“We believe shares of Apple are mispriced because the value of the business has grown much faster than the stock price. Given Apple’s run of product development successes, the value of its brand, and its fortress balance sheet, we are hard pressed (even baffled) to explain why the stock is trading where it is. However, our job is to evaluate the historical financial data, assess company fundamentals and industry dynamics, and utilize our judgment to arrive at an independent valuation as to a company’s worth. Our conclusion is Apple’s shares represent an attractive risk/reward opportunity at current levels.
Apple is very widely followed by the analyst community. Because of that, most analysts are focused on ferreting out information that will differentiate themselves from their competitors. They focus on everything, it seems, except the current valuation. This is what matters most to us, not whether Apple will meet or beat its next quarterly earnings estimates.
At acquisition, Apple traded at about $335 per share. With 936 million shares outstanding, this equates to a market capitalization of $315 billion. Based on our earnings estimate for the fiscal year ending September 30, 2011 of approximately $24 billion, Apple is trading at a price-earnings ratio of 13x. While we consider 13x to be fairly inexpensive for a company of Apple’s stature, it’s actually even cheaper than that when one takes a closer look at he structure of the balance sheet. Assets include $66 billion of cash and short-term and long-term investments, which is up from just $15 billion less than four years ago as cash generation has massively exceeded spending. Stripping out the cash and investments, which can theoretically be liquidated and used to buy back stock, the enterprise value decreases to under $250 billion and the P/E is closer to 10x. As we said, baffling.
So, at the price we paid, we believe that risks are mitigated. Cheapness (i.e. buying at low prices relative to intrinsic value) is, in our opinion, the best way to limit threats like these, minimize losses, and earn dependably high returns.”
I’ve generally not had much interest in Apple (NASDAQ:AAPL) as an investment. I have no doubt that it is an extraordinary company. I love its cash loaded balance sheet. And I’m even attracted to its traditional valuation metrics. But I have a couple of issues.
One is just how big the company has become and the incredible amount of money that it makes. Last year, the company generated more than $20 billion in cash flow on $65 billion of sales. This year through three quarters the numbers are $27 billion and $79 billion. Incredible numbers. They are so big they frighten me. At some point, won’t the public’s appetite for these products be exhausted ? Won’t people wise up and realize that they shouldn’t take on credit card debt to buy the newest Apple device ? Just how long can Apple be cutting edge ? When does it end and if it does, how big is the haircut to sales and cash flow ?
The second problem I have is why can’t a competitor hit a hot streak and make Apple not so cool ? It seems ridiculous to think now, but thinking Apple would do what it has done would have seemed ridiculous 10 years ago. I feel it is impossible to know what might be developed by a competitor that could seriously damage Apple.
I guess what I’m basically saying is that if Apple was a major league baseball player, it would be on a streak where it has hit 50 home runs per year and batted .400 for the past decade. It has been incredible, but can it really keep playing at this level?
So while I take a pass on Apple as an investment, I am also very aware that there are investors much smarter than I who currently think Apple is attractive. Recently, I came across a quarterly letter from Kovitz Investment Group that I thought presented the bullish reasons for investing in Apple very well:
Despite the compelling case made by Kovitz and the presence of ultra-smart investors like David Einhorn as shareholders, I’m still going to take a pass on Apple. The downside risk is somewhat mitigated by the balance sheet and the reasonable multiple, but I don’t think it is impossible that five years from now Apple’s sales have been cut in half. Why would that happen? I don’t know for sure, but when you have the enormous dollar volume of sales Apple does it just has to be difficult to maintain, nevermind grow.
And yes, you would be right to point out that I could have made the same argument three years ago at much lower sales levels. I guess that is why I am not David Einhorn!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.