By Mark Bern, CPA CFA
I only own a relative small number of shares of Apple (AAPL) for two reasons: share price (asset allocation) and the fact that the company only recently began paying a dividend (it was the only stock I owned that did not pay a dividend previously). I don't know if the company will ever split the stock, but hope that they will. That's not part of the vision just a personal preference.
Let me begin by laying out a few facts before I get all futuristic on you. The source for all my data comes from the annual 10Ks filed by Apple with the SEC. The two I used can be found here and here. Over the last three years Apple sales have increased by an average of 43 percent per year. In 2011, Apple sales growth was 63 percent. That is called acceleration and is quite an incredible feat for a company of this size. And that is just one more record that Apple can hang on the wall (actually two), since no other company of this size has ever posted growth of such magnitude. That is the case, not only because such growth hasn't happened but because there has never been a company this large (by market capitalization) before that I am aware of. There are only five companies to my knowledge that have surpassed the $500 billion dollar market capitalization milestone before Apple: Microsoft (MSFT) (Dec 1999, $604B), Cisco (CSCO) (Mar 2000, $538B), General Electric (GE) (Aug 2000, $581B), Intel (INTC) (Aug 2000, $503B) and Exxon Mobil (XOM) (Jul 2009, $514B). I read a report somewhere that Cisco actually reached a market capitalization of about $700 billion in 2000, but was unable to confirm it as factual. The growth rate for Cisco earnings in its peak year was 39.5 percent and its best 1 year growth rate came in 1997 over 1996 at 53.5 percent. Microsoft's best year for earnings growth while near its peak was 1999 at 55.7 percent. Exxon Mobil hit 38 percent growth rate in 2005, its best during it race to $500 billion in Market Cap. Intel reached a best of 32.8 percent growth in its earnings in 1997 while GE had only 20.6 percent as its best rate near its top during 2000. I had to calculate the percentages from the earnings reported in the 10Ks available at SEC Online. Notice that only Microsoft and GE hit their peaks in earnings growth during the years that their market caps hit their respective peaks above $500 billion.
Intel, Cicso and Microsoft were all aided by the tech boom (balloon) that burst in 2000. GE built its house of cards upon a financial foundation that turned to sand. Exxon Mobil was the beneficiary of the approaching peak oil and the effects of Hurricane Katrina that wreaked havoc with the energy sector prices, spiking oil prices to $147 per barrel that year. None of these companies was really in control of its destiny. They al did the best with the cards that they were dealt. But when external forces changed, each saw its earnings growth and market caps slump. Apple seems to be creating its own destiny and its own future. The external benefit that it is enjoying seems to be consumer acceptance and adoption of its products at an ever-increasing rate. Apple, I would have to argue, has more control over its future earnings than did any of it peers of the past.
Now let's talk about earnings. Over the past five years Apple has increased EPS at an average compounded annual rate of 65 percent. Over that period the stock price has increased at an average compounded annual rate (total return before the dividend) of 24.8 percent. The price/earnings ratio (P/E) has dropped from an average of about 29 to less than 14 today. Strange that as growth increased the multiple investors have been willing to pay has fallen so precipitously, isn't it? One must assume then that there is a significant fear that the growth cycle must stop sometime soon. But when we look at the most recent quarterly results we find the opposite is true. The street consensus view called for earnings of $10.04 per share while the actual EPS grew to $12.30. Last year's second quarter EPS were $6.40, which means that EPS grew at a staggering rate of 92 percent year-over-year (yoy). Again, it appears that not only is the growth rate extremely high but the rate itself is also accelerating. That is phenomenal and bordering on the unbelievable! My theory on why the P/E continues to contract as earnings keep growing at an accelerating rate is that investors just can't wrap their finite brains around the infinite possibilities. And that is where I intend to provide a little more illumination.
But first, I have a confession. I am not a lover of Apple products. I use a PC-based laptop and an android phone. I have never been to iTunes or the Apple App Store even though my children (ages 16 and 19) have. The only Apple product that resides in our house is a one-year-old MacBook Pro that is owned by my 95 year-old mother-in-law, (if you're really interested ask me about it in the comments section) but that is another story altogether. So, I'm not coming at this from the point of view that everyone has to own Apple gear because I do and because it does everything better. I am simply looking at this from the point of view of an analyst who wants to make sense out of the numbers and who can project a limited number of possibilities into the future. However, if what I imagine comes true I'll have to become an Apple user, too.
One final note about the recent quarterly report that I believe is relevant to future growth prospects. The sales of iPhones increased by 88 percent yoy compared to the same quarter last year primarily due to huge increases in sales in China. Remember that the potential of consumption in China just a few years from now will overtake the U.S., Europe and Japan as the largest marketplace in the world and its growth will likely continue for a couple of decades until consumption in China dwarf's that of the U.S. Then, of course, there are Brazil, India, Russia, and South Africa. And there will be other developing nations to include in coming years like Indonesia and other nations located in Asia and the Pacific, or Eastern Europe, the Middle East, Africa and Latin America. The world's middle (consuming) class is exploding and the breadth of the movement will inevitably grow. There will fits and starts along the way; there will be stumbles and chaos; it will slow to a crawl at times, perhaps, but the movement will not die out completely. The more evidence that the possibilities and results can be achieved in places that were not supposed to be able to make it work, the more others will believe that they can have the dream (or at least a downsized version) for their own and the people will demand it from their leaders. But even without that, there are vast possibilities that I believe investors are not expecting or including in their projections. Let's take a look at what I see in the not-too-distant future for Apple.
First, as more and more professionals purchase iPhones and iPads and demand to be allowed to use them for work instead of the PC-based options provided by their employers, more companies will make one of two changes: 1) some large companies may support both PC-based and Apple hardware/software or 2) some small and medium companies will switch to support only Apple hardware/software for a variety of reasons, and in some cases, to keep key personnel happy. Even some large companies may decide to make the switch at some point. This could lead to Apple gaining share in the hardware and software business for commercial business uses. The company could even make a foray into the consulting end of the business if they want, but will probably do so through partnerships that add almost no cost but tend to increase sales of core products. Even some local governments are adopting iPads and iPhones according to a government mobile case study. All in all the business and government represent a huge market with the potential to nearly double sales and profitability for Apple over the next decade if they can master enough of the landscape through strategic acquisitions, partnering and integration. How does it double sales? Just think in terms of the math and how the company has progressed thus far. Apple now controls about 25 percent of the overall total market for computers (if iPads are included), most of which are in homes, and an even smaller market share of the business and government market. In 2000, I read a study as part of my work that I cannot find now that showed Apple with only a seven percent share of the computer market. The company has grown from seven percent to 25 in just 12 years. But Apple has only scratched the surface of market share in the business and government sectors. Adding growth in the those sector could help Apple continue on its path to dominating the computer business. And the continued growth in emerging markets means that the whole pie (overall market for computers) will continue to grow. So, Apple doesn't have to double its market share in order to double its sales. It just needs to continue to increase its share in a growing market. Apple management know this is making a push in that direction for iPads and the iPhone.
Second, even if Apple doesn't make large inroads into the commercial business area, the home is their sweet spot and contains ample growth potential, both here and abroad. We just need to think beyond the current lineup of products and make the leap to the next logical extension: the Apple TV. And then we need to think in terms of what the Apple TV will do in the future. What the addition of the Apple TV could achieve, in terms of growth potential and adoption rates, is far beyond what has been achieved thus far. It will boggle the imagination (and obviously already has based upon the valuation of future growth via the stock price). This is where the investor has been unable to let loose his/her imagination. Microsoft wants to enable the smart house with an open system, but we all know that there will likely be many iterations of applications before everything integrates and works seamlessly and many players vying for a share in that market. Remember what the tech department always asked when we called about a problem with a pc? "Have you tried shutting down and then powering back up first?" With the Apple proprietary system everything is more likely to work seamlessly from the start. Think about the potential this next step has to change the way each of us (every single last one of us and all the consumers in the world) views home entertainment. Okay, let me help you with that vision.
When you buy an Apple TV in the future you'll be able to stream video via your iPad wirelessly from anywhere in the house directly to one or more Apple TVs, controlling what everyone is watching either through the iPad or remotely with a hand-held Apple remote (or perhaps voice activated controls) that sends signals only to the Apple TV in the room. The parent with the iPad will be able to continue their work on the Internet or other software on the iPad while this is happening and will be able to also monitor what everyone is watching; the ultimate parent control system for child viewing. At the same time, there will no longer be stoppages in the streaming due to slow loading, but this will only be available if you use proprietary Apple products and software for your entertainment system and use the Apple Media Store for all your viewing choices. Apple won't build everything itself. Actually, Apple won't build any of it. Any electronics or software company on the planet that wants to get on and ride the train to the fastest selling products in the world will simple have to pay Apple a huge royalty, meet Apple specifications in design, put Apple's name on their products, and ship the finished products to markets as determined by Apple according to sales demand and global inventories monitored by Apple from its bagel-shaped world headquarters in Cupertino.
I know that sounds a little far-fetched. Reality may fall short of that vision, but anywhere between where we are and that vision still means almost unimaginable growth for Apple. And that's the key, isn't it? It's unimaginable. If we can't imagine it, we can't believe it. If we can't believe it, we can't value what we don't believe. That has been the problem with Apple's valuation up to this point and will probably continue to be the problem for much longer. When will the veil be lifted from investors' eyes? I predict that when the Apple TV comes out and can do all the things that I imagine it can in harmony with other Apple devices, investors will realize that Apple has the potential to be king of the hill in not just cell phones and music downloads or even mobile computing. It has the potential to play a dominant role in movies and commercial television programming/distribution (think competition for cable, Netflix and satellite TV), radio/music distribution (think analog radio and satellite radio), television manufacturing and distribution (think of growing toward 50 percent or more of all new flat screens coming with the Apple logo someday), electronics retailing (the Apple Stores will expand product lines to include the entire spectrum of home entertainment, mobile communications, mobile computing, home computing and more), sound systems to work with Apple products to enhance the entertainment experience, and more again.
Third, I believe that Apple will eventually get into the gaming arena with something that will knock our socks off. The company may not even be working on such a concept yet, but it is just one more logical extension that enables Apple to control the home entertainment environment. Why let someone else play in your pool if they have their own pool and compete with you for friends or customers? Why would Apple want other gaming consoles to work well with the Apple TV? Why wouldn't the iGames console provide better graphics and more game options through seamless integration with other Apple tools and products, both online and on DVDs? Or will Apple merely skip the console and go directly to the online gaming arena? There isn't room for Apple in this space unless it decides to take it over. But, then again, it is part of the entertainment environment that Apple wants to own and it may just decide to dominate the area through acquisition so that it can have all the bases covered, giving Apple users a complete Apple-based entertainment system that is guaranteed to all work perfectly together.
The Apple TV is so critical to the vision because it is the central nexus to the home entertainment environment. Everything needs to work through/with the Apple TV and the iPad. It can be used as an enlarged computer monitor, for telecommuting meetings, home-schooling (classes being taught from a centralized location reducing (not eliminating) the need for buses and reducing the cost of educating our children while improving the level of teaching in every school with team-based teaching, revolutionizing education for the world), and for entertainment as well. You'll be able to play home movies on the Apple TV using your iPad which you previously used to record the movies. You'll be able to upload movies and pictures from your iPhone to your iPad to be viewed, all wirelessly, on your Apple TV. Of course there will be much more that you can do with your new, shiny Apple TV, but I just thought I'd throw in a few ideas to get your mind started down the path of imagination. I threw in the education concept as just one idea that could, if implemented properly, become a world-changing benefit that could also spur additional sales both in the U.S. and internationally. There are many others that come to mind (at least my mind) when I let it wander a bit. Try it. It's invigorating!
Everyone who buys an Apple TV will also need an iPad. Everyone who owns an iPad will want an iPhone. Every one of those users will use the Apple App Store to download new applications to make life more convenient or fun, will also use the Apple Media Store to get TV episodes and movies, will use the iRadio Store to listen to their favorite radio programming, and will use iTunes to download their favorite music. They will probably go to the iGames Store to play online gaming or buy/download the latest games that are not massively multi-player online games.
My point in all of this is that Apple may just be getting started on the road to a future of growth and profitability that today's investors cannot imagine yet. Buy AAPL now while it is still more than 13 percent off its recent high. You ain't seen nothin' yet!
Watch for Part 2 with the valuation projections.
Disclosure: I am long AAPL.