One of my favorite metrics for valuing a business is the price-to-earnings ratio. I view it in very simple terms: if the company were to pay out all of its earnings in the form of a dividend to shareholders, how many years would it take for me to get my initial investment back?good
Many people have remarked that it is quite puzzling that Apple (AAPL), the world's largest and arguably the most successful company, trades at a mere 12.39x earnings (and the valuation looks even cheaper when you consider the $120B in cash that just sit pretty on the firm's books). On the other hand, Google (GOOG), the search giant, trades at 20.77x earnings and has a net cash position of $36B. Even more interesting is that Apple pays a dividend to the tune of nearly 2% annualized while Google doesn't pay anything.
So, which is the better value? Let's dive deep into some key financial metrics to try to figure out which is the better long-term buy.
Growth Rates: Google
The most important aspects of growth stocks such as Apple and Google are the growth rates of the top and bottom lines, with particular emphasis on top line growth. It's much easier to cut back on spending to try to make a quarter or two look much more profitable than it is to fundamentally generate demand for products and services. At the same time, if such growth isn't done so profitably (and increasingly so), then it is not viable.
First, let's take a look at Google's revenue and earnings growth year-over-year for the last several quarters:
GOOG Revenue Quarterly YoY Growth data by YCharts
We see an interesting phenomenon. Google's revenue growth rate over the last four quarters has been mostly accelerating while earnings per share has actually become negative year-over-year in the most recent quarter.
While the decline in EPS is partially due to a modest dilution in the share count, the real problem is that absolute net income took a huge hit. In Q3 2011, Google earned $3.06B in net income while in Q3 2012 the company only took in $2.18B in net income. What's going on here?
GOOG Shares Outstanding data by YCharts
Explaining The Net Income Drop
Since the Motorola Mobility acquisition, Google's revenue has come from two major sources: "Google (advertising and other)" and "Motorola (hardware and other)", the former of which is the core business.
The core "Google" business saw a nice 18% year-over-year jump in revenues (from $9.720B to $11.526B), although significantly less than the "45%" figure that the press-release stated (this is because the Motorola acquisition allowed the company to inherit a big revenue stream). Cost of revenue jumped 31.4%, which falls in-line with the decreased revenue-per-click that the firm witnessed during the quarter.
This means that gross profit is only up 11% year-over-year despite 18% growth in the top line. Not terrible, but it does raise concerns going forward.
On the "Motorola" side of things, year-over-year comparison is not given as the acquisition just recently closed. However, according to Motorola Mobility's Q3 2011 mobile device revenue was $2.4B against Google's Motorola Mobility sales of $2.575B in Q3 2012, implying a modest 7% increase in sales.
However, as the core business actually saw a low double digit gross profit increase, where did the year-over-year net income decline come from? Simple: R&D and SG&A.
R&D is up from $1.4B to $2B year-over-year and SG&A is up from $1.2B to $1.76B year-over-year. This is no doubt due in no small part to the new baggage of the Motorola Mobility acquisition. Designing and marketing hardware is a fundamentally different beast from selling ads, so it will materially change both these lines going forward.
Growth Rates: Apple
Turning to Apple, we take a look at both EPS and revenue growth:
AAPL Revenue Quarterly YoY Growth data by YCharts
We see that Apple's revenue growth y/y is slowing but still quite positive. Further, EPS growth is healthy as it tends to track nicely with revenue growth.
Explaining The Slowing Growth
The slowing growth is very simply explained: its target markets are starting to saturate coupled with heightened competition in all of its end markets.
In the most recent quarter, Apple, once again, performed well by posting a 27% year-over-year increase in sales. This was driven by a 58% unit growth and 56% revenue growth in its iPhone segment. More muted, but still material, was the 26% unit and 9% revenue growth in the firm's iPad segment as well as the 1% increase in units and 6% in revenues in the Mac segment. Finally, the iPod segment (which is more-or-less left for dead) shrank 19% in units and 26% in revenue year-over-year.
Let's take a look at each of these segments separately.
Apple's bread-and-butter item is the iPhone. The smartphone sector is likely to continue to see fairly explosive secular growth for at least a few more years, although the rate of growth is likely to slow. I fully expect that as smartphones increasingly become commodity items (as the standard "flip phones" became after several years), Apple will find itself suffering from gross margin compression due in mostly to a mix-shift to older generation iPhones (that come free with contract).
However, I do not expect that this phenomenon will take place for quite a while. Simply put, with carrier subsidies, the $200 price for an iPhone 5 (or any other high end smartphone) is actually quite reasonable, especially in light of the following facts:
- 61.5% of iPhone users have an annual household income of $75,000 or more, so $200 every two years is not likely to be a significant expense for "the best"
- Verizon (VZ), one of the leading wireless providers in the U.S., reported a net addition of 1.5 million devices to contract-based plans during Q3. AT&T (T) also reported a net 151,000 new contract subscriptions.implying that there is still healthy demand for contract based plans in the US.
In short, I fully expect a continued positive growth in the high end iPhone products over the next several years although I do expect that growth in the very highest end will lag compared to the overall segment growth as the mix does shift towards lower margin, lower end iPhones.
The next "hot" growth area is the tablet segment. There has been a particularly high amount of hype in this area as the sell-side and the media tend to play up the "death of the PC/rise of the tablets" shift (which I believe to be mostly untrue, but that is a topic for another piece in which I can explore the issue more thoroughly).
In any case, the segment saw nice year-over-year growth of 26% in units but 9% in revenues. The writing is on the wall here: as tablets are essentially content consumption devices, the point of diminishing returns when it comes to upgrading to new iPads is exaggerated compared to the same phenomenon in the PC/Mac space. This is why despite the double-digit unit growth, the actual revenue growth was muted. This implies that there is a real bias in the mix towards last generation discounted models as opposed to the latest and greatest.
This phenomomenon will further be negatively compounded as credible competition enters the tablet market. Until now, the quality and usability of Android tablets has been uninspiring, partly due to bad/cheap hardware design and partly due to the fairly barren application ecosystem as compared to either iOS or the traditional Windows and Mac notebook platforms.
The Android hardware ecosystem is improving, although I believe software will still hamstring the efforts here. The Windows 8 tablet space is a much more lethal competitor to Apple's iPad product. Note that I say Windows 8 and not Windows RT; the application ecosystem on Windows RT is even more barren than the Android one. But Windows 8 tablets that use traditional Intel (INTC) Architecture processors will have a huge software ecosystem advantage over Android and even iOS due to binary compatibility with all pre-existing Windows 7 and below applications. The usability of Windows 8 tablets as productivity devices will also serve to entice users who wish to have only one computing device.
In short: the iPad, like the iPhone, had a major first-mover advantage in the nascent tablet market, but the threat from Microsoft's (MSFT) tablet ecosystem will be formidable, thanks to a capable, legacy-compatible hardware platform from Intel.
This is a segment in which Apple's performance is not quite as widely acknowledged as its other segments. The low year-over-year growth simply confirms the by-now obvious notion that the traditional PC market is maturing. The factors for the less-than-inspiring growth from Apple and others include:
- "Good Enough" - in order to have a really good reason to upgrade from several-year old systems in such a weak macroeconomic environment, there needs to be a compelling "need" to do so. Right now, the advancements are in power efficiency and battery life rather than radically new functionality, so the PC/Mac community just isn't accelerating the rate at which it upgrades
- Saturated Market - while tablets and smartphones are still in growth phase because not everyone has one, PCs/Macs are ubiquitous. Everyone in the developed world that wants one has one and it is mainly a replacement market at this point. As the global economy improves, I expect that there will be additional growth vectors via emerging markets, but until then, growth will be muted.
Interestingly, however, Apple is still the "underdog" in terms of market share relative to the combined Windows PC ecosystem, so there is still quite a bit of headroom for share-gains. Apple operates in the high-end of the PC segment, so the share gains will necessarily be muted since many PCs are sold in the $400 - $700 range. Luckily, Apple will be keeping the lion's share of the profits in the commodity PC business with this approach.
Apple Versus Google: Answering The Title
It is clear why both companies are priced the way that they are: the market is clearly pricing in the following for Apple:
- Long term margin compression/mix shifts in iPad/iPhone segments
- Limited growth prospects in the boutique iMac/MacBook segment due to the PC market being fairly saturated at this point
- Competitive threats in marketshare from Google Android devices in the smartphone space and Windows RT/8 devices in the tablet space
While Google's results in the most recent quarter were fairly uninspiring, the market likely sees quite a bit more growth from the company due to:
- Acquisition of Motorola Mobility allowing the firm to ride the secular mobile device wave directly
- A potential to monetize mobile search fairly effectively(this is pure upside)
Fundamentally, this is a no-brainer: Apple looks better across the board today. However, investors price stocks for tomorrow, and it is likely that people see Apple as having much more to lose than to gain. Google, while in a similar position in search, is much better protected due to its high popularity in spite of pre-existing competition. Further, the firm's dominance in the smartphone platform world via its free Android gives it the opportunity to play to a much larger captive audience.
That being said, I believe that until Google can show a strong monetization of mobile search, the sentiment will continue to be negative and its multiple will contract. Apple, on the other hand, already trades at a dirt-cheap multiple that seems to bake-in the worst case scenario.
As of now, Apple's the better value. Its balance sheet is stronger, its earnings multiples are very low, and the potential for non-trivial dividend increases is quite high, even in the worst case scenario of margin compression and share losses (given the secular growth in its major operating segments). Google is less vulnerable to margin compression in the longer term and probably has stronger growth prospects.