Apple reported its fiscal fourth quarter results last night, and the Street was not impressed. The reported earnings of $7.05 per share were slightly lower than the $7.26 in expected earnings per share. To be exact, they missed by 3%. But in after hours trading the equity is down 6.3%. Netting out the cash, the equity markets believe Apple’s business is worth 8% less than yesterday.
Truth be told, management guided the Street to $5.50 in EPS for Q4, so they beat their own low-balled budget by 28%. First of all, when a company’s top line shows year over year growth of 66%, I don’t really care that they missed Wall Street’s estimate of 68% year over year growth. The company didn’t launch any new products in Q4, so many buyers have been waiting until October to buy the new iPhone 4S, and even at lower quarterly revenue growth rates, the stock is quite undervalued.
Back in January, I wrote that Apple should be worth at least $375, and that it could easily top $450 with a little multiple expansion. Multiple expansion hasn’t happened, however. Quite the opposite in fact. Apple stock has traded from about $305 per share a year ago to around $395 today (after hours). That is a 30% gain but far lower than the 83% gain in EPS from FY 2010 to FY 2011. On a multiple basis, AAPL has fallen from 18x earnings (net of cash) to 11x earnings today on a trailing basis. With the S&P index trading at 11x earnings, it seems the market is convinced that EPS cannot grow faster than the average company. Below I will make a case for why growth should still be solid for 2012, and why even hard core value investors should find AAPL interesting.
Fourth quarter revenue grew 39% year over year to $28.3BB. iPhone and iPad sales continue to capture and keep huge market share, but the top line was light by a bit more than $1.2BB overall. Much of this I attribute to the lack of a new product launch in the quarter. The iPhone 4S, launched in early October, has already sold some 4mm units, and clearly many customers deferred buying an iPhone anticipating the new release. Considering that iPhones generate $625 a pop in revenue for Apple, that 4mm in phones adds up to $2.5BB and easily explains the shortfall in revenue.
iPad sales were also a tad below expectations. However, no competitive offering has gotten anywhere close to Apple, and I personally think the Kindle Fire is a low end product that may sell well, but will serve a different niche. I still want my iTunes music and Apple apps on my iPad, as well as a much bigger and brighter screen. iPad sales will also pickup during the Q4 holiday season.
The most important metric, cash, was up $5.7BB in the quarter. As of September 30th, total cash and equivalents totaled $82BB. The cash hoard is so large now, that it makes up roughly 75% of the company’s balance sheet. Stripping out the cash implies that the company generated TTM net income of $25.6BB (excluding interest income), for a humongous return on equity (ROE) of 74%. Show me another company that generates such high ROEs and trades for such a low multiple.
Clearly, the biggest overhang for AAPL is its ability to grow in the future. The law of large numbers indicates without doubt that Apple cannot grow EPS at 66% per year forever. Perhaps many sellers are concerned that this is the quarter where growth finally tails off. Perhaps true to some extent, but I still think growth will exceed 30% next year.
As for this quarter, this miss I would chalk up to normal quarterly lumpiness as opposed to slowing growth. Deferred iPhone purchases, coming in at 17mm compared to expected number of 22mm will be made up in Q4. Same with iPad purchases for the holidays.
Bigger picture though, there are still three key areas of secular growth left, at least for 2012 and 2013. They are: 1) International and emerging markets, which Apple has only partly tapped into. 2) Computer gear, Macs, where market share is still quite low, and 3) the high worldwide growth rates in smartphone adoption.
On the international side, Apple’s primary growth targets are China and Brazil. In China, the company is planning two dozen more retail stores showcasing Apple products all over the country. Market share of Mac computers jumps in markets after Apple retail stores are opened.
But perhaps more important is the move to offer iPhones with China Mobile. While AAPL’s sales in Asia Pacific were $6.3BB last quarter, that is with only 1% phone penetration in China and 8% smartphone share. Worldwide, Apple has 19% share of smartphones, so it is clearly lagging the competition in China. To date, Apple only offers its iPhones with China Unicom, who has around 200mm wireless subscribers. It is entirely missing the boat on the 600mm subs at China Mobile.
The good news is that Tim Cook has been having (openly) secret meetings with China Mobile management. Reports are that Apple is developing a phone compatible with China Mobile’s new TD-LTE network. I would speculate an announcement will be forthcoming in the next 1-3 quarters. I read one report indicating that today there are about 30mm smartphone subscribers in China, which number likely will double in the next 2 years. That means, Apple could capture 15-20% of that market with a China Mobile iPhone. 60mm X 20% is 12mm more iPhones. At $625 a piece, that is $7.5BB in sales over a two to three year period.
This also leads me to the secular growth story of smartphones in general. I was surprised to learn that cell phone growth worldwide in Q2 2011 was 11.3% year over year (according to IDC Worldwide). However I was even more surprised to learn that smartphone growth was an astonishing 76% year over year! Overall, 110mm smartphones were sold in Q2 2010, compared to 62mm the year before. The US market is 25% penetrated with smartphones, and China only 3%. The trend here is tremendous and still in the very early stages.
On top of the growing trend toward smartphones, Apple recently announced a Sprint deal, one that I would call quite a coup for AAPL. Sprint has agreed to purchase over $20BB worth of phones from Apple over the next 4 years. When the iPhone 5 comes out, Sprint will get an exclusive deal on that phone for a certain amount of time, which could shift some market share back to Sprint from Verizon or AT&T, but even so, would only mean more iPhone sales for Apple.
Big picture, Apple sold 17mm iPhones in Q3 2011, compared to 14mm the year before in Q3. That is still sales growth of 24%. Apple’s market share increased from 13.5% last year to 18.5%. But perhaps even more important, worldwide sales of smartphones in Q2 were up an amazing 76%. Even if Apple had simply maintained market share, there appears to be lots of wind behind the backs of smartphone makers.
So, assuming in 2012 that the overall smartphone market grows to a mere 30% level (from 76%), that implies that Apple will potentially sell over 94mm iPhones in 2012, an increase of 22mm smartphones. Throw in some market share gains from Sprint ($5BB), KDDI out of Japan ($1-2BB), and China Mobile (perhaps $1-5BB), and you can easily see growth of $20-25BB in topline in FY 2012. Just from iPhone sales.
As far as the PC side, Apple is gaining share, albeit more slowly than in smartphones. Gartner Group estimates that Apple’s US market share at year end last year was around 10%, up from 4% in 2006. With sales of only 4.9mm Mac’s last quarter, and such small market share, I suggest that growth can continue at least at its 20% rate in the near future. Actually Mac unit sales accelerated in Q4, up 48% year over year, but just being conservative.
I didn’t even discuss iPad or iTunes sales growth, but nothing to me indicates that these will decline in 2012. I assume they are flat for conservatism’s sake.
So, given just the items outlined above, I think $30BB of sales growth in 2012 is highly likely. Compared to sales of $108BB for the fiscal year ended September, that implies at least 25% growth in 2012, or total 2012 FY revenue approaching $140BB. If margins stay at current levels, then Apple could easily report $34.50 in EPS for 2012.
Now, the reports of Apple’s cash hoard are important. To be fair, some of this cash would have to taxed in repatriation, and some may be used for low return acquisitions. Both are debatable, so I assume that only 70% of the internationally held cash ($50BB estimated as of the end of Q3 X 70%) or $35BB is true value to shareholders, plus the US based cash of $32BB. That is a total of $67BB available to shareholders. That comes out to $71.50 per share of cash on the books today.
Subtracting the current share price of $395 implies you are paying $323.50 per share for a business that will likely generate around $35 in EPS in 2012. That is under 10x earnings, 9.4x to be exact, compared to a market multiple of 11.5x 2012.
I think a conservative fair value for Apple in twelve months is around $500 a share. I got there using merely a market multiple of 11.5x and assumed additional cash per share of $34.50 to get to around $100 in cash per share by next FYE:
Cash / share
Still, I must ask the question: who wouldn’t pay a 9.4x multiple (or 11% FCF yield) for a stock that is growing by 30-40% and generating ROE’s of 74%?
What to Do with the Cash
Apple is a free cash flow machine. It was my favorite phrase when I managed money on the institutional side of the world, and still is today. What I love about Apple, is that reported earnings actually are lower than true cash earnings. For fiscal 2011, Apple generated more in cash earnings per share than in reported earnings per share. Some of it is the fact that Apple charges stock based compensation to earnings, and on a cash basis, these charges come back on the CF statement.
But look at the deferred liabilities, which increased by almost $5BB and deferred revenue which increased by $1.7BB. There could easily be some uber-conservative accounting going on here. Cash from operations, less capex, totaled $33.3BB, or $35.50 per share, which is significantly higher than reported EPS of $27.68.
The same thing happened in 2010, with FCF/share of $17.25 compared to EPS of $15.15. I think earnings reported in the most conservative manner allowable under GAAP accounting, and if one in fact used cash earnings as a proxy for Apple earnings, then the PE multiple would be a lower by 2 turns (ie 9x instead of 11x trailing).
If Apple instituted a simple $10 per share annual dividend, which is small relative to both its pile of cash on the books, as well as its earnings power (just over 1/3 of earning today), then it would yield 2.4% and attract an even larger investor base.
Alternatively, if management considered both a special distribution of cash to shareholders, as well as a share buyback plan, then they could push the stock far higher. I admit to being a Buffettologist, so believe that only a buyback at a reasonable price makes sense. But really, when Apple can buy back shares with cash that earns zero percent, and immediately earn a 11% Free Cash Flow yield on those purchases, then why wouldn’t they at least consider doing this?
Net net, Apple is cheap at 9x next year’s earnings. I would suggest that the worst case for the equity is that we get another recession a la 2008. After that disastrous year, Apple saw earnings growth reduced to 14% from its 52% growth rate the prior year (2008). A similar slowdown here might imply $32 in EPS, an 8x multiple and $98 in cash per share. That equates to a $354 stock. From today’s price of $395 per share, that is downside of 10%, upside potential of 27%. Not bad, I would suggest adding more shares here, or to be very safe, add shares in the $360-380 range. The stock is probably a sell above $475. Good luck.
Disclosure: I am long AAPL.