Forget The Value Angle, Apple Is A Pure Growth Play

Jan.26.12 | About: Apple Inc. (AAPL)

One of the worst-kept secrets out there is the fact that Apple (NASDAQ:AAPL) shares command a P/E that strikes many as shockingly low given the company's apparently still-excellent prospects. The answer that unfortunately seems to find its way into publication far too often nowadays is that Mr. Market somehow or other doesn't get it and doesn't understand or respect Apple. This is nonsense. Apple is one of the most closely-watched and deeply-studied companies on the planet. Its growth prospects have consistently been and still are very well understood in the investment community. There's always room for disagreement, as is inevitable when we consider assumptions about the future, as investors necessarily do. But Apple's being widely understood to be a growth company is clear from the stock's consistently-very-high price/sales ratio. What bothers the company's diehard fans is another side of what is really a many-sided valuation coin, the consistently-very-low P/E ratios.

In my 1/25/12 article, I explored the nature of the dichotomy between the two signals, and demonstrated why, as much as some would like to focus on P/E alone, it's really necessary to look at both P/E and price/sales when assessing Apple. I also used some stock screening to show how price/sales needs to be taken seriously, how it can really be an anchor restraining the stock's valuation-based progress. But in terms of developing a clear point of view regarding Apple (as investors must since there are only two choices: own the stock or don't own the stock and no room for waffling, as can be done in society at large), I left things hanging. Today, I want to finish up by resolving the seemingly conflicting signals and, hopefully, spotlighting the issues you should consider, and the decisions you should make, as you decide where you stand regarding this passion-inducing stock.

Actually, the messages given by P/E and price/sales are quite clear. We start with the notion that both metrics reflect Mr. Market's growth expectations. High numbers are consistent with expectations of strong growth. Low numbers suggest expectations of less attractive growth, and possibly shrinkage. The ratios, taken together, tell us Mr. Market forecasts continuing strong sales growth for Apple (i.e., the high price/sales ratio) combined with the potential for significantly less-attractive rates of EPS growth (i.e., the low P/E). This pair of expectations is not at all unusual or exotic. What we're seeing here is a set of assumptions to the effect that the company will continue to sell a ton of product but make less money on each item as time passes, or put another way, strong sales combined with narrowing margins.

Is this view reasonable?

One way margins can narrow is through rising costs. That's possible here, but given long-observed trends in technology, I doubt Mr. Market is worried about that. Another possibility would be diminishing volume that makes for less-efficient coverage of fixed costs. That, too, may happen, and I will put the volume issue on the table later on. But the magnitude of this concern is not likely to be such as to bring fixed-cost coverage to the forefront. I think I can reasonably suggest Mr. Market is concerned that Apple's margins will fall based on lower prices.

So Apple, in Mr. Market's view, is an early leader in new tech-oriented product categories that is likely to experience margin compression as we move forward. One Seeking Alpha author, responding to a suggestion I made in response to his article claiming Mr. Market doesn't appreciate Apple, attached the "nifty tech gizmos always get cheaper over time" label to this sort of thing, although he did acknowledge that this is usually sound and true. I agree. There's a ton of precedent to this effect and I expect pretty much everybody reading this, including those who are considerably younger than I am, have had occasion to personally experience it many times. But let's not just leave it at that.

Figure 1 shows gross margins for Apple and for comparative benchmarks.

Figure 1

Click to enlarge

One obvious point of comparison is the industry average which, according to the data provider I'm using (Thomson Reuters) is Computer Hardware. Apple, in its own 10-K, uses a similar industry grouping (as compiled by S&P) for the required share-performance comparison.

More debatable is the role of data relating to Amazon.com (NASDAQ:AMZN) and the industry in which Thomson Reuters classifies Amazon (Retail - Catalog and Mail Order). The latter two series are relevant because they, rather than hardware, are more appropriate bases of comparison for Apple's iTunes operation. Apple is clearly in this business, but it's small, a bit less than 6% of revenues for fiscal 2011 and has been growing more slowly than hardware. So in one sense, it would seem pretty easy to just ignore it, as Apple does in its share-performance comparison. But I find it hard to imagine how any iPad user can avoid being struck by the strategic importance to Apple of iTues, the Amazon-like operation and nerve center its iProducts. Digital retailing may not be statistically important for Apple today, but as long as management continues to design its products in such a way as to force iTunes into the picture, we have to assume the company wants it to be much bigger and, hence, ought to be at least aware of its likely margin characteristics.

Figure 2 offers a similar presentation for operating margin.

Figure 2

Click to enlarge

As to which is more important, that's in the eye of the beholder. Speaking for myself, I like to look at gross margin (sales minus cost of goods sold) because it provides, arguably, a clear view of the margin-performance of the day-to-day business as opposed to the corporate entity at large. And for many companies, this is, indeed, a good answer. But the real world can get quite messy and there's often room for opinion as to whether a particular company should classify an expense as cost of goods sold or selling, general and administrative (which is subtracted from gross profit in order to compute operating profit). It gets even messier given the way modern accounting departments tend to break the mold in terms of line items included in financial statements. Apple tends to be pretty classic in this regard, but many, in the interest of providing more detail, break the broad categories into sub-categories such as labor expense, technology expense, etc. etc. etc. and leave it to users to determine whether the individual line items relate to gross margin or just operating margin.

This increased granularity definitely makes life easier for a user looking at a single 10-K, but it makes life much, much harder for data providers like Thomson Reuters by requiring them to make more judgments regarding how to classify items that will be used to compute the standardized gross and operating margin figures investors need to make comparisons among many companies. For this reason, operating margin, although arguably less pure, may be a better basis for cross-company comparison because there's likely to be much less controversy regarding how particular expenses are categorized.

Of course all of this relates to the past. We and Mr. Market are ultimately concerned with Apple's future margins. But being human, we can't know them. So the best we can do is use the data we have, combined with common sense, historic precedent and observation, to come up with what we believe are reasonable assumptions.

The impact of the iProducts is evident from the way Apple's once-pedestrian margins have, lately, been running away from the hardware norms with the most recent period being its strongest. An increasing role for iTunes would seem likely to dampen that a bit, but I don't see that as being so intense as to detract from the main story: Apple's extreme and escalating hardware margins. This is at variance from the standard scenario for technology pricing and margins coming down over time, but it is understandable because of the way Apple's new product flow, whether large (iPod to iPhone to iPad), medium (iPod to iPod Touch etc.) or small (iPad to iPad2) has served to postpone the onset of the "over time" phenomenon.

Despite the so-far strong product flow, there's no way I'm going to presume Apple will be permanently exempt from the "nifty tech gizmos always get cheaper over time" phenomenon. This is common sense and basic economics. The number of people who will or can pay $499 and up for iPad2 is a heck of a lot less than the number who can or will pay $199. That's been the case for all other gizmos, even those that don't qualify as nifty. And usually, the pace at which companies drop prices to expand the market bears some relationship to the production learning curve, or in other words, the extent to which companies are able to do so while at the same time maintaining reasonable levels of profitability. And as is often the case with economic phenomenon, we don't stop at equilibrium but tend to run through it to a dysfunctional result on the other side, hence the reason why the traditional PC makers no longer want to actually make PCs.

Apple, however, presents an interesting variation on the basic theme. Looking at its margins, it seems reasonable to assume the company has room that prices are already well ahead of where they'd be based solely on general application of supply and demand. Apple seems more than able to drop prices right now (this is not about the cost of making better products; cost is already being subtracted to compute the margins), but appears to be choosing to maintain what economists might refer to as economic rent (hence the buildup of Apple's much-discussed cash hoard). We see this most often in monopolies, typically legal monopolies conferred by patents. There are, of course, many patents in this business and it is arguable that Apple has enough of this going on to support economic rent. This is a hot debate.

In terms of pure hardware, even a non-tekkie like me can see certain degrees of performance elegance approached closely but not precisely matched by even the strongest among its rivals. And Apple does seem to be working pretty hard to stay sufficiently ahead of the pack to justify stretching its economic rent as far into the future as it possibly can: In many respects, for example, some Droid phones seem more appealing; to me and my fat fingers, a bigger form factor is important, but just when it looks like rivals are really circling the wagons, Apple comes up with something like iPhone4S and Siri to make a fresh dash for first place at least for now. I'm not sure all the things that result in a judgment of superiority for Apple products are really needed to do what the products are supposed to do. Seriously, does anyone with family, friends or colleagues need to have conversations with Siri or irritate people near them by speaking routine cell phone commands? Of course not. But they WANT this stuff and when dealing with luxury branding, that's what it's all about. Think of it as akin to driving a Jaguar on New York City's Cross Bronx Expressway. Yes, it may be a bit better than driving the route in a Hyundai, but not that much. A lot of the day-to-day appeal of Jaguar is based on little more than simply wanting a Jaguar.

I think at this point, Apple has earned some benefit of the doubt in terms of the potential longevity of its stream of economic rent. It would be tenuous for any investor to plop money down based on an assumption it will last forever, but it would seem reasonable to assume Apple can keep it going longer than many others have.

A big wild card here is the absence of Steve Jobs, who does seem to have been something of a design savant. Presumably, new products that come out in 2012 will continue to reflect a lot of Jobs' influence. But by 2013, we will need to be looking more closely at what Apple introduces and re-examining this aspect of our economic-rent assumptions in light of the further diminution or absence of a Jobs connection.

Economic rent also can come from branding, even beyond product quality. Apple is unusual in the way it has brought that to technology, but it is not at all unusual in terms of luxury goods as a whole. A friend of my family, for example, is a fanatic collector (and occasional re-seller, via eBay) of high-end branded watches. I don't get it, not a bit. I think it's lunacy to pay $10,000 (and often much more) for any watch when, at the end of the day, all it can do is tell time and look good (both needs being eminently achievable for much less than $10,000). But that's me. There are lots of people out there who are pretty intense in their quest for these luxury watches. You can replicate this in many other ways at any high-end mall, or pretty-much any boutique on Worth Avenue in Palm Beach. Normal women, for example, don't pay thousands of dollars for handbags. But there are brands that motivate affluent women to really ante up. Like the watches, go figure.

It looks like the Apple brand has brought some of this from the world of fashion to the world of consumer technology. Some may argue against this and try to justify all the pricing in terms of actual features. But I've known many Mac owners who openly acknowledge that when push comes to shove, they really are paying more per unit of performance than PC owners (they're loving it, but paying for it). I have no idea how far this can continue to go. Nobody does since this hasn't been typical of the normally-functional tech area. We can presume it will stretch beyond Worth Avenue (forking over the price of an iPad bites, but not nearly as much as for a designer handbag or a luxury watch). The luxury gadget market is, sort of, being invented as we go along, so we'll know how big it is as soon as it stops growing. (It's like a great line from the 1970s movie Oh God! where a mortal asks god if he can predict the future. The answer: "Yes, I can predict the future - as soon as it becomes the past.")

Another unknown is, again, the passing of Steve Jobs. When we're dealing with luxury branding, the personal touch counts. I think it's analogous to art. Many people would pay a heck of a lot more for a paint splattered canvas by Jackson Pollack than a similar (maybe even a more aesthetically pleasing) one executed by Marc Gerstein (don't scoff; I did time at the Art Students League of New York). Will people a couple of years down the road be as willing to pay for branded gadgets, even Apple branded gadgets, that have no connection whatsoever to Steve Jobs? Who knows? Only time will tell.

Finally, here's the key margin issue. I think it's reasonable to assume Apple can maintain, or perhaps even enhance, outsized margins and economic rent in the short term, and perhaps even in the intermediate term if the company can continue to introduce genuinely better products and if the value of the brand can be pinned (transferred if need be, in the hearts and minds of consumers) from Steve Jobs to Apple. And given the way organizations with great engineering talent can attract and retain great engineers, and given the persistence of luxury branding, I'm not prepared to dismiss the possibility that this can stretch beyond the short term. So in this sense, it might be reasonable to argue for some sort of narrowing of the dichotomy between high price/sales and low P/E.

But there's a catch.

The rhetoric I've been using to justify the persistence of Apple's margins and its economic rent has been couched in terms of luxury. That's fine. It's real. It's substantial. But it's also something else: Low volume.

Yes, there are people who happily pay $10,000 and up for extremely high-quality well-branded watches. But there aren't many compared to the number who won't pay much more than $100, if even that, for something that tells time. The lifestyles of the rich and famous, and even the less rich and wish-they-were-famous, provide lots of precedent from which one might draw some general consumer-goods assumptions regarding numbers. But the mix between this sort of thing and technology is unprecedented so I wouldn't trust any answer except a shrug of the shoulders and an answer along the lines of "I'll predict the future - as soon as it happens."

Obviously, the demand for premium-priced Apple products can be much greater than demand for $100,000 watches or Jaguars given that the cost of entry is so much lower. But we don't know when we'll hit the wall here. The larger our assumption regarding the size of the luxury-Apple buyer market, the more readily we can think in terms of a higher price/sales and P/E for the stock. On the other hand, the high price/sales is something we have to watch because if the size of the luxury-apple buyer disappoints, that ratio can make for some ugly share price action.

There are a couple of other issues here.

One is cost progress. It seems reasonable to assume Apple, along with tech firms everywhere and at all times, will come down the learning curve in terms of cost. We know from the economic rents the company is earning it could cut prices right now. Perhaps as costs come down, it may seize upon opportunities to cut prices a bit (to expand the number of luxury buyers) while simultaneously preserving economic rents.

Another issue is iTunes. As great as Apple's hardware is, I have to confess I see iTunes as a horrendous negative, one that has been buried under the Jobs mystique but which may become more of an issue as the distance between Apple and Jobs grows. It's not so much a matter of being tied to a single platform. Amazon.com does that, too and consumers seem fine with it. It's a matter of being tied to a clunky badly-designed platform, so bad I'm not even sure I can consider buying an iPhone to replace my Blackberry because of the potential hassles of trying to register a third device to an iTunes account: When I started with my second device, iPad, iTunes would not allow me to input my user name because the it was already being used by somebody (iTunes had no way of learning that person using that name was me - for my prior iPod purchase).

And just this morning, having put an Audible book onto my iPod, I was reminded for the umpteenth time how clunky the process can be if you don't do exactly what Apple's developers thought you'd be doing, not to mention the idiocy I have to go every time I want to move a newly installed app from my iPad desktop to one of the iPad folders I set up or delete an app. The iTunes mess is quite consistent with the savant label I put on Apple-per-Jobs; extreme brilliance in one particular area paired with sub par functioning elsewhere.

It'll be interesting to see how Apple handles this as the post-Jobs era unfolds, whether it finds it may have to jettison or modify the iTunes lock down in order to preserve a continuing hardware-based stream of economic rent. (There are security issues that would have to be addressed, but another often-cited issue, quality control, is a complete fabrication, as is well known to any iPad user who continually sees the stream of app updates with "Bug fixes" being the most-frequently cited reason, not to mention the many one-star iTunes app reviews complaining of once functional apps that encountered new problems after installation of updates.)

The potentially bad news here is that the there are some serious negatives that have been cloaked by the Jobs mystique (unlike the $10,000 watches, which for better or worse, are pretty much what they seem to be); in the absence of Jobs may come more into focus. The good news is that these negatives can easily be fixed or eliminated if Apple decides it has room to moderate some of the least appealing of its savant traits without dampening its luxury appeal.

And even though I started by citing margin concerns as a reason for Apple's low P/E, anyone discussing any aspect of valuation has to address the company's pile of cash (including long-term marketable securities), which is now about $104 per share. On paper, it would seem plausible to simply reduce the share price by that amount and recompute the valuation metrics, a process that would change the numbers in a substantial way and probably make Apple as compelling a Buy as any that are out there.

But we have to be careful about such an exercise, which often reflects investment community fantasies rather than business realities. It's easy to imagine Apple instituting a dividend policy at some point and/or buying back some shares. But we have to remember that technology evolves and new competition always surfaces. While I have written elsewhere on Seeking Alpha expressing a favorable view of companies that pay dividends, Apple doesn't really fit that mold. This looks to be a company that at least for the foreseeable future can do far better reinvesting in the business than sending the cash back into the financial market.

Reinvestment isn't occurring all at once (hence the cash buildup), but I've been around long enough to have seen more times than I can count the benefit of building for a rainy day. As noted, we don't know how much of Apple's economic rent comes from the Steve Jobs mystique versus the objective merits of the products, but we do know that at some point in time, the Jobs factor will be eliminated from the products, meaning Apple will have to pin its hopes on the products themselves. Given that, and an uncertain environment (will one or more rivals come up with serious "wow!" products? Will Apple bump up against the upper limit of luxury buyers sooner rather than later and have to bring "wow!" to lower price points?), I strongly disagree with many who write ad nauseam about how the company should spend its cash. Apple's recent acquisition of Anobit, the small Israeli firm that makes the NAND chips that are so important to its products, may be as wise a use of the cash as anything anybody else has concocted. But if we must dream, at least let's dream big, and perhaps suggest Apple use its cash to support a bid to acquire Amazon.com (and thus merge the premier content hardware firm with the premier content distribution firm) and pay for the antitrust lawyers to do their thing.

So what's the bottom line? Is Apple a Buy?

There are many on Seeking Alpha who expect me to say "No way!" Actually, I have written favorably about Apple stock elsewhere in the past, when its stock was a lot lower than today (pat, pat). But rather than worship the company, I've always tried as best I can to take the sort of balanced view, pro and con, as I do with any other stock. But the savageness often seen in Seeking Alpha comments responding to anything less than worship is, actually, is an example of something I discussed above; the sort of purely-emotional passion that makes for luxury branding, whether it be for a Jaguar, a $100,000 watch, a $499-plus iPad or a Siri-equipped iPhone 4s.

Apple "fanboys" definitely are a bizarre group (so, too, is my watch loving friend), and I use the label unapologetically because that really is the best way to describe so much of what is seen (including the whackos who camp out over night in front of an Apple store to be among the first to get their hands on a product they could easily buy a few hours or days at most later many other places) and more importantly, because the "fanboy" phenomenon is an important aspect of an investment case for the stock. Assuming a reasonable number of the "fanboys" are buying products and will continue to do so and as long as they continue to evangelize so passionately and occasionally succeed in persuading, that would facilitate Apple's ability to maintain its economic rents and, hence, its margins.

I think there are enough questions about the post-Jobs sustainability of the brand and the hardware pre-eminence (we really have to see what Apple's tekkies come out with after they've exhausted all the notes left behind by Mr. Jobs) to prevent me from suggesting Apple is a screaming Buy or a no-brainer. And this is not the sort of stock into which I typically put real money (one where quant work has to be pretty-much cast aside and decisions made on forecasting broad trends), although I do occasionally dabble with "fun money." But for those who are into playing trends, Apple seems a much more viable growth story than many others out there based on a passionate customer base that supports the luxury brand, the financial resources to push costs-prices down in the future (and drive more volume than what the typical luxury brand can usually expect) as well as to at least preserve some measure of hardware prowess, and the company's ability to fix its biggest negative (iTunes) if it buys into the need to so do, which is pretty significant since a lot of companies are weighed down by negatives they can't readily fix.

This is not a value play: I don't really think there's much room for the price/sales to move or stay sustainably higher and the P/E needs to stay low to accommodate the usual risks inherent in margin and profit levels that reflect so much in the way of emotion-based economic rent. But the metrics seems to be such as to allow the stock to move if the company continues to grow. In other words, this is a classic growth story: Don't look for rising valuation ratios; assume they'll stay more or less stable and look instead for growing sales and EPS.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.