Value Investors Could Do Far Worse Than Apple

Apple (AAPL) reported earnings for the fourth quarter last week and the stock has appreciated 17% since. The market was nervous about what Apple would report as the stock sold off to $91 the day earnings were to be reported, but investors got what they should have expected based on the past: great performance with a safe, conservative forecast for the future. Jobs and company earned $1.26 per share, a 26% rise over last year, which outpaced analysts’ consensus estimates of $1.11. Apple announced tremendous sales results for the iPhone with 6.89 million units sold in the quarter (already surpassing its goal of 10 million iPhones sold by year’s end). The iPhone also outsold Research in Motion’s (RIMM) Blackberry phone. Apple became the 3rd largest phone maker by revenue in the quarter behind Nokia (NOK) and Samsung (SSNLF.PK), not bad for a company that has only been selling phones for five quarters now.

Apple is one of the most closely followed stocks on the planet so none of the earnings results is a surprise to an avid Apple watcher. However, there were a couple of surprises in their earnings release that some people may have missed. As Ken Cheng points out in his excellent article,

“For the most part, as we all know, Apple is deliberately vague and conservative when talking about their financials, so revealing this info {iPhone sales breakdown}, is rather extraordinary. Analysts and pundits have constantly criticized Apple for poor corporate governance by not breaking out their revenue streams more clearly. For example, can anyone tell me how many Mac Pros Apple sells? No, they don’t break it out. No one knows and Apple won’t tell. Then why so much info on iPhone deferred sales and income? I mean, over the next seven quarters, Apple will recognize all of those deferred sales, won’t it? Yes. It’s there. Sitting in the bank, collecting interest, and just waiting to be counted by GAAP rules.”

This change of policy demonstrates that Steve Jobs is clearly not pleased with where the stock is presently. He must be thinking, “What must I do? My company is ringing the registers at our packed Apple Stores, we have loads of cash and great products that consumers seek above all competitors. Yet year to date the stock is down 46%, more than the major indices!” It is clear that he felt there was a lack of understanding about his business and so he gave a more detailed breakdown of revenues, earnings, and accounting than ever before…not to mention that he even chose to be on the conference call. As good as the reported results were on their own, the growth looks even better when you factor in the iPhone deferred revenue streams. Were those sales and earnings recorded in this quarter, the revenue results would have been 48% better and improved earnings by a shocking 115%!

We already wrote of the phenomenon of the Blogging Joes beating the Wall Street pros when it comes to Apple analysis (Blogging for Apples). It seems Andy Zaky and company are the ones who really understand what Apple has in store. I think that these results may silence many of the pundits who thought that a slowdown in consumer spending was going to hurt sales of Apple’s premium products. Sure, it must have an effect to some degree, but no tech stock or any other company for that matter can post these kinds of sales. Macbooks are grabbing more market share as sales rose 21%, iPod sales—partially cannibalized by iPhones—still increased by 8%. Not to mention Apple is still coming out with new and improved products like its new line of “unibody” aluminum frame Macbooks with improved graphics chip set provided by NVIDIA (NVDA). Will the momentum slow? Almost certainly, but by all accounts it’s not slowing yet.

When we rate a stock based on fundamentals there are two inputs that are paramount: sales and cash. Sales we have already discussed: they are amazing and seem to only get better with each quarter. It is a well known fact that Apple has $25 billion in cash on hand and no long term debt to speak of. This cash on hand allows Apple to be nimble in this environment by not having to worry about obtaining credit. Do not be surprised to see Apple use that cash to buy out a competitor or maybe a supplier (NVDA?). Or the rumor has started to fly today of a substantial stock buyback program. Furthermore, the company is showing strong earnings momentum, and when compared to historical norms, the stock is very cheap. Apple’s price-to-cash flow has traditionally ranged 19.5x and 39.6x, but it is currently trading for only 14.3 times cash flow.

So, the question now becomes, not whether AAPL is undervalued (almost all stocks are fundamentally undervalued right now), but is the market starting to recognize that fact? Perhaps the market is starting to better understand Apple’s worth, but Apple is still cheap in the low $100s by our valuation methodology. For a long term investor looking to take advantage of a stock that continues to grow but has been beaten down lately, you could do far worse than Apple. Consider Jobs's own words,

“We may get buffeted around by the waves a little bit, but we’ll be fine and stronger than ever when the waters are calm in the future.”

Comments

[Timeline St...:]

Nice article, I agree 100%.

One thing for you to correct - don't waffle in your writing. Apple doesn't have "no long term debt to speak of", it doesn't have any long term debt - AT ALL. It's printed right in the balance sheet. Don't use more words than necessary and don't make something qualitative when it's quantitative and sitting in plain view. Be like Andy Zaky in your unwillingness to simply repeat what the analysts say. If you are long AAPL (which your disclaimer does not state), you recognize the need to constantly be vigilant with fact and figures to make this stock price move.

2008 Oct 30 06:08 AM

[ockham:]

TimboM: Thanks for your advice, but I get paid by the word. Its all about dragging out conclusions and running in circles in the blogging business. Haha, just playing...thanks for reading.

2008 Oct 30 11:27 AM

[Dividends A...:]

Margins....margins.......

I have no clue why any company would compete on price in order to grow sales or secure more market share. Margins are how you make money and in this environment a company should be protecting them rather than exploiting them on the downside. Apple's revenue isn't even diversified anymore among a few products - its heavily reliant on one product.

I don't own it and wouldn't regardless of how good its products are or how well its R&D division is run. On the most basic metric that I evaluate a business (operating gross margins) this stocks fails.

2008 Oct 30 11:39 AM

[chano:]

A good article, thank you

@ Divs Anon and many others, I guess.

There are so many holes in the arguments you present.

There are thousands of low margin companies that turn in solid profits. They rely on massive sales volumes and essential economies of scale in their purchasing and cost management. They are nimble and fit because they have to be to prosper in low margin territory. This applies to all commodity product makers and vendors.

The amazing difference with Apple is that it chooses not to play that game - even though it is a high volume business. It has said so, many times.

Even though there are tens of millions of people who are happy with a $10 Timex watch....there are many tens or hundreds of thousands who are equally happy to pay a thousand times more for an Omega. Both sell watches. Both biz models work, but for different reasons.

Walmart is a low margin business as a deep-discount retailer. That hasn't stopped it being one of the best, fastest growing investments of the last 50 years and, I guess, America's largest retailer. A bad investment? Nope. A great investment because Walmart has a very strong biz model in a very stable area of consumption.

Dell is a low margin business. But it has a failing biz model as they thrash around trying to find alternative ways of selling, to survive. Why is there a problem here? It is a weak biz model that cannot prosper because it is all too easy for others to compete and, as in HP's case ( a company not reliant on computer sales alone), they can do it much better. A bad investment? Definitely needs a wealth warning now and over the next 2 years. It is unlikely to survive and will likely be bought out by a Taiwanese production contractor in a vertical M&A.

You think AAPL is a low margin company? I shudder to think how you do your research. There are very few companies which can boast of higher margins than Apple. In fact most corporations would kill to get such high margins. No one can earn the $ value of sales per square foot that Apple earns in its stores. And these are the venues where Apple keeps all the margin available on sales, including the margins that would normally go to a reseller. All of this info about Apple's margins is there for anyone with a K-12 Grade education to see. Of course there will always be a few people who are damn good at looking, but they never see what's there in front of their noses.

If this is your reason for avoiding a stake in AAPL, you deny yourself a rare opportunity in these risk-ridden times. In fact, it is an approach that is committed to loss, if you cannot see true value AND high margins where these are so prominently obvious.

Sincerely suggest you open a lemonade stand. Now that IS high margin biz.

2008 Oct 31 08:04 AM