When the Company gave guidance at the end of July, management said they expected currency to be a sequential drag of about $4m in Q3 after being a $3m sequential headwind in Q2.  At the time, the Euro was 1.21 to the Dollar.  It currently is over 1.30.  Other currencies have also appreciated.  I estimate that instead of being a $4m sequential headwind, currency will actually be a slight tailwind in Q3.  Therefore, all other things being equal, currency effects alone would imply over $4m revenue upside.

4)      Acquisitions.  In July, the company closed a couple of important strategic acquisitions in markets outside of North America.  Equinix’s CEO stated that Q3 would have about $13-15m of revenue associated from these acquisitions.  However, this figure does not take into account cross-sell opportunities.  Many of Equinix’s customers do business globally.  When the company made foreign acquisitions in the past, it was able to sell some North American capacity to newly acquired foreign customers.  It was also able to sell the newly acquired foreign capacity to existing Equinix customers.  “Revenue synergies” take some time to materialize, but it is another positive variable for Q3 that was not in Q2.

Given the factors above, I am fairly confident in Equinix delivering short term revenue upside.  And, given the very high operating leverage of this business, even small top line upside can yield very large upside in earnings.  Moreover, due to the high recurring nature of Equinix’s revenue, any upside in the short term would flow through to upside for future quarters.  Finally, improved sales force productivity and a higher pace of capacity additions will not be unique to Q3.  Q4 is expected to have 5 new data centers and Q1 is also expected to have 4 new centers.  This new capacity combined with synergies from recent acquisitions and lower churn will likely drive an acceleration of growth over the next few quarters.

A stock price is a function of earnings and the multiple applied to its earnings.  Earnings estimates are likely to be revised upwards and, in my experience, growth stocks that show accelerating fundamentals typically get rewarded with improved earnings multiples.

Risks to monitor are changes in the Company’s schedule for new datacenter openings, currency movements and competitive industry pricing.  There is also the risk that the IRS will deny Equinix’s application to become a REIT although I think the probability is low and the IRS is unlikely to even comment until the middle of 2013.

Please see the Disclaimer associated with this blog.  I own shares in GLW and may trade in and out of it without posting new information.  You should consult with a professional where appropriate.

Those who are familiar with my work know that I like it when investment ideas remind me of prior decisions that have worked out well.  Corning (GLW) reminds me of other cyclical stocks that have done well once earnings estimates first start to get revised upwards.  A year ago, the Street was expecting Corning to earn $2.00 per share in 2013.  Today, the consensus expectation for 2013 EPS is $1.43.  In early 2011, Corning was trading above $22.  It is now below $13 which puts it at 9x 2013 EPS and below book value.  The company recently increased its dividend (yield of close to 3%).

Corning is involved in several businesses, but most of its earnings currently come from LCD glass.  The LCD glass industry went into oversupply, because of two simultaneous events.  First, the weak economy caused demand to be weaker than expected for LCD TVs, computer monitors and laptops.  Second, the industry started a transition to using thinner glass, which effectively increased supply.  The industry is currently half-way through this transition.  The oversupply caused pricing pressure and market share loss for Corning and was the primary reason for the dramatic cut in earnings expectations for the company.

Corning responded by taking close to a quarter of its own capacity offline.  Since Corning has about half of the industry’s supply, this move resulted in a moderation of pricing pressure.  On the company’s Q2 earnings call, CFO Jim Flaws stated, “Our quarter two price declines for LCD glass were indeed much more moderate than the previous two quarters.”  During the question and answer session of the call, Flaws also stated, “I’m delighted by the Q3 pricing that we basically have reached agreement with almost all of our customers already.” With pricing more of a known variable, the company appears to be set to beat earnings expectations in the short term for several reasons:

1)      Demand has turned out to be better than expected.  Since Corning’s last earnings call, there have been many industry data-points that imply strengthening business conditions.  AU Optronics (AUO), one of Corning’s largest customers, reported September quarter revenue that was better than expected.  When AUO initially gave Q3 guidance at the end of July, it expected large panel shipments to be flat sequentially from Q2.  Actual shipments wound up being up close to 5% sequentially.  A couple of weeks ago, Nippon Electric Glass (NEG), the number 3 manufacturer of LCD glass, also revised upward its expectations for the September quarter.  Retail TV Demand from China during its Golden Week Holiday appears to have been better than expected.  This is important since Corning’s CFO specifically highlighted Chinese demand as the biggest risk-factor during the Q2 earnings call.  He stated, “I feel our biggest risk is our television forecast is China.”  Despite all these positive industry data points, consensus estimates for Corning’s Q3 have barely changed.

2)      Currency has gone in Corning’s favor.  Something many people usually miss is that the company prices much of its LCD glass in Japanese Yen.  The Yen has strengthened versus Q2.  The stronger Yen will not only help the company beat short term expectations, but it will also give even more confidence to bulls who are looking for continued moderation in pricing pressure.

3)      The company has become more aggressive with returning capital to shareholders.  It recently increased its dividend by 20%.  Corning also bought back close to 2% of its total shares outstanding in Q2.  This was at a faster pace than Q1.  The Street does not appear to be accurately modeling Corning’s share buyback going forward.  Most expect the company’s share count to increase going forward when it should be decreasing.

People who are bearish on Corning will point out how the stock has recently risen from slightly below $11 to about $13 per share in a couple of months.  They will affirm that recent data points are already “priced in.”  The problem with this point of view is that it is fails to take into account the larger context.  While the stock has done well recently, it has still underperformed massively over the last couple of years.  A large portion of industry supply has been taken off-line and the most painful part of the transition to thin glass is in the rear-view mirror.  At the current valuation, the stock is not priced like a company that is expected to beat earnings expectations.  The price-to-earnings multiple at 9x can only go up from here and it should go up given the improved certainty around industry pricing and the return to growth.  Q4 should be the first quarter in a long time when revenue and EPS inflect back to positive year-over-year growth.  This is usually a positive for the multiples of cyclical companies.

Longer term, there are several potential positive scenarios for the company.  I do not necessarily have a strong view about any of these, but at the current valuation, I think of the stock as a cheap call option (Actually, it’s better than a call option, because instead of paying premium, I get paid close to a 3% dividend to wait).  The positive scenarios:

1)      Large new business opportunities and diversification should help the stock’s price-to-earnings multiple.  Corning is an R&D company that has regularly reinvented itself over its long history.  During the dot-com bubble, it was primarily known as a supplier of fiber optics and it is currently viewed as a manufacturer of LCD glass.  The company’s labs are constantly churning out new technologies.  It is only a matter of time until one or more of these new products become another big business for the company.  Furthermore, because some of the technologies Corning is working on leverage its existing manufacturing facilities, there is the potential that its success leads to better industry supply conditions and pricing for LCD glass.  The company’s effort in glass for solar panels is one example.  Corning is working on lightweight glass that would protect solar panels but also would make them much more efficient at generating electricity.  Since the Street is not modeling anything from this new business, any success in this area would be a source of earnings upside.  Moreover, since solar glass would be made with LCD glass factories, success in solar glass could also lead to upside in pricing for LCD glass.  Even without a large new explosive business, corning’s earnings should become more diversified over time as other businesses are expected to grow faster than LCD.  In an upgrade note published in mid-September, Goldman Sachs noted that it expects Corning’s LCD business to account for 74% of earnings in 2013 down from 96% in 2009. The diversification should lead to less cyclicality and increased predictability over time.  This, in turn, should improve the stock’s multiple.

2)      Replacement demand and a housing recovery could drive an upturn in LCD TVs.  According to the company, the average LCD TV is replaced about every 6.5 years.  This replacement rate implies that a very small amount of current TV demand is for replacement.  However, that will change in a couple of years.  In 2008, there were about 118 million LCD TV units sold.  Replacement demand for these units could drive an upturn in overall TV demand in 2014.    Furthermore, while many expect housing to recover, current TV demand expectations assume little to no correlation to housing. Therefore, any positive correlation could lead to upside.  I hypothesize that the correlation is higher than people think.  I personally bought a new TV when I recently moved into a new apartment and I know several other people where this was also the case.  Since industry supply has been taken off-line, any significant upside surprise in demand could cause pricing to actually go up for a short-period of time.  This has happened in the past and there is no reason why it can’t happen one day again if demand improves.

3)      Windows 8 could drive an improvement in PC demand.  While most believe that the PC market is secularly challenged, there is an argument that PC demand is also cyclically depressed ahead of the launch of Windows 8.  Any significant cyclical improvement could lead to upside to industry demand projections.

Of course, there is also the risk that Christmas demand for TVs and PCs is very weak.  Retail demand will be the main variable to monitor.  The Japanese Yen is another variable to keep an eye on.  As of now, channel inventories appear to be in good shape and I feel relatively confident with the stock’s risk / reward.  A stock’s price is a function of earnings and the multiple applied to its earnings.  Both the earnings and the multiple are more likely to be revised upward than downward after Corning’s Q3 results are reported.  I am apparently not alone in thinking this.  A few corporate insiders have bought stock at around this same price over the last several months.

Please see the Disclaimer associated with this blog.  I own shares in ASML and may trade in and out of it without posting new information.

ASML is the world’s largest manufacturer of semiconductor equipment. It  makes lithography equipment, which is the most critical / costly machinery a chip-maker buys. In 2011, ASML had systems sales of EUR 4.9 billion out of a total lithography market of EUR 6 billion and a total fab equipment market of EUR 25 billion. Over the last 10 years, ASML has grown revenue at about an 11% CAGR. This growth has largely come from lithography consistently taking share of semiconductor capex budgets and from ASML taking market share from other lithography players.

I like it when investments remind me of patterns that worked well with other securities in the past:

1) ASML is becoming a monopoly in a winner-take-all industry. In some sub-sectors of technology, the leading company in the niche ends up with virtually all the market share. This is partially because the leading company is the only one in the industry that can afford to invest in the research and development necessary to drive technology forward. ASML’s market share went from about 30% to 80% in the last 10 years. The company spends about 5 times more in R&D than Nikon, its closest competitor. This has resulted in 90%+ share for the most advanced lithography tools. Intel is currently Nikon’s 2nd biggest customer and recently decided to make a large investment into ASML. The street seems to be underestimating the long term implications of this move. It pretty much guarantees that ASML will be a monopoly in the not-too-distant future. I also think that it is interesting that ASML’s gross margins are currently significantly lower than the gross margins of Intel and many other chip companies. ASML will earn much higher gross margins long term as it benefits from its monopoly position.

2) Opportunities usually arise when investors get overly concerned about short term cyclical weakness and forget about secular growth. Intel recently lowered its 2012 capex budget. The memory companies (DRAM and NAND) have also basically stopped spending money on anything other than technology improvements. They are not adding any wafer capacity. Recently, there were rumors that Samsung would significantly reduce its capital expenditures for 2013. Several sell-side analysts have lowered growth expectations for semiconductor capex for both 2012 and 2013. I expect that semiconductor capex will very likely be weak through the rest of the year. However, for cyclical stocks, the best time to buy is when business is weak in the short term. Next year should be a better year and the worse that 2012 is, the better 2013 growth will be. The memory segment cannot spend much less than what they are spending now. Furthermore, SSD adoption and tablet demand will likely drive an upturn in memory-related capex at some point next year. In addition to the rumored iPad mini, several Android based tablets are expected to be launched by the end of the year. Microsoft will also start selling its Windows based tablets. Intel usually grows its capex in the first year of a line-width shrink, which bodes well for 2013 spending. PC demand may also benefit somewhat after new version of Windows is released. While Intel lowered capex in the short term, one should remember that Intel is now facing a much more competitive environment. Intel dominated the PC processor market, but the convergence of tablets and laptops and Intel’s ambitions for new end markets like mobile phones put it on a collision course with many other Arm-based chip companies like Qualcomm, Broadcom and Apple’s own internal semiconductor design division. This new competition will likely make Intel’s business more capital intensive over the next several years. Rumors regarding Samsung’s capex are also misunderstood. Like other memory companies, Samsung’s memory related capex can’t go do down much. If Samsung were to reduce capex significantly, it would have to come from its logic-related capex. Samsung’s logic spending would only go down significantly if Apple moved to a different supplier. If this were to happen, the spending would just shift to someone else like TSMC. Lithography’s share of semiconductor capex is also set to accelerate over the next few years. In his initiation report of ASML on June 21, 2012, Bernstein analyst Pierre Ferragu stated that he expects lithography’s share of logic semi capex will rise from about 11% to at least 17% from 2012 to 2015. This is because the lithography step of semiconductor manufacturing gets more important with every successive generation of chip technology. According to Ferragu, “Modernizing a logic fab from 45nm to 32nm represents in our estimate a minimal EUR 23m net incremental spending on lithography, assuming no wafer capacity increase. A modernization from 32nm to 22nm would cost EUR 400m.”

While the above two patterns remind me of other technology stocks that turned out to be good investments, ASML is still very unique. It is the only company I have ever seen where the industry’s top 3 customers actually became shareholders. Intel, TSMC and Samsung will own a combined 23% of ASML. These customers have also agreed to fund a significant portion of ASML’s R&D. They realize that ASML is the only viable long-term player for lithography equipment. Rather than trying to fight the trend by continuing to keep Nikon alive, they have decided to give in and participate in ASML’s upside by being investors in the company. They agreed to fund close to EUR 1.4 billion of ASML’s R&D over the next 5 years because they desperately need ASML to deliver newer generation equipment. Despite this momentous news, ASML’s stock is trading only slightly higher than the price these chipmakers will pay. The stock trades at 12.5x 2013 EPS and at a mid-teens multiple of 2012, which is reasonable given that 2012 is likely going to be the cyclical trough for the company. For those that are concerned about the 22% revenue growth rate expected by the Street in 2013, note that the company doesn’t need much, if any, industry capex growth to make those numbers. Virtually all of the incremental revenue modeled by the Street can be explained by new products that the company already has orders for. Furthermore, since these new products are “development tools” (equipment customers are buying initially for R&D purposes), they will not be cannibalizing other equipment ASML makes. Margins will actually be depressed in 2013. The street correctly is modeling gross margins to come down because these new products will initially have low profitability. Gross margins should rise again in 2014 as the new products achieve higher scale.

Putting possible short term news aside, a long term investment in ASML at a reasonable valuation and at almost the same price as its three largest customers should work out well. The company has a very large and sustainable competitive advantage, which should drive share gains and margins long term. The coming war between Intel and Arm and the explosion of NAND based devices will make the semiconductor industry more capital intensive. Lithography has steadily taken a larger share of overall semiconductor capex and there are some reasons to believe that this trend will accelerate over the next few years. Finally, the company offers a 1% dividend and has consistently bought back stock. ASML’s management has stated that the company will resume buying back shares after the 3 chip manufacturers become investors.

The main risk is timing-related. I do not know when the upturn will start and it is certainly possible news gets worse before it gets better. Technically, ASML’s chart is bullish above all moving averages.  I suggest taking an initial position now and leaving room to add on weakness.

High conviction is not overconfidence. Overconfident investors are not prepared for what can go wrong. An investor making a high conviction trade is quick to recognize when to be even more aggressive and is equally fast to sense danger and get out. The purpose of this post is to make the reader aware of a couple of things that could start to go terribly wrong for AAPL over the next couple of years. I am NOT recommending you to sell APPL today. I believe that a good investment process involves anticipating scenarios that could lead to failure. Most financial analysts tell you all the reasons why their favorite stocks will go up and then end their reports with a list of risk factors. Instead of listing risk factors as an afterthought, I prefer to visualize disaster and then work backwards to think about root causes. These visualization exercises help me to build conviction in my investment decisions and help me to develop the intuition necessary to sense danger (preferably earlier than others). Hopefully, after reading this, you will feel higher conviction in your AAPL investment, since you will be more prepared to quickly sell (or possibly aggressively add to your position) when the time is right to do so.

Successful technology companies often find it difficult to make revolutionary changes. This makes them very susceptible whenever a revolutionary change does occur in their niche. Professor Clayton Christensen of Harvard Business School describes this as “the innovator’s dilemma.” For example, when RIMM was the leading smartphone company, it had many customers that liked its physical QWERTY keyboard. Its customers primarily used its products for mobile email. If RIMM diverted its research and development focus towards products that did not have physical keyboards, it risked damaging many of its existing customer relationships. As a result, RIMM’s research effort mainly concerned incremental improvements. After AAPL introduced the iPhone, it was clear that RIMM’s dominant market share would be at risk. Moreover, product cycles in the smartphone industry are very short – consumers tend to replace their phones every couple of years. Technological change happens rapidly with new handset models being released by each manufacturer every year. Consequently, when RIMM fell behind, the company found it very difficult to catch up. While AAPL has a great brand, I do not think that AAPL is immune to the innovator’s dilemma. People who buy phones are not brand loyal. If they were, MOT would still be selling RAZRs and NOK and RIMM wouldn’t be having such a tough time. People buy the best phones that fit their needs. If you primarily want to use a phone for email and messaging, RIMM probably offers products that are better for you than AAPL. AAPL and Android smartphones took a lot of share from RIMM, because most consumers went from primarily using smartphones for email to using them as general computing devices that access apps. Note that, similar to RIMM, AAPL now only makes incremental changes to the iPhone. The iPhone 5 hasn’t come out yet, but the latest available version of the iPhone appears relatively similar to the very first version. If AAPL were to make a revolutionary change, it would risk alienating its app developer community. AAPL only makes incremental changes to the iPhone (and iPad), because the company wants older applications to work on any new hardware it sells. Therefore, like RIMM was, AAPL is now susceptible to a revolutionary change in the smartphone industry. Until such a change happens, AAPL will probably continue to do well. It is possible that a radical change never happens again in this industry. However, any investor following AAPL needs to be paranoid about spotting a major technological shift earlier than others.

One possible revolutionary change could be wearable computing. It is clear that people are interacting with their phones a tremendous amount and that the trend is only for much more interaction. At some point, it will make sense for a more intimate computing experience so you don’t have to waste time pulling out your smartphone and so you can more easily walk and interact with applications at the same time. Anyone who saw the opening ceremony of the Olympics probably remembers many athletes walking around holding up their phones. They were recording their eye-witness experiences. It would have been much more convenient for them to be using a pair of Google glasses. If you haven’t seen the YouTube video on project glass, you should see it now.  The video has had over 17.5 million views already. Google is not alone in developing a wearable computing device. Several companies including AAPL, MSFT, MSI and even Oakley have plans for “smart” glasses, “smart” watches, “smart” ski goggles, etc. I expect wearable computing to be a major theme at the next Consumer Electronics Show (CES) in January.

So what happens if wearable computing becomes the next big thing in consumer electronics? There is one argument out there that it makes the smartphone more important since it can be the brains and hub of various wearable devices. However, there is another argument that the smartphone risks becoming commoditized. It risks becoming more of a modem / connection device as opposed to being the center of your mobile computing experiences. I don’t know which hypothesis is correct, but it would obviously be very bad for AAPL if their main product becomes more of a commodity. The vast majority of AAPL’s operating profit comes from iPhone sales. iPhones represent over half of the total revenue but they also have a much higher gross margin than the corporate average. Furthermore, if another company like Google winds up taking the lead in wearable computing, it is possible this creates a halo effect for Android based smartphones. GOOG and AAPL appear to have very different visions for the future of mobile computing. Sergey Brin, co-founder of GOOG, has said that he is spending about half his time on the Google Glass project. According to Nick Bilton of The New York Times, AAPL is focusing more on a device that could fit on your wrist. Who knows which company has made the right bets? But, shareholders of AAPL should monitor whether or not the company is right. If AAPL bets incorrectly on the direction of wearable computing, it risks being like RIMM and having to play catch up in a fast-changing, hit driven industry.

The convergence of laptops and tablets will also be interesting to watch and will have major implications for AAPL. I currently use both an iPad and a laptop. I generally find the iPad better for consuming content and the laptop better for creating content like this article. While I like the iPad’s instant-on, touch screen and form factor, I find it much easier to type using a physical keyboard. File management and switching between applications is also far superior with my laptop. What I ultimately want is one device that offers the best of both worlds. Like the iPhone, AAPL has just made evolutionary changes to the iPad. It has remained a device that is poor for producing content. This puts the company at a serious risk. Traditional PC companies and upstarts are not standing still and if someone else can produce a tablet that does both well, AAPL’s tablet business will be at risk. MSFT will be starting to sell its new tablet with a physical keyboard soon. I don’t know if MSFT got it right, but it is certainly a step in the right direction. It will be interesting to see how it does.

So here is what I am looking out for when it comes to AAPL over the next couple years. I am looking to see if Google Glass or other wearable computing products gain momentum with consumers. That could indicate whether AAPL made the right long term technology bets. I will be monitoring the success of MSFT’s competitive tablet offering and see if any other tablets come out that offer a good experience for producing content. AAPL is a great company, but whenever a short product cycle technology company gets to the stage of being more evolutionary than revolutionary, the risks to its business rise.  Some may point out how AAPL’s ecosystem of app developers, iTunes, etc. creates a strong barrier to entry. I may be underestimating this, but my point is that the ecosystem is a double-edged sword. It is also the reason why AAPL can only make evolutionary changes and is susceptible to a revolutionary change. MSFT also has a strong ecosystem, especially with corporate users who have over 4 million applications written on Windows. Nevertheless, most people do not seem to view their chances favorably long term at all.  The more aware investors are of these risks, the more prepared they will be to make correct decisions.

I may be very early in starting to worry about these things, but better to be worried about them than not. I like to feel in control and know what to do when certain events happen than feel like the market controls me.

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By Ravee Mehta, Author of The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance.