by Jason Fitnich
There's a lot of bad information in the financial press. So much that the typical individual investor has a hard time processing it all, leading to self-doubt and bad decisions. So when I read this nonsense on one of our Complete Growth Investor Growth & Value Focus portfolio stocks from Bloomberg market commentator John Dorfman, my confidence is restored that most of the "market" hasn't got a clue.
Evidently I don't appreciate Dorfman's resume as a quick search he has appeared on countless financial programs including CNBC, PBS, and writes a regular column for Bloomberg. He is also Chairman of Thunderstorm Capital in Boston, MA., so one would be led to believe he knows what he's writing about.
But then he discusses Apple Inc. (AAPL) and says that the stock is overpriced because it sells for 32 earnings. Now, I may be just another internet shill typing 799 miles away (thanks Google Maps!) in Boston, MA., but even I know that earnings per share have no correlation with the actual business performance of Apple. Not least, the subscription accounting for Apple's iPhone sales under GAAP masks the real cash generating power of the company, though this will soon change due to a recent FASB announcement.
To be fair, Dorfman notes that Apple sells for 6x book value and 5x revenues as well, with both measures high relative to the market. But trotting out earnings per share on Apple and calling shares expensive isn't the whole story and does a disservice to the casual reader's understanding of the company's valuation. A little extra digging would lead you to look at the company and measure its worth through its cash flow statement.
Here at Complete Growth Investor we cite Bruce Berkowitz, manager of the Fairholme Fund (FAIRX), and “count the cash in the till.” Earnings per share is interesting and useful for tracking performance in some cases, but can be misleading and in the case of Apple, downright wrong. Why? EPS counts income, which may or may not be cash flow. And in Apple’s case, the cash flows tell the real investment story, driven by three catalysts detailed below. Hey, buyers of companies pay not attention to EPS. Why should you?
We’ve only scratched the surface on the iPhone’s potential both here in the US and around the world. APPLE will soon be supplying the iPhone to China Unicom in China and the Orange PLC in the United Kingdom. Canada’s three major carriers will all support the iPhone by the end of this year too. Unlike in the US, these are not exclusive agreements with one carrier; in foreign markets, APPLE is allowing multiple mobile providers to sell and support the iPhone. These additional carriers will bring another round of iPhone sales and adoption among users, and allow the network effect of the App Store---with its 85,000 apps and 50 million total iPhone/iPod users worldwide---to take hold.
Rumors of an upcoming tablet product surface regularly, most recently in a Wall Street Journal story detailing Steve Jobs’ involvement in its development. Given Apple’s product launch successes—three for three with the Mac, the iPod, and the iPhone—the bet here is that this tablet product, whether overgrown iPhone or a netbook competitor, will be another successful product for APPLE.
The third catalyst addresses Mr. Dorfman’s lack of due diligence when referencing Apple’s EPS. GAAP recently changed for companies like Palm (PALM) and Apple, which sell software-enabled devices. Without diving into the minutiae of the accounting, I’ll say that this will enable companies like Apple to determine the value of their devices at the initial sale, less the value of any upgrades over the life of the product. Right now, Apple recognizes only a small portion of revenue for the iPhone in its initial quarter of sale which has the effect of placing much of the iPhone’s value into deferred revenue, while the cash flow statement reflects what’s really going on in terms of business performance.
Apple is presenting us with multiple ways to win with the triple combination of greater iPhone adoption, a new tablet introduction, and a greater awareness by the investment community of the real financial performance of the company. Adding to Apple at this price is a growth-at-a-reasonable-price bet with the stock selling for around 15x free cash flow. A 20x multiple or higher is not out of the question for Apple’s growth, combined with its product innovation and the rock-solid balance sheet---$31 billion in cash and no debt. That’s a potent combination of valuation and catalysts that makes an investment in Apple today enticing.
I’ve put my money where my mouth is when it comes to Apple as it is the single largest position in my CGI Growth and Value Focus Growth Portfolio. I disagree with Mr. Dorfman on Apple’s prospects and believe Apple will perform better than the average stock over the next two years. In the meantime, I will count Apple’s free cash flow while market pundits like Dorfman misguidedly count earnings per share.
Disclosure: Jason Fitnich manages CGI Growth & Value Focus’s real-money Growth Portfolio. He and the portfolio are long Apple common stock.