Apple's Valuation Is Looking Attractive Again

The recent drop in shares of Apple (AAPL) has probably been more pronounced than most expected. It's true, the stock was very expensive at its all-time high of more than $200 per share (40 times forward earnings), but the catalyst for the sharp $80 per share drop we have seen recently was the company's extremely conservative guidance for the current quarter.

Apple always sandbags quarterly guidance, so this did not come as a surprise, but evidently investors were hoping they would have been a little less cautious. However, in this day and age, when quarterly guidance is given simply to help out Wall Street analysts, under-promising is the only way to go. This is true even more right now, as the economic climate is highly uncertain.

Despite all the reasons to be worried, the fundamental story behind Apple is still strong. The company is gaining market share in desktops, notebooks, and cell phones, and is holding their lead in music players. The company will not be immune to a consumer led slowdown, but market share gains will allow them to hold up better than the competition. Given that, and the likelihood that Apple will earn well north of $5 per share during calendar 2008 (current consensus estimates stand at $5.27), the current share price of $119 looks very attractive if investors are willing to wait out the uncertainty in the economy.

Not only does Apple stock trade at only 22.6 times this year's expected earnings, which will likely prove conservative as usual, but the company has quietly been building up a gigantic pile of cash. Apple hasn't been buying back shares aggressively or making large acquisitions, so cash reserves are rising at a staggering clip. Shown below are the company's cash balances as of the end of the last four fiscal years, as well as the last quarter. And keep in mind Apple has no debt whatsoever on its balance sheet.

Apple Cash Balances ( in millions of USD):

Sept 2004: $5.46 billion

Sept 2005: $8.26 billion

Sept 2006: $10.11 billion

Sept 2007: $15.39 billion

Dec 2007: $18.45 billion

Apple currently has $21 per share in cash, with no debt, yet another reason to be attracted to the current stock price after a drop of more than $80 from its high. Steve Jobs has been hesitant to part with his cash in recent years (the company had liquidity issues years ago before the iPod came along), but eventually he will accumulate so much that he will be forced to do something with all of it. Large acquisitions are a less likely option, but a huge stock buyback or one-time dividend would certainly excite investors.

Full Disclosure: Long shares of Apple at the time of writing.

Comments

[SSROSS]

not only are they piling on the cash but they are also piling on the deferred revenues, currently over 3 billion, much of which will go to income over the next 8 quarters.

[Brewer]

Good point ssrosss. Everyone seems to be bagging Apple for 'lost' revenue on unlocked phones. But none of their 'competitors' in the phone business get ANY revenue from the network operators. And the unlocked phones demonstrate incredible demand.

[Daniel Agramonte]

Chad interesting analysis. If you're interested in a different perspective, feel free to check my recent posting on seekingalpha.com. While it's definitely drawn the ire of Apple fanatics, my analysis leads me to believe AAPL is priced at or somewhat above its intrinsic value (focused strictly at earnings). I'm basing this on: (1) it will be extremely for AAPL to grow earnings at 20% annually for the next 10 years, and (2) AAPL's on a major product development treadmill.

To elaborate on the first point, all one has to do is look at AAPL's financials for the last 10 years. Revenue is up at about 20% annually ($5.9B in 1998, $24B in 2007). Earnings, however, have increased by 30% annually. This is phenomenal. The difference? Growing margins. In 1998, margins were about 5%. In 2007? 15%. Again, this is phenomenal. AAPL is focusing on high-margin businesses (iTunes, videos, etc.) by reinventing themselves (they even changed their name last year) and 'value pricing' their products. Can it go on? Well, that gets me to the 2nd point.

AAPL is on an innovation treadmill. The cash it's sitting on is actually an insurance policy (a hedge of sorts, if you will) in case they make a bad bet. An analogy? MSFT and the XBox. How much have they plowed into the XBox? Has it paid off? The jury is still out. The interesting part is that AAPL has to plow the earth to retain their prime mover status which is why they enjoy the fat margins. This means they will have to continue to push the envelope, which inevitably means they will roll the dice. Eventually, they'll come up snake eyes (are you old enough to remember Betamax?).

For AAPL, my sense is 20% earnings growth for 10 years--which is still great. At that rate, intrinsic value is about $90/share. You pile on the cash and deferred revenues (which I would still argue is nothing more than an insurance policy against taking on long term debt), and you might get to close to what the stock is trading for. Is it a bargain? At best it's priced at fair value with a ton of execution risk.

[sf94127h]

Big money has been ignoring AAPL, waiting for it to come down to an attractive price and I believe that point has arrived. Lots of momentum going forward unless we go into a deep recession, which is unlikely since the Fed is finally helping, stimulus package passed, and lets not forget AAPL sells a lot overseas.

[jonreagan]

Last point seems to be the most relevant: whether the fundamentals are good, bad, or indifferent, the big institutional investors have bailed--and who knows when they'll come back? When the stock tanked after MacWorld, we were told that this was a buying opportunity....and then after the earnings disappointment on 1/22, same thing. And so on... I know one guy who's been buying shares all the way from 202 down to 120; sometimes he's in tears when I see him.

In an irrational market, perhaps the toughest thing for traders and investors alike is in deciding what constitutes "value". I've been told to go after "bargains" on the dips...damned if I know what they are anymore.

[BlahBlah]

There's a real calculation for what the value of a stock should be based on it's growth rate and free cash flow. I use a spreadsheet that Joe Ponzio was kind enough to provide.

With a momentum stock like AAPL though, I would follow the charts and would have clearly stopped out around 160. There's absolutely no reason to buy here until it either starts basing or produces a new uptrend. I never fail to be amazed at people who buy a stock like AAPL at 200 based on fundamentals(?) and keep buying more down the 'slope of hope'.

[jcrash]

$6 earnings easily this year. P/E is thus 20. Plus it has $20 per share cash and will generate another $10 per share this year. If you look at the deferred earnings from the iphone, already at $250 million recognized in the latest quarter, given that they defer over 24 months, you can say that by the end of 2008, they will be recognizing some $600 million per quarter for the iphone and TV thing. That's 2.4 billion a year, or $40 billion in market cap that is attributable directly to the phone and TV thing.

Finally, you have to realize that the stock WILL gain favor again and when it does it will go to some high P/E value, at least for a while. might be 2008, might be 2009, but it will happen.
Growing at 40% with a P/E of 20? Yeah, I'll sign up for that.

[RKT]

Good analysis. Determining reasonable valuation is always difficult. One of the issues is that Apple is definitely a momentum stock, and unfortunately we have a lot of negative momentum right now.

I believe that what's sometimes missed is seeing the forest from the trees. The month-to-month and quarter-to-quarter sales numbers for macs, iphones, and ipods are going to vary, and will definitely be impacted by the consumer recession.

However, where will the company be in two, three, of five years?

If you want to invest in Apple, you have to believe, as some do, that Apple is on the leading edge of the digital consumer electronics industry. Apple has its hands in many of the major categories of electronics: computers, cell phones, music, and video. These are all large and profitable markets. Apple also has a significant advantage with sophisticated software technology, that few companies can match.

To believe that Apple will not succeed in these areas does not seem to be reasonable. To believe that these industries will not grow significantly in the upcoming years also seems unlikely to me.

I suspect that the long-term investors in this stock will be rewarded, as long as they can tolerate the inevitable hiccups along the way.