I was always a pretty good kid. So it was a safe assumption that the workshop elves would never leave me on the naughty list. And every year I'd prepare a package that was bound for the North Pole, along with a letter informing Santa of the items I'd most like him to bring me for Christmas. One time it was a wax box of baseball cards. Another year it was Nintendo Gameboy. There was also the one where I could have sworn I'd asked for a motorized scooter, but apparently had asked for a cool microscope set instead!
One Christmas in particular though sticks out in my memory, because it required such careful planning. It all started right around this time of year on a hot June day. School had already let out for the summer; and along with some friends, I decided to take part in a water fight. I filled up balloons for the better part of the morning. Kept buckets of reinforcements at the ready with wet sponges in tow. Used sidewalk chalk to outline safe zones. It was going to be glorious! But as the fight began, one of the neighborhood boys rode into battle on a destrier, the likes of which I'd never seen before. The Super Soaker 2000. Oh I'd held a few water pistols in my day, but that gun was a thing of beauty. The spray from the nozzle was as strong as it was accurate. And my side of the battlefield was all but washed away in a sea of destruction.
That fight left me with a yearning for two things. One was ear infection medication. The second was an intense desire to own that water gun for myself.
But there was a serious problem. My birthday had already passed in April. My room was adorned by a radio controlled car that served as proof of that. Allowance savings were scant. And Christmas was almost 7 months away, nearly a lifetime to a child that can count up to their age with just fingers. So I did what I think any rational kid would do. I wrote my annual letter to Santa... in June.
Santa, Santa, Santa. I already discovered what I want for this Christmas. I promise I'll still be good for the rest of the year. I need the Super Soaker 2000. And if I can't have one this summer, then at least I can plan to have it for next summer.
And that was how it happened. My mom read the letter, eventually bought the water gun when it went on sale at the end of August and stashed it away for four months until Christmas. And by the time next summer rolled around, I was able to assume my domination over the neighborhood.
These days I'm too old to write letters to Santa, but if I were going to send him one, just for kicks, I think it would read like this...
Dear Santa Claus,
I've been good this year. I got top grades in school. I haven't caused much trouble and I'm even trying to be nice to my butthead sister. Since I don't deserve to be on the naughty list, please bring me shares of Apple at a split-adjusted price of $90/share. That is all I want for the holidays.
Little Timmy C.
Shares of Apple at $90. Ahh, that is what I'd most want for Christmas this year. But just like with the Super Soaker, it will take some careful planning. Because to be able to unwrap shiny new shares at that price come December 25th, I would likely need to sock them away now.
Santa, Please Bring Shares of Apple at $90
Now why in the world would I want that for Christmas? And why would I need to put them away today? Simple. Because I believe shares of Apple (NASDAQ:AAPL) at this price are a gift. I don't think the stock will be trading anywhere close to that level come December. Perhaps not in 6 months, but Apple is going to $142.85/share and beyond.
Ok that may not sound like the prettiest number, but in pre-split terms it represents a nice, round $1000/share. And that is not just some pie in the sky target intended to grab headlines. That is not me being an 'Apple Fanboy.' That is the economic reality.
By the end of the split, Apple will be a $90 stock trading at 14x EPS with net cash of ~$20/share. Excluding cash the stock is trading at roughly 11x EPS. Maybe adjust the cash figure a bit for the buyback. Bump up the earnings figure to account for the reduced sharecount. But in rough numbers, that is valuation.
And the craziest part, is that it is fairly well known.
Apple is a Value Stock
It seems to be widely understood that Apple is a 'cheap' stock. But what exactly does that mean? And more importantly, why is it cheap?
'Cheap' is a relative term. And from a relative perspective, Apple is still cheaper than most public alternatives.
This is a fairly straightforward comparison, and it can be made based on actual trailing historical results or projected performance of forecast out-year earnings. But in either case, there is really no arguing here, it is factual. Buying an 'annuity stream' of Apple's earnings is significantly less expensive than most comparable companies.
Apple is expected to earn $35bn-$40bn this year. On a per share basis that gets to the consensus of ~$45/share. So at current prices, an investor is paying ~$14.00 for the right to an annuity generated on any $1.00 of current earnings... in perpetuity.
Well how cheap does that make it? Relative to some other notable tech-related companies, this is quite low. For Google (GOOG, GOOGL) this amount is closer to ~$20.00 for every $1.00 of earnings. For Facebook (NASDAQ:FB) it is ~$45.00. Investors in Netflix (NASDAQ:NFLX) and Twitter (NYSE:TWTR) are paying over $100.00 per $1.00 of earnings. In Amazon (NASDAQ:AMZN) this is over $300.00! Now some of these figures are a bit more 'adult' than others adhering to strict, buttoned-up GAAP accounting. Certain others may be a bit fuzzier around the edges with non-cash adjustments on next year's projections. But roughly speaking, that is where the numbers shake out. And by comparison, I'd say Apple looks pretty good...
But we can't forget that certain streams of earnings are expected to grow/shrink over time. And with hindsight, if that $1.00 of earnings quickly grew into $2.00 (or likewise shrank down to a measly $0.50), then an investor would actually be paying a very different price per dollar of earnings. And over time, different companies will prove to have greater/lesser capacity to generate that same amount of profit on a sustainable year-in, year-out basis. This dynamic gets to the heart of how a company becomes priced expensively or cheaply. And how a company outperforms or underperforms in the long run.
In most instances, it is important to remember that you usually get what you pay for. The market is a consensus of intelligent opinions. And 'cheap' usually comes with a red flag, or at the very least a question mark. Smart people evaluate these companies every day and most assets are priced appropriately for the risk. Cheap stocks are usually cheap for a reason.
Most often this will relate to concern on visibility and/or sustainability of long-term earnings power. Take the newspaper industry for an example. The general, widely-held consensus is that the industry over time should expect to decline from negative secular trends. It is a shrinking business.
And a large majority of people believe newspapers are going the way of the dodo bird. For a smaller portion of investors, the viewpoint is that newspapers will probably be around in some form for a long time. And for still others, there is a well-trodden path for newspaper companies not only stick around for a while, but to pivot and actually be able to monetize the digital assets and grow. Now if that last group of investors turn out to be right, well then at today's prices they will likely have gotten a tremendous deal, because the consensus valuation reflects the looming secular question mark. It reflects the very real potential that there will only be a limited amount of good years with which to harvest any cash flow. And not surprisingly because of that dynamic, some of these stocks can be bought 'cheaply' relative to the market.
But that scenario doesn't sound very much like Apple. And oddly, even these stocks are trading at higher multiples. Gannett appears on par with the Big Red from a P/E perspective at approximately 14x trailing earnings, but it is also holding a small mountain of corporate debt that will at some point need to be paid back; and while the New York Times doesn't suffer from the same capital structure problem, it is trading at a substantial premium to Apple at over 30x last year's profit.
I'd venture that the capacity of those companies to maintain earnings let alone grow them is significantly less than that of Apple. But perhaps I'm wrong. In any case, something must be going on here.
Apple was Cheap For a Reason
As is the case for most 'deals' you find out there in the stock market, Apple was in fact cheap for a reason. Actually three of them...
See a couple of different things were going on last year. Price competition in smartphones continued to intensify. Technical capabilities of competitor products improved. Carriers began to give off the impression that they would be less willing to support customer subsidies over the long term. The growth rate of mobile device unit production volume began to decelerate as the North American market naturally moves closer towards saturation. And Apple itself was in the midst of an 'S year' with only evolutionary product roll-outs. As a result earnings declined modestly. Meanwhile the overall cash balance held in the company's coffers continued to increase; and while that alone would ordinarily be a good thing, all of these factors combined prompted a lot of uncertainty about the future strategic direction of the company. And this uncertainty essentially boiled down to three meaningful questions. The rest is just noise...
The three knocks on Apple were that it at times appeared to be a company to be without leadership. That it didn't know what to do with its cash hoard and was therefore at risk of making poor capital allocation decisions. And lastly that its earnings power would continue to shrink over time.
Those three knocks left a big secular question mark right on Apple's core. And it was that question mark, perhaps rightfully so, which led to the stock becoming 'cheap' on a relative basis.
But it is my contention that with hindsight this secular question mark was unfounded from the very beginning. And investors will continue to find that the issues of 2013 simply offered a tremendous deal based on the revised answers we have today.
Knock #1 - Lack of a Visionary
The visionary question (knock #1) will continue to dog Apple for years to come. I have no misconceptions about that. There are already articles being written about whether the Board acqui-hired Jimmy Iovine to replace Tim Cook. The same articles were written about the hiring of Angela Ahrendts. And while I have yet to see anyone write a similar article about Dr. Dre, it is only a matter of time before someone comes up with something.
Personally, I feel that Tim Cook is a genius. And I think his greatest quality about is a lack of ego which drives him to assemble the best team around him.
This is the biggest problem I have with other tech companies. Google. It is the Sergey and Larry show. Eric Schmidt was probably the greatest thing to ever happen to Google. He was the conductor. The Alan Gilbert of the Google harmonic allowing the visionaries of the company to do what they do best... innovate. And he then focused those creative energies to navigate the company through a period of unheralded dominance. Because not every visionary idea is a good one. Not all of them will be profitable. And certainly not all of them need to be force-fed with precious capital. This somewhat less rosy-eyed, adult decision making was a boon for the company's financials. But Eric was not the visionary and the public markets can't seem to get behind conductors acting as the refined voice of strategic direction. It also makes visionaries afraid. It causes an ego problem that their vision may need to be altered. And so he was ousted as CEO and moved back to executive chairman.
In the time since, Google has performed phenomenally. But it is all still from search. The company has thrown a handful of other balls in the air, none of which it appears to have had much success on monetizing or keeping a careful eye on. And the visionaries also retain voting control. Same with Zuckerberg at Facebook. It should be one share, one vote. If the visions are so good, then there is nothing to worry about.
I think this feeling of uncertainty on strategic leadership looms large at every large technology companies, but ones with visionaries at the helm are less vocal about it. It is hard to say no when the directive comes from the original cast. But simply being the founder doesn't guarantee that lightning strike twice. Just ask investors of Zynga (NASDAQ:ZNGA) or Groupon (NASDAQ:GRPN).
The best leaders and the truest visionaries are willing to surround themselves with the strongest supporting cast. They aren't worried about a mutiny from the people they themselves have brought in because they are confident in their own abilities. They know their own skill-set will speak for itself to be valued by peers, colleagues and investors. This is Tim Cook. And I believe it is a rare trait. Will the next earth-changing idea come directly out of his head? It seems unlikely. But he can be an absolute all-star at putting the right people in the right position to succeed. And willing to listen to them when the time comes, which may matter even more than anything else.
There is no true answer to this knock though. It is no secret that Apple's products released the past few years have been more evolutionary than revolutionary. And even when it does finally announce its next product category, the lack of vision will simply push to the right and continue to be a knock for years to come. It comes from people with the short-term need for gratification every three months. The what-have-you-innovated-for-me-lately crowd. And there is never going to be a way to appease this group. There is never any finality. So it is a question that simply needs to be combated over time... by cash flow.
Knock #2 and #3 - Poor Capital Allocator with Declining Earnings
For that reason, it is perhaps more important that the other two knocks have now been answered. And they have been answered in a big way.
In terms of capital allocation (knock #2), Apple recently identified the largest acquisition in company history. No, I am not in any way, shape or form talking about the purchase of Beats Electronics for $3bn. I am talking about Apple. Over the past two years, Apple has made a $60bn acquisition in itself...
And fortunately this acquisition came at an opportune time when the company was priced inexpensively relative to its future earnings prospects. How many other public companies have been able to source $60bn of acquisition volume at ~11x earnings? Apple's aggressive buyback plan has resulted in it significantly shrinking the outstanding float and has been highly, highly accretive to long-term shareholders.
At the same time, Apple was able to fund part of this acquisition through the cheapest form of capital available. Debt. It essentially was given $17bn at nearly as attractive a rate as the U.S. government.
Capital allocation had been the biggest true knock on Apple, even before Steve Jobs passed away. The man was a brilliant visionary many times over, but in hindsight, he was also perhaps a terrible capital allocator. The company sat with literally billions of dollars in the bank while it watched its earnings power increase 10x fold. If the company needed the cash for internal reinvestment or acquisition, the infamous 'dry powder' then that would have been another story. But one of the best financial characteristics of Apple's model is that the overall capital requirements of the business are relatively modest. Therefore holding that much excess liquidity may have severely impaired potential returns on equity for long-term investors. But not anymore. Tim Cook has overseen the company buy back $60bn worth of stock when the market provided an unlikely chance to do so opportunistically.
And now the company has plans to do it all again, re-upping the buyback with another $30bn left to go.
Of course all of this repurchase activity is only helpful if the company's future earnings are in fact sustainable (knock #3). Sustainable, I might add, with only relatively modest capital reinvestment and/or acquisition.
And this was a real question, because Apple's earnings declined in FY'13. That is fact.
The company had a banner year in FY'12, whereas last year this proved to not be the case for the reasons mentioned above. But with hindsight, it seems very likely that Apple merely took 1-step back on its way to taking 2-steps forward.
Earnings in H1'14 have expanded yr-yr; and the outlook for H2 and FY'15 appears bright.
Apple's core earnings power is generated from only a handful of product categories -- computers, mobile phones, tablets, peripherals and software. The most important of which is mobile phones, namely through the flagship iPhone model. Apple is now on the precipice of releasing what in all likelihood will amount to the greatest selling phone of all-time. At least until it is potentially eclipsed by the next generation model. If you don't see this scenario about to unfold, then this is where we're at odds. This article isn't for you and we'll simply have to agree to disagree...
But like many others out there, I feel the iPhone 6 on its own will be able to propel significant earnings growth for the next 1-2 years, providing a net of visibility. At a minimum though it should provide an answer to the knock on sustainability of earnings power as it displays a very clear technical lead in mobile with a moat that is expanding, not shrinking.
Will the new phone be everything it could be? No. Of course not. For example, we already know that the company is making sacrifices on its radio frequency (RF) performance. This was the subject of an article I wrote recently about Peregrine Semiconductor (NASDAQ:PSMI) and why it would have made sense for Apple to acquire it.
But regardless of the product's flaws or missing features, the phone is sure to be best-of-breed. And the innovations it does have are going to drive a huge sales cycle.
This is likely to include a proprietary operating system through the new iOS8 launch. Proprietary next-generation A7 processor chip based on SoC development from PA Semi acquisition in 2008. Proprietary memory controller from Anobit acquisition in 2012. Bio-metric fingerprint technology through acquisition of AuthenTec. Sapphire cover screens through supply agreement with GT Advanced (GTAT) inked in late 2013. New technology in optics, casing, etc.
So Apple was cheap for three reasons. But through an aggressive buyback plan it has now answered the capital allocation knock. And with the iPhone 6 coming, it should be answering the earnings knock. In the short-run this is important since it forces investors to refocus on the company's long-term growth prospects.
And that had seemingly been a fourth knock on the company...
Knock #4 - Growth Prospects
People are betting against Apple's growth. Why they'd be doing that is a mystery to me. It seems almost masochistic.
I am not talking about Apple 'permabears' here either. Investors should feel free to be negative on the stock all they want. I personally think they're wrong, but that is a subjective debate around fundamentals and valuation. I am talking about people that are just constantly negative on the future prospects of Apple as a products company. There exists a not-so-small group of people that seem to always be quick to point out how terrible Apple is at all the various hardware and service products that it doesn't actually make or provide...
"Google is so much better at search than Apple." Well it better be! That is Google's core business!
"Apple can't stand up to Paypal or Venmo when it comes to mobile payment systems." Well it's never done a mobile payment system, so I suppose your right...
"Apple can't make up a TV worth a lick." And it has never tried to yet...
Why would people be so negative? It is a bizarre mentality that seems to not understand that change takes time. And also that Apple's existing products and services are currently enjoyed by literally millions of people around the globe on a daily basis.
These are probably the same type of people who bash Tesla (NASDAQ:TSLA) for any reason other than valuation. Valuation absolutely is nutty on paper but that doesn't undermine the product. Have they actually seen one on the road? Give it some kudos. This is a company revolutionizing the auto industry. The cars are beautiful and offered at nearly the same price as any other luxury auto. These are probably the same people that call Whole Foods (NASDAQ:WFM) by the nickname 'Whole Wallet'. It is like they've never set foot in a store. Sure it is more expensive, but it is full of healthy, happy people. And it offers an incredible customer experience for those who truly care about the quality of food being put into their body.
So why the hate? Apple's products have similarly proved to be inspiring. Walk into any transportation station, concert event, coffee shop or public park and you'll see people on iPhones and iPads and using Mac laptops. And that is Apple of today. A company generating billions in profitability for the very things it does best. And I understand that stocks don't ever look back... but the good news is that the company's future product pipeline for the things it already does best seems as strong as ever.
If Apple was a high-flyer, perhaps I'd understand the pushback. Since in that instance it would necessitate a certain level of growth in order to justify valuation. But I don't see the reason to knock on the growth prospects themselves. The potential for tomorrow is enormous. And even if the company were already trading at a dramatically higher valuation multiple, that growth appears to be lining up...
Take the most recent WWDC for example. For anyone disappointed by lack of new hardware announcements, remember that this is a day intended for developers. And to that end, it was wildly successful. Apple laid the groundwork for future product and software developments around the health and home automation markets with the launch of HomeKit and HealthKit. Partnerships with industry giants like Haier and Epic Software. Coders just received an open invitation to strike it rich as it rides along with Apple into new territories.
The extension of authentication through Touch ID also represented a major milestone moment for development, but seemed under-reported by the media. It is signifying a level of comfort that Apple has made with bio-metric security as it will now allow app developers to embed fingerprint authentication into applications in lieu of an alpha-numeric password. This will drive innovation because of its universal application for security, making it commonplace. And in doing so all but guarantees that Apple will be able to launch and successfully execute a mobile payment platform. The iTunes / App Store platform already has a database of nearly 1bn credit cards on file. To put that in perspective, it is a larger user network than Amazon. It is not hard to imagine growth from this type of endeavor.
In search, Apple is toeing the line, inching closer and closer to the heart of Google. In trying to remain balanced, I personally think some of that direction is wrong. The failure is in trying to force a human-like response from a query. Even Apple algorithms won't pass the turing test. But the possibility of an audio-based search engine via Siri... it is not something out of the realm of possibility.
It is coming after Facebook too. Investors almost never hear about iAd, Apple's mobile advertising platform. Even while sticking to its guns about not sharing user info (thank you!) net revenue has grown to an estimated $500mmE, not so far behind the entire mobile businesses for Facebook and Google that warrant enormous multiples in the marketplace.
And wearables. This is almost undoubtedly coming to the market in the form of a watch. Will an iWatch double earnings? No. But it is an entire new product category for the company which has already seen significant interest from early adopters of products like Fitbit and Jawbone.
I didn't even mention other potential electronics markets like DSLR cameras, or the server market. Apple TV or crypto-currencies. Heck if it could just come up with an ordinary spreadsheet program that has the same hotkeys as the Windows version they'd have a fighting chance to steal market share from the enterprise market.
So in terms of the growth, it is true. It is never easy and none of it has arrived yet. But Google, Samsung, Sony, LG, Comcast, Facebook, American Express, MasterCard, Paypal, Venmo, Isis, Fitbit, Spotify, Pandora and many others... you are all officially on notice. Naysayer investors won't be appeased but all of that should equate to more potential upside than risk.
No matter what though, Apple will most likely still not be considered a growth company anymore. It essentially can't be... because it already grew. But even for investors that see dramatic growth as being out of the cards, this is not nearly the same thing as a business in decline.
And don't forget acquisitions. For all the hoopla around Beats and how could Apple spend so much on it, even if you don't believe in the value of the streaming platform at the end of the day it is 3x revenue for the hardware portion. High, but not crazy high. And it is expected to be accretive to next year's earnings. So even at low returns, contributing to growth. And if it ever made a larger acquisition for value, the contribution would be all the more greater. Apple more typically though makes small technology-oriented buys to extend its lead in various markets. And there is no reason those are not set to continue.
Is it all guaranteed to work? No, of course not. There will surely be mistakes and slips along the way. I thought getting rid of the spaces function in the old Mac OS was a terrible decision. The almost anime feel of iOS7 still irks me. Antenna-gate was a brief nightmare. But will there be another Apple maps anytime soon? I sure hope not. Maps was the exception, as a rare giant misstep. And I am optimistic that Tim Cook only needed to learn that lesson once.
So in a nutshell, Apple had gotten cheap in 2013 for some very real reasons. But with hindsight those reasons appeared to be unfounded, since the company is once again demonstrating a propensity for sustainable growth along with a clear strategy for reinvestment. Therefore even with its recent sharp move higher, Apple is still cheap. It still trades at a significant discount to the market and institutional managers are already underweight it as a component of the S&P. This discount though is only based on the very clear, evolutionary pathway that investors seem apt to bet against for reasons I can't fully understand. Do they honestly think the iPhone 6 won't be a massive commercial success? Is there not going to be another upgrade cycle on the iPad or the Mac?
Investors are implying that the sustainability of Apple's earnings is severely below average against all other companies out there, even those that are staying afloat in secular challenged industries. That is a bet I am more than willing to take the other side of. Especially since it does not also incorporate any of the potential growth from straying into revolutionary pathways. Wearables. Home automation. Health monitoring. Mobile advertising. Audio-based search. Mobile payments. None of those are embedded "in the numbers"... and Apple has a history of turning niche markets into mainstream success stories. You can argue that this innovative piece of the business died with Steve Jobs. But given the value-multiple on roughly $40bn of cash flow coming at you each year, it is an argument that can drown you quickly. And other than the obnoxious what-have-you-innovated-for-me-this-quarter crowd, it is an argument that seems to have no validity. Apple doesn't need to be the first $1 trillion company, we'll leave that to Kanye West's Donda. Apple just needs to keep doing what it does best: bringing to market some of the world's most fantastic technology products... and perhaps also finally get its capital ratios in order...
$1000/share is a huge psychological level for any stock. It also happens to be equivalent to Apple's all-time high post the split. Do you really think this didn't cross the Board's mind when it decided on a 7:1 ratio? Knowing the resistance it will face at that all important level, it would be pretty dumb unless it felt confident in its product cycle. To that end, Eddy Cue, longtime senior VP with the company, recently said that the company has its strongest product lineup in 25 years. Is that a promotional statement? Absolutely. But there is also likely a layer of truth to it. The company is the leading technology company in the world and it has in no way been standing by while competitors try to narrow the gap.
So that is why I badly want shares of Apple for Christmas at the current post-split adjusted price of ~$90/share. And that is also why I'd likely need to sock them away now...
Christmas hasn't come early. But sometimes the most rational thing for a kid to do is write a letter to Santa... in June.
Disclosure: I am long AAPL, PSMI, WFM, GTAT, FB, TSLA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Long AAPL calls. Long PSMI. Long PSMI calls. Long WFM. Long GTAT. Long FB. Short TSLA puts.