Many investors focus on either the short-term price movement of Apple (AAPL) or the long-term buy and hold approach to owning Apple stock. Short-term traders can utilize the momentum and volatility of Apple to their advantage but rely on past performance (price movement up or down) to predict future results. Long-term investors are at the mercy of market shaking company specific events and competition or unforeseen macro-economic shocks and recessions. Holding Apple for the next two to five years based upon Apple's past successes and existing products is as frightful as relying on past price movements to predict future price movements. Projections of where a consumer electronics company like Apple will be in two years or more is foolish and speculative at best. The most reliable period for generating a solid investment thesis is determining where Apple's market price will be in the intermediate term of three to 15 months.
The intermediate term is where valuations, profitability, management effectiveness ratios, financial strength, and cash flow analysis is useful. These financial ratios ignore the short-term noise and market reactions to daily news, present a picture of the current strength and support of its existing business operations, and help validate and project future earnings based upon historical trends and relative value. The data table below illustrates the financial strength of Apple's underlying fundamentals relative to its industry, sector and Google (GOOG), which is probably its closest peer despite being in a different industry.
Source: Intrinsic Research Systems
This article will primarily focus on the most widely used valuation metric, the forward price/earnings multiple (PE f12m). The PE f12m multiple is materially important to measure the relationship between a stock's price and its future expected earnings. Currently, Apple's 10.49 PE f12m implies virtually no potential for Apple to re-accelerate earnings growth. An investor can easily make sense of some high earnings multiples by looking at bio-techs with breakthrough drugs or low earnings multiples by looking at broken companies like Dell (DELL) at 6.24 and Best Buy (BBY) at 8.76. If a company has recurring ad revenue like Google at 14.89 or an increasing subscriber base like Netflix (NFLX) at 214.95 it also logically should have higher earnings multiples. Not surprisingly, a sampling of several other Apple valuation metrics (see chart below) shows the destruction a 24.54% price drop since September 19, has done to its valuations. The blended value of Apple valuations (simple average based on included multiples) at 5-year median levels shows how significantly undervalued Apple is at current levels.
Source: Intrinsic Research Systems
So, what is the market missing with Apple's desperately low 10.49 PE f12m multiple? First, we need to rationalize what PE really is. Importantly, the PE multiple should be looked at two ways:
- The price a buyer or seller is willing to pay for (or sell) $1 of a company's future earnings
- As a measurement of the unseen earnings potential of any security
The market is telling us it is no longer willing to pay an extra premium for Apple's future earnings or its earnings potential. The market is willing to pay $10.49 for each $1 of Apple's anticipated earnings. Meanwhile, it is willing to pay 70% more for each $1 of GOOG's anticipated earnings (see first data table display). Apple investors have heard all the negative market projections before:
- iPhone and smartphone saturation, particularly domestically
- The always mentioned margin compression
- Competition heating up
- The large % of revenue and earnings derived from two products, the iPhone and iPad
I agree many of these projections are legitimate concerns two to three years from now. However, we are clearly not in a position to forecast a slowdown in the intermediate term of iPhone and iPad sales as evidenced by projected worldwide smartphone and tablet growth. Future margin compression is accurately analyzed as a temporary contraction within Seeking Alpha: see Why Apple Will Beat the Street. Competition is a greater threat at the lower-end affordability of smartphones and tablets as the competitive landscape takes a toll on those selling phones and tablets at or near cost. Apple's premium product satisfaction exists because of build quality, stability, fluidity and a smooth user interface across all its mobile devices. In addition, consumers are willing to pay a premium for quality, support, longer life and integrated ecosystems across multiple devices. This premium product marketplace will continue to be a sufficient target market for continued consumption and growth of Apple products.
Earnings potential may be an even more important key to justify the price an investor is willing to pay for a future earnings stream. If any company on earth should be rewarded with a premium for "earnings potential" it's Apple! Prior Apple product innovations (or improvements on existing innovations) include: iPod in 2001, iPhone in 2007, and iPad in 2010. How about the potential to disrupt television in 2013? Certainly fits the innovation timeline. How about the potential to disrupt Google search? How about the potential to get a piece of China Mobile (CHL) subscribers? Let's briefly discuss the possibilities…
iTV - could it be a flat panel display or just a new set-top box? Regardless, disruption is likely. Could an iTV "show stream" or take recorded movies/shows and share them with friends and family, similar to photo stream? Could I tell Siri a voice command to find a channel currently discussing Hurricane Sandy? It is commonplace to dispel speculation about content agreements with the cable/satellite providers and broadcasting companies. But let's face it, only a decade ago selling individual songs for $.99 sounded foolish too. What about a revenue-share plan with content providers, like a pre-defined price to purchase Super Bowl XLV immediately from an iPhone or iPad? This embargoed or dead content may have significant value in the marketplace for both Apple and the content owners. Tim Cook's recent NBC interview and quotes "TV, as a market has been left behind," "don't bet against us," and "people love surprises" certainly describe something big on the horizon.
Siri search - let's not fool ourselves; Siri is not going away anytime soon. I bet it's actually getting more intelligent every day. With Siri search can Apple steal a portion of Google's recurring advertising revenue stream legally, unlike Google's creation of Android (allegedly) ? This would certainly help multiple expansion going forward by adding another dependable recurring revenue and earnings stream. Without maps and potentially search, Apple gets a collateral benefit of impacting search-related revenue generated on iOS devices by Google (just in case it still holds a grudge).
China Mobile - with a 70% market share of the Chinese smartphone market compared with 20% for China Unicom (CHU) and 10% for China Telecom (CHA) [the only two current Chinese licensed iPhone carriers], potential earnings are very significant. As of November 2012, China Mobile market share equaled 703 million subscribers or roughly twice the U.S. population. A modest 5% share of China Mobile subscribers over the initial year would add $22.3 billion in revenue. Applying Apple's net profit margin of 26.67% yields another $5.9 billion in earnings or another $6.26/share over the course of a year.
The PE f12m has an added benefit over the traditional PE t4q (trailing four-quarter earnings). A stock's price is based upon its future earnings so investors should look at expected earnings going forward and "lagged" earnings historically. Lagging earnings historically provides a "normal pricing relationship" of a stock's price along with the earnings it generated one year forward. In the chart below, you can see the representation of lagging earnings when doing intrinsic value modeling. The intrinsic value model below has Apple's entire earnings stream lagged one year, uses a conservative forward-looking earnings growth of 10% (vs 20.67% as projected by sell-side analysts), consensus FY2 (fiscal year 2014) earnings, and an equity discount rate of 12.04%. Utilizing these assumptions Apple's intrinsic value is $731.30/share. Apple's market-implied growth of 3.12% further illustrates the market's discounting of expected earnings growth.
Source: Intrinsic Research Systems
The primary takeaway after evaluating the market discounting of Apple shares is the market itself has doubts of future earnings drivers. The sheer size of Apple's market share, revenue base, and the % weight within many institutional portfolios are huge bases to continue to grow. But should Apple get beaten down because no other company in (arguably) stock market history has been in a similar situation? While Apple may not sell every new iPhone5, iPad, or Mini it can manufacture this quarter, it is difficult to imagine it will under deliver when it announces December quarter results in January. Demand has seemingly exceeded supply most of the quarter. Nearly every carrier, retail outlet, and Apple store now has an adequate supply of product for the remaining two-week holiday shopping season. And Apple now has more than 40 countries selling all its latest hardware refreshes including iPods, iPhone5, iPad (4th generation), iPad mini, and MacBook Air and Pro laptops.
Absent most of all is the lack of an earnings multiple premium assigned to Apple based upon three potential game changers; iTV, Siri Search, and a China Mobile roll-out of iPhones. Revenue generation, earnings growth, and industry disruption will vary across all of these ideas or future products. But at some point the market is going to have to price in these potential opportunities.
Apple's share price has significant appreciation potential based upon two very possible scenarios. A 43.8% return based upon the gradual reversion to historical medians across its valuation metrics and a 37.1% return if Apple's intrinsic value is realized over the next year. Once a new earnings catalyst becomes apparent and once the market elects to pay for these earnings catalysts, Apple shareholders will be handsomely rewarded for accumulating shares at the current level. I expect this likely to occur over the next three to 12 months.