Apple's Current Valuation Is Still Reasonable 10 comments
August 12, 2009
| about: AAPL
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Apple Inc. (NASDAQ:AAPL) $162.83- Despite Apple shares rising more than 100% from its 2009 low of $78, the stock still appears to be attractively valued especially as a long-term holding. Using cash-flow and non-GAAP earnings, AAPL trades at less than 15x on a trailing 12-month basis. Since sales and cash flows were likely significantly depressed over that time period due to the sharp economic contraction, demand should improve considerably in the quarters ahead. Thus, forward multiples would be even lower given the anticipated rebound in sales and earnings growth.
The modest price multiple at which AAPL currently trades leads me to conclude that investors are: 1) Attributing the slowdown in Mac and iPod segments to a permanent secular decline, rather than temporary weakness consistent with economic contractions. 2) Ignoring / under-appreciating the growth potential of the iPhone and products yet to be introduced.
Non-GAAP Earnings & Cash Flow:
Apple has reported $5.72 GAAP EPS for the past 4 quarters combined [ttm]. However, over the same period, Apple has earned $9.23 in non-GAAP EPS [ttm]. The non-GAAP figures are a better representation of Apple's earnings power since iPhone revenues are recognized in the period sold and not deferred over a 24 month time frame as is the case with GAAP EPS. The GAAP EPS numbers grossly understate Apple's profitability and cash-flow generation.
Looking at the difference between GAAP revenue and non-GAAP revenue for the past 4 quarters, GAAP revenue would be $7.7B higher, or 22.3% if Apple were not required to account for iPhone sales using the subscription method. Reported EPS [ttm] would have been $3.51, or 61.4% higher as well. The most noticeable difference is the effect iPhone sales have on profit margins. Since the iPhone carries the highest margin for Apple hardware, there is a dramatic impact on gross and net margins when subscription accounting is reversed. Gross margin rises from 35.5% to 39.6%, and net margin increases from 15.0% to 19.7%.
From June 2008 to June 2009, Apple's cash holdings increased $10.35B, from $20.77B to $31.12B. On a per share basis, cash / share increased $11.38, or 50% from $22.85/share (June 2008) to $34.24/share (June 2009). Apple generated $10.26B in free cash flow over the last 4 quarters, or $11.28/share.
GAAP Revenue [ttm] has increased 10.9% compared to the prior trailing 4 quarters, yet non-GAAP sales increased 22.9%, more than double the rate of GAAP revenue growth. GAAP earnings growth [ttm] versus the prior 4 quarters was 10.5% ($5.72 vs. $5.12). However, non-GAAP EPS [ttm] increased 39.9% ($9.23 vs $5.55) compared to the same period for the prior year.
It is clearly evident that the reported GAAP figures widely understates Apple's true performance. Therefore, investors should focus on the non-GAAP numbers and cash flow when evaluating Apple.
Valuation Metrics:
Even though stock values reflect future cash flows, we can examine Apple's performance over the last 4 quarters [ttm] to use as a conservative proxy since the recessionary backdrop has most likely depressed revenue and earnings. Apple's GAAP EPS [ttm] of $5.72 translates into a historical P/E [ttm] of 28.5x. That would appear to be quite a rich valuation, especially given the multiple compression that has occurred in the overall equity market. Or, at least, imply significant future growth.
However, investors should know that evaluating AAPL based on GAAP accounting is completely flawed. To compare apples to apples, investors must gauge Apple using its non-GAAP figures relative to peers / market. Apple uses subscription accounting methods to account for iPhone sales which spreads handset revenues over 24 months by accruing unrecognized revenue in a deferred revenue account that is stated on its balance sheet. Apple's non-GAAP EPS [ttm] is $9.23 which equates to a trailing P/E of 17.6x. That is a stark difference than the misleading GAAP P/E of 28.5x.
Considering that Apple has $34.24/share in cash and securities that could theoretically be distributed to shareholders, Apple trades at even a lower multiple based on non-GAAP EPS ex cash. If we strip out $34.24 cash/share from AAPL's $162.83 share price, we are left with $128.59/share, which essentially reflects the value of Apple's operating assets. In addition, interest income must be stripped out of earnings before calculating a P/E multiple due to the assumption that the cash stockpile would be distributed, hence no longer contributing interest income to EPS. For the trailing 4 quarters, Apple earned 33 cents per share (after-tax) in interest income. Apple is trading 14.4x ex-cash [ttm] based non-GAAP EPS ex-interest income of $8.90.
When there is a large disparity between interest yield (interest income/cash) and earnings yield (EPS/Price or 1/PE), the large cash balances can skew the value of the (non-cash) operating assets. When short-term rates were over 5% (pre-tax) and Apple traded at 20+ multiple, the earnings yield was roughly equivalent to the cash yield. Therefore, there was little or no difference between the standard P/E and P/E ex-cash and interest. Now that current short-term rates are near zero, Apple's cash holdings contribute very little income to total company earnings.
If Apple used its $31.1B for a stock buyback, it could reduce share count by 191M to 718M. Non-GAAP EPS (adjusted for interest income) would rise to $11.21 translating into a P/E [ttm] of 14.5x.
In the past year, Apple's cash position has increased by $10.35B or $11.38/share giving a P/CF [ttm] of 14.3x. Trailing free cash flow was slightly less at $10.26B giving a P/FCF [ttm] multiple of 14.4x. Removing the value of cash and interest income (from share price & FCF), the P/FCF multiple drops to 11.7x.
Recall that this valuation exercise has been based on historical earnings, not expected future earnings which is more appropriate since investors only care about future cash flows. However, I used trailing earnings since those figures are known while future earnings are not. I am confident that Apple's next 4 quarters will be better than its previous four. The economy has been in a deep recession for the past year, but has begun to improve. Apple has managed to withstand the downturn reasonably well; and with the success of the iPhone/App Store, along with the possibility of new products, Apple's growth should accelerate moving forward. Thus, I am reasonably confident that Apple's valuation multiples are even lower on a prospective basis.
Price Implied Expectations:
Trading for less 15x trailing earnings and ~12x expected earnings, AAPL on the surface appears cheap. Historically AAPL has traded at much higher valuations, yet expected growth was much higher too. In addition, investors are demanding a higher required rate of return on equities by paying lower price multiples. The increase in equity risk premium inherent in all stocks has led to the decline in P/E ratios. Investors perceive greater risks and are less sanguine about the long-run prospects of equity returns. This accounts for a portion of Apple's low valuation relative to its historical premium.
The primary reason why the investors are assigning a paltry price multiple is due to expected declines in Apple's growth rate. In my opinion, the current share price reflects the expectation of Mac growth commensurate with the industry average, declining iPod growth, and iPhone growth that will peak and rapidly decline to the industry average in a couple years. In short, Apple is priced as if its growth is quickly maturing, such as Microsoft (MSFT) or DELL who both saw their margins compress as growth stalled. All firms eventually fall victim to the industry / firm life cycle. However, is this expectation likely for Apple's future? That is the key question.
I don't believe that overly optimistic or unrealistic expectations are priced-in AAPL shares. I believe the current outlook implied by the share price is conservative, but not entirely unlikely. The future of Apple's growth hinges on innovation and new products / services, as it does for most firms. Many firms are unsuccessful at being able to continue to innovate, staying relevant and avoiding being commoditized. In short, Apple's share price doesn't give much value to its ability to innovate and reignite growth. In my opinion, it's the belief whether or not Apple can continue to introduce products that wow consumers that determines if AAPL is over or under valued.
Apple's Record of Successful Innovation and Execution:
1) iPod's Dominant Market Share-
Apple's unit market share has exceeded 70% in the U.S. for years as it has successfully continued to ward off competition leaving carcasses by the wayside. Many powerful companies such as Dell, Sony (SNE), and Microsoft have attempted dethrone the iPod, only to fall short or outright fail. Apple has been able to keep iPod prices relatively high as its revenue share of the U.S. PMP market is higher than 90%.
2) Apple's iTunes store is largest music retailer-
iTunes surpassed Best Buy (BBY) and Wal-Mart (WMT) to take the top spot in sales volume. Apple should increase its lead as bricks and mortar stores cutback on music selection due to high inventory cost and required floor space. Demand for physical music continues to decline as consumers shift to buying digital music online. Competitors have followed with online music download stores, yet they have made little dent in iTunes' market share.
3) Retail stores generate highest revenue/sq.ft. and foot traffic-
It's quite indisputable that any retail strategy has been as successful as Apple's retail stores. Apple leads in performance metrics such as revenue/sq.ft. and visitors/store etc, but its retail strategy also has been extremely successful in promoting its brand and introducing customers to its products. Other computer makers' retail efforts have failed, such as Gateway and Dell. Many third-party computer and electronics resellers have also disappeared, such as CompUSA and Circuit City. It's quite evident that it's a very challenging environment to navigate. Apple continues to open new stores and is expanding considerably abroad.
4) Turn-around of Mac business and domination of premium segment:
Mac unit sales increased 38% in FY08 and 40% in FY07, which was more than 3x the PC industry as a whole outpacing the industry in 18 of the last 19 quarters. Even though Mac unit growth has slowed to single-digits, its share of the premium price segment has exploded. According to NPD, Macs made up 91% of sales for PCs priced $1000 and above for June 2009, up from 88% in May. This compares to 66% share Mac had in Early 2008. I believe Apple had about 40% share of the premium market in 2007. It is quite evident that Apple is the only PC manufacturer than can command a premium for its products.
5) Large and increasing share of smartphone market-
Even with the experience and industry footing incumbent mobile handset makers possessed, Apple was able to enter the market and quickly gain share. According to several surveys, the iPhone has the highest satisfaction rates by a considerable margin. Industry competition is very intense, yet Apple is the one to catch in the smartphone segment.
6) iTunes App Store-
One year after launching, the iTunes App Store offers 65K applications and has seen over 1.5B downloads. Other firms have followed with their own mobile app stores, yet haven't been able to duplicate nearly as much developer and consumer interest. Nintendo (NTDOY.PK) mentioned last quarter that Apple's App Store is impacting its handheld gaming business.
These remarkable achievements illustrate a common theme. Apple has been able to enter new product markets and become the leader that others must chase. Even though many competitors have attempted to duplicate Apple's strategy, most have hardly had much success, at least in terms of stealing business from Apple.
A popular concern among Apple investors is the increasing competition from the number of firms following in Apple's footsteps. They believe that others will eventually catch up with Apple (iPhone, App Store, iTunes Music), hence its lead is only temporary. However, this has been a concern for ages and yet to come to fruition. That is not to say it won't happen, as there is a real possibility that it will eventually. But given Apple's proven track record of disrupting, dominating, and defending its new endeavors, it's likely Apple will remain the innovative leader for sometime.
Apple's share price may reflect declining iPod growth and decelerating Mac growth, but it doesn't reflect potential new products which are a certainty. The success of those new products are less certain, but Apple makes products / services that are complementary to its others, rather natural extensions. Basically, Apple products help drive sales of other products as well as increasing switching costs creating customer "lock-in."
Apple's products elicit the some of the highest customer satisfaction scores for their respective categories which has created immense loyalty and a powerful brand.
Conclusion:
On a non-GAAP basis ex-cash, Apple is trading at less than 15x trailing EPS. Considering the economy has been going through the worst economic downturn since the Great Depression, Apple's trailing earnings are depressed. As the economy turns up, earnings will normalize at a higher level. In addition, iPhone sales should continue to exhibit strong growth and drive free cash flow. Therefore, investors should be highly confident that future earnings will be considerably higher.
On a forward earnings basis, AAPL's price multiple is 10-12x, a valuation representative of maturing growth. However, Apple has a long track record of innovation and using products to promote and attract consumers to its other offerings. Looking at the many remarkable achievements by Apple and the many stumbles by competitors, it can be argued that AAPL deserves a premium multiple, not a multiple reflective of ordinary growth.
Disclosure: Long AAPL
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This article has 10 comments:
Financially: great margins with growth on a cash-flow basis while minimizing risks through diversification (product portfolio) and pricing. It still has plenty of room and flexibility for lowering prices if necessary.
New products by other companies are desirable, even if they claim to be better, since that will only last for about a minute after spurring Apple to do even better. No one on the planet innovates better and faster than Apple and that's the name of the tech game.
Thank you again for a wonderful article.
Long APPL
Mac sales were strong in 2007, when the economy was still growing. In 2008-09, Mac growth has declined to the single-digits, as the economy contracted. My point is that, when the economy begins to grow again Mac sales should rebound. Since I used trailing earnings for my valuation metrics, those figures are on a depressed level, thus future earnings should be higher.
I doubt Apple will do a buyback anytime soon, but a cash build doesn't necessarily entail a mature company. Apple doesn't need much cash to grow since it has little physical assets such as PPE and inventory.
I think the market is assuming that Apple is a mature company, due to slowdown in Macs, iPods, the cash build, etc. Just as you pointed out. I believe that is priced-in to the stock, there fore there is upside potential in AAPL is growth is much better than expectations. And based on past successes and ability to innovate, I believe there risks are balanced in AAPL's favor
On Aug 12 09:57 AM Techtrader10 wrote:
> Mr. Muller uses numbers from 2007 to make his argument for increasing
> sales of MAC computer future earnings, everyone was doing well in
> 2007. He also talks about Apple as a growth company, however discusses
> the increasing un-used cash build up, the sign of a maturing company.
> He also discusses stock buy back, another sign of a maturing company.
> You can't have it both ways growth company multiple with a maturing
> company. It is doubtful Apple will buy back stock, and also doubtful
> they will admit they are transforming from growth to maturing company
> by declaring a dividend. Disclosure: Day Trader, long as of this
> writing.
My only worry about your article is that a number of people who own the stock, own it because of positive articles like yours. They are not sophisticated in the ways of the market, and only know that someone is saying positive things about the stock they own.
There are many "forces" to work against the future earnings of Apple that you don't mention and I would like to mention some of them to balance the field. 1. Apple is getting more and more of its income from the iPhone While not a bad thing, and since they have a small niche in the cell phone market (not to mention a fanatical following) they will probably be alright, but if Nokia, LG, or some other mass marketer of cell phones comes out with a new, spectacular, smart phone at half the price, it is going to very adversely affect their earnings. 2. It is my feeling and I admit, it has me more than a little uncomfortable is the company's move away from their base computer business and more into the "gadget" field. I get the feeling they are becoming the new Sharper Image on the block, with high mark up gadgets and little substance to fall back on. 3. The other area for concern is thecompany's stock valuation. You and others still feel the company should be valued as a growth stock. While it is slowly becoming evident that they do not have an effective way to use the cash flow they are producing, the sign of a maturing company. This isn't bad, it just means they should not be commanding a growth multiple on the price of the stock. I doubt Mr. Jobs would be willing to go for the idea of a dividend as that would mean he would have to take the cash and pay the taxes on the money versus selling off small (by his standards) amounts of stock to finance his life style. I feel Apple will be around for a long time, but not as the growth company that we have all known over the past several years. Disclosure: no position as of this writing
Aug 12 10:18 AM turleymuller wrote:
> Just to clarify-
>
> Mac sales were strong in 2007, when the economy was still growing.
> In 2008-09, Mac growth has declined to the single-digits, as the
> economy contracted. My point is that, when the economy begins to
> grow again Mac sales should rebound. Since I used trailing earnings
> for my valuation metrics, those figures are on a depressed level,
> thus future earnings should be higher.
>
> I doubt Apple will do a buyback anytime soon, but a cash build doesn't
> necessarily entail a mature company. Apple doesn't need much cash
> to grow since it has little physical assets such as PPE and inventory.
>
>
> I think the market is assuming that Apple is a mature company, due
> to slowdown in Macs, iPods, the cash build, etc. Just as you pointed
> out. I believe that is priced-in to the stock, there fore there is
> upside potential in AAPL is growth is much better than expectations.
> And based on past successes and ability to innovate, I believe there
> risks are balanced in AAPL's favor
As for point #2, comparing Appple to Sharper Image? I feel that comparison is unwarranted, my 80 year old gramma might confuse their stores at the mall, that's about all the two companies share(d).
Point #3, they are a tech company with fairly consistent operating costs, no need to use their cash to lever up to try and eek out more growth than there is out there for them to take. Or maybe an effective way to use their cash would be to start paying all their engineers huge bonuses! --You are spot on about dividends.
An operating system meant for a small mobile device cannot easily grow and scale up to handle demands of a larger computing system. An operating system meant for a large computing system does not always translate well when running on a small mobile devices. How easily each will scale depends on the architecture. Legacy systems such as Symbian and RIMM may or may not scale well when compared against WinMo, Android and iPhone 3.0.
WinMo, if the architecture is suspect as many claim, cannot be evolved quickly to match the capabilities of Android, WebOS or iPhone 3.0.
Palm's WebOS is for now, a lightweight OS meant for web applications. Given proper architecture, it can scale to run complex applications but so far, no hint of that yet.
Android is still evolving but it is a mobile OS, not a full-fledge desktop capable OS. It is also untested on desktop and laptop. Compared to iPhone 2.0+, based off Mac OS/X, it has been well tested.
For now, at least for two more years, iPhone 3.0 is the one OS that is the most flexible. Given increasing CPU capabilities and ever increase solid state drive capacities, iPhone 3.0 is best positioned to take full advantage of the underlying hardware improvements. The other OS will require additional and likely significant engineering work to retool.
So while your worries are reasonable at face value, they are not properly supported by the technological details; at least not for two more years. Will Apple stay stagnant for two years for others to catch up? Will others be able to outrace and surpass Apple in two years? We shall see.
2. Apple is getting more income from iPhone but it does not mean the company is ignoring the core Mac business. TechTrader is confusing mass media focus with reality. Mac refreshes were announced three times this fiscal year and Snow Leopard, a new version of OS/X is due in September. The company continues to refine iWork and iLife software suites and professional grade DB and media suites.
While the media and some portions of the public may be talking iPhone with each breath, the company is continuing to deliver on the Mac's. It is so obvious that people are simply ignoring it.
3. Growth or Mature? I am an engineer by trade so these terms are confusing. For me, when I invest, a "growth" company means a company that continues to grow its revenue rapidly, continues to realize increasing net profits and diminishing debt, continues to deliver new products and continues to forge new frontier in the eco system that supports their product suites.
Mature? It means a company that is no longer introducing new products, no longer pushing the frontiers of innovations or inventions, they are simply revising existing products with new versions, continuing to service existing customers and rely on recurring revenue from services and repeat purchase to replace old products. They are more about maintaining status quo and stability than about creating disturbances to allow new solutions to take root.
I do not see Apple as a "mature" company. Apple is not sitting still and has not done so since the revamp of the initial blueberry clamshell iBook. It has accelerated innovation with iPod, iPhone and iTouch. It has accelerated innovation with new iLife and iWork suites and a new OS with a new facility take advantage of GPU's.
Apple's growth potential into databases, analytics, data mining, device controllers, integrated services is practically close to 99% because it has 0% to 1% presence in those areas. If you think these areas are already saturated and today's solutions are already so good that further innovations are no longer possible, just look at the first-gen iPhone.
The question is not whether Apple is a growth company, it certainly is behaving like one; and one with a huge amount of resources. The question is whether it will choose to stop growing one day soon. A subtle but important distinction. Calling Apple "mature" is at best overly narrow-focused and at worst, just plain wrong.
While TechTrade does raise good points, they are lacking detail facts and data we can use. So then it becomes mostly subjective opinions that are near impossible to use.
Finally, I will agree that it is bad to fall in love with a stock. One has to read the technical tea leaves as well as understand the market sentiment. Even professionals who claim to be expert analysts continue to fail when calling Apple's growth over the past eight years. That same logic applies to this discussion. Turley has been very accurate in his data-intensive and verifiable analysis of AAPL. While I will not believe him 100%, I will integrate his data and analysis into my own research.
Oh, and I'd be sure to correlate iPod and iPhone sales; the iPhone is a superset of the iPod. If you buy an iPhone, Apple doesn't CARE if you buy an iPod-- the phone gives you all the iPod functionality plus a phone.
One last thing: all those 20,000 plus developers making iPhone apps? It's basically the same process as writing Mac apps. All those guys now understand 1) how to write code for the Mac 2) that it is way, way easier than writing for legacy systems (like Windows).
if apple ever ports the iphone to verizon i will jump on the platform with all the apps (iphone). and as tom points out, the developer world will start to gravitate toward apple (not abandoning windows, but taking advantage of apple consumer appeal). currently, apple appeals to the consumer pc market, but look for apple to start making headway in the small biz market with developers' efforts.
my biggest concern with apple is the ipod, but even there, they have the "razor blade" of itunes etc to go with the ipod "razors". itunes seems to be a durable franchise.