"I just don't know how to value them."
Warren Buffett made this claim about Apple (NASDAQ:AAPL) when queried on the tech giant at Berkshire Hathaway's (BRK-A) annual meeting in May-and it wasn't the first time he had intimated his AAPL aversion.
More than a year earlier, Buffett said the following: "Even though Apple may have the most wonderful future in the world, I'm not capable of … evaluating that future. I simply look at businesses where I think I have some understanding of what they might look like in five or 10 years."
In a recent article, I made the claim that AAPL defied traditional valuation techniques. The assertion was criticized by some for its lack of supporting evidence. A primary purpose of this piece is to provide that evidence or, at the very least, proffer a reasoned explanation for AAPL's "in"-valuable condition. More importantly, based on this condition, the article hopes to convince current and potential AAPL investors to reevaluate (read: SELL) the company as an investment. Buffett has good reasons to stay away, and you do too.
Professional investors generally rely upon two methods to value a company: 1) discounted cash flow ("DCF") analysis and 2) multiple comparisons. In AAPL's case, neither is a viable technique.
DCF Analysis - Determining AAPL's Intrinsic Value:
For much of AAPL's history, analysts' growth and margin assumptions were too low. They underestimated the demand for revolutionary products like the iPhone and iPad. The last two quarters, these assumptions have been too high. The latest industry surveys show smartphone and tablet growth at 45% YoY and 66% YoY, respectively. Given such growth, the space is highly competitive and market share gains are extremely volatile. The graphs below illustrate that historical volatility. While AAPL has performed well as of late, the rapid market share gains and losses suggest that no company is immune in the mobile electronics space.
*Data current as of September 2012 (source: Comscore)
*Data current as of June 2012 (source: Gartner)
AAPL reports seven business lines-the two primary lines being the iPhone and iPad (72% of LTM sales). Let's simply trying to forecast next quarter's (2013 Q1) iPhone sales (not even the margin).
Analysts will triangulate a forecast for iPhone unit sales based on AAPL's historical sales data, management guidance, industry growth projections, and ad hoc supply and demand conditions. For the iPhone, estimates tend to vary widely. Last quarter, estimates ranged from the low 20M to low 30M range. At an ASP of $635 and ~50% gross margin, the 10M unit difference accounts for $3.2B of incremental gross profit, 75% of which--$2.4B-accrues to the bottom line (~$2.50 of on ~$9.00 of EPS).
iPhone historical sales data is all over the place. YoY unit growth over the last 4 quarters indicates a downtrend (128%, 88%, 28% and 57% sequentially). On the other hand, Q1 YoY growth in the two years prior was 86% (2011) and 128% (2012), which indicates a seasonal variation. With annual YoY growth of 81% (2011) and 73% (2012), it appears that seasonal trend is becoming more pronounced, even as overall growth slows. I can also look at 2011 Q4 versus 2012 Q4 (17M vs. 37M units), which gives a similar growth number to YoY (although the earlier Q4 iPhone 5 release-6M units sold-needs to be considered). If credence is given to all three trends, you end up with one trend offsetting two others-to what degree is up to the analyst.
Analysts will, of course, factor in industry growth rates (46% last quarter), potential market share gains or losses (AAPL grew 11% more than the market in CY 2012 Q3-contrast that to 74% outperformance in CY 2011 Q4), supply chain issues (of particular importance currently), geography, and any customer demand survey results (among other factors). All of this leaves us with… well, not a whole lot of clarity. One can see, however, how YoY growth as low as ~12% (28% growth (as in Q3) less 6M iPhone 5s in Q4) or as high as ~112% (128% YoY growth less 6M) could gain traction. The difference between those estimates is 37M iPhones and a whopping ~$23B in sales!
For AAPL, the process is further muddled by the company's secretive nature. Guidance is limited to one quarter forward and isn't broken down by business line. Individual product margins aren't reported. Analysts have nothing to benchmark to. AAPL is one of the few companies where an analyst can be so very wrong with regard to individual product sales and yet nail his EPS estimate. I can predict iPhone units of 22M and iPad units of 19M, while actual results are 27M and 14M (see Q4), respectively, and yet come in almost in line-depending on the predicted margin.
Compare this valuation process (and this was just one quarter forward-as opposed to years-for a single business line) to forecasting total revenues and margins for Berkshire Hathaway-owned Geico. Insurance companies are some of Buffett's favorites for a reason. Demand for a product such as car insurance isn't going anywhere, policy turnover is low, and the resulting premiums and margins are predictable. If I can predict customer growth (a reliable proxy is population growth), my cash flow assumptions can be made with considerable accuracy even decades in advance, and my intrinsic valuation is more reliable as a result. Barring global calamity, growth projections fit within a narrow band even in the most volatile markets (the same is true for diversified Buffett favorites such as Coca-Cola (NYSE:KO), Wal-Mart (NYSE:WMT), Procter & Gamble (NYSE:PG), etc.).
Multiples Analysis - Utilizing the PE Ratio:
The PE ratio and its relative valuation cousins (EV/EBITDA, P/FCF, P/B, P/S, etc.) are favorites of sell-side analysts. Trading below historical or competitor PE multiples means a firm is cheap; above, and the firm is expensive. The logic is relatively sound and avoids the burden of a DCF. Relative valuation fails, however, as applicable comparisons wane. Unsurprisingly, this is AAPL's present state.
AAPL is a company with many competitors yet lacks integrated rivals. Its combined hardware-software business model is unique, and no competitor comes close to its size or profit margins. Any one of these concerns might cause one to dismiss competitor multiples. Utilizing a blended multiple of AAPL's various business lines is a possible solution, but the reality of the situation is that AAPL integration makes such a scenario difficult to envisage-and the comps are still lacking. What handset or tablet manufacturers have the requisite size and growth characteristics (such characteristics aren't necessary, but they certainly help to benchmark)? How many integrate their software and hardware so intricately? The process isn't as simple as separating the upstream and downstream businesses of a large energy firm.
As to historical comparisons-AAPL's PE has ranged from ~9x to ~14x forward earnings over the past two years-their relevance becomes suspect given the company's explosive growth. Presiding over the design, manufacture, delivery and ongoing support of 72M iPhones and 32M iPads (FY 2011) is quite a bit different than ~200M and ~100M, respectively, of the same (projected FY 2013). AAPL's largely unprecedented market cap serves as an additional obstacle for investors with size restrictions (e.g. 5% of the portfolio) or psychological biases (e.g. nothing grows forever).
Some may point to a PE ratio's usefulness as a standalone valuation technique. At AAPL's PE of 12x and projecting zero earnings growth indefinitely, an investor will make his money back in 12 years (a ~7% yield-assuming earnings are distributed). If I expect earnings growth of 10%, that wait drops to 8.5 years (a ~12% yield), and so on. Valuing AAPL in this manner-or any company for that matter-is crude. The valuation relies on earnings growth, which is summarily projected forward with little regard for the underlying business. While the calculations are relatively quick, the assumptions lack depth. If that depth is sought, one finds himself back in the position of undertaking an intrinsic valuation, which we have established as next to impossible for AAPL.
Why You Should Care:
Why should investors care about AAPL's aversion to reliable valuation?
If Buffett won't invest in a company, that might be enough of a warning sign for some. Beyond Buffett, the answer to that question is simple: if investors can't value a company, they won't invest in it. Now, obviously, as the most valuable public company in the world, AAPL still has investors. But who are the current holders, and where might the incremental buyers come from? The answers to these questions should bring pause to AAPL bulls.
As described herein, most investors use one of two valuation techniques. I believe that the technique utilized generally corresponds to an investing style and accompanying time horizon. A cash flow analysis is the preferred technique for truly long-term investors. Such investors are people like Buffett and his many value manager disciples, in addition to some portion of growth or stylistically hybrid (or agnostic) managers. They are the big fish, the institutional investors characterized by long-term time horizons and active mandates. They invest when they see a company trading at some discount from its intrinsic value (25-40% is common). A few of these managers, like Buffett, never invested in AAPL, but no doubt many did.
At this point, very few-if any-of these long-term investors remain. When one relies almost exclusively upon intrinsic valuation to make investing decisions, he can't justify investing in an "in"-valuable company. AAPL's historical earnings growth, while impressive, has proven too volatile. Future earnings growth (or decline), as a result, is too uncertain. Predictions three to five years forward are pure guesswork-investors hardly know what to expect next quarter. Even if investors could rationalize growth and margin assumptions, AAPL is too large-its market cap so high-that compound growth assumptions quickly give credence to incredible absolute profit levels. Three year compound earnings growth of 20% (historically low) would generate profits of ~$72B in the third year-roughly double the combined LTM profits of oil giants Exxon (NYSE:XOM) and Chevron (NYSE:CVX). Two years ago-even a year ago (I would argue most long-term investors bailed before last year though)-projecting 20% earnings growth yielded very different numbers. Long-term investors just can't get comfortable with the current unprecedented numbers and, as a result, they won't be AAPL's incremental buyers.
For those short-to-medium term investors who prefer multiple valuation, the argument against incremental AAPL buying is also rooted in this latter notion of size. Such investors are less concerned with predicting precise growth and margin assumptions for each of AAPL's business lines. They are, however, very cognizant of AAPL's most recent historical and imminent future earnings growth. AAPL is a steal at 12x with projected earnings growth of 20% into the foreseeable future. At 10% growth, the value is less apparent. The absolute profit levels required in the former scenario, however, have to worry short-to-medium term investors. Perhaps equally worrisome to such investors is the downward trending earnings growth. For many short-term AAPL investors, next quarter's "E" is all that matters. The "P" will follow the "E," they argue, even without multiple expansion (which is more sensitive to forward growth). Management's 2013 Q1 guide to a YoY earnings decline raised a red flag, and the normally bullish consensus ($13.40 vs. $13.87 last year-a decline!) only confirmed the fears of short-term investors. Considering the potential earnings decline along with its size, AAPL just doesn't present an attractive scenario for PE-based investing.
If the valuation guys are out, who's left to take up AAPL's cause? The index funds (closet or otherwise) hold AAPL, but they won't be the incremental buyers (particularly if they have strict position limits). Who will do the buying? The logical-and scary-answer is twofold: 1) those who prefer to eschew the valuing and 2) those who are convinced AAPL can actually be valued.
The first group includes your day and swing traders-the technical analysts-content to obey the laws of price action wherever they may lead. The group also includes, I fear, large swaths of retail investors, and who can blame them? Some have likely built retirement nest eggs on the strength of AAPL's share appreciation over the years. Many others will have invested as recently as last year and ridden the parabolic wave of 2012's first quarter. Still more will have been inspired to invest in recent weeks or months by some combination of brand loyalty, product approval or simple AAPL hype. The second group mentioned above has a large following on the sell-side (although they are paid to do it), but I would suspect this group is rather small if measured by actual assets under management.
Neither of these groups, either alone or in combination, has the capacity to drive an AAPL rally like the one witnessed over the past year. AAPL is too large and too many institutional funds are content to sit on the sidelines. Both of these groups, however, along with those valuation-based investors who maintain AAPL positions (and many do for beta purposes), can instigate a sell-off. Current and potential investors should not underestimate the severity of such a sell-off-and we might be in the midst of it. As I write this, AAPL is bouncing around the $540 level (note that many of the valuation statistics above were calculated early this week), down from ~$610 two weeks ago and more than 23% off its all-time high ($702.10). To this point, a picture (or chart) is worth a thousand words.
*Chart shows MSFT's trailing and forward 133 week returns up to and after its December 1999 peak; Chart shows AAPL's trailing 133 week returns to the closing price on 11/7/12
While AAPL may rebound from current levels and offer a more attractive selling point, investors should understand the significant downside risk. For current holders, a 23% decline is tough to walk away from, especially given AAPL's propensity to recover from price swoons. On the other hand, if AAPL has indeed peaked (as I believe), the price history of the last great tech giant-MSFT-suggests it's not too late to hit the eject button.
This article began by offering Warren Buffett's opinion on AAPL as an investment, but it will end with a suggestion that AAPL investors heed their own advice. AAPL holders should ask themselves which specific circumstances, scenarios or events would cause them to let go of their investment. They should then consider if, upon the occurrence of such events, it would be too late.
It's midnight and the party is thinning out-the eligible partners are dwindling. You've indulged enough that a hangover is unavoidable, but it's nothing a large cup of coffee can't fix-and at least your dignity is intact. The urge to gamble-to have something to show for your efforts-however, is powerful. Know that what you decide next will likely have an outsized impact on your fortunes.
AAPL investors: please choose wisely.