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Why are we so excited?

My recent analysis comparing Apple Inc. (NASDAQ:AAPL) to a microcap stock, Air T, Inc. (NASDAQ:AIRT), has definitely drawn the ire of Apple fanatics because the analysis leads me to believe AAPL is priced at or somewhat above its intrinsic value. In saying this, I’m focusing strictly on earnings and basing this on: (1) it will be extremely challenging for AAPL to grow earnings at 20% annually for the next 10 years, and (2) AAPL's on a major product development treadmill. In that analysis, I focused strictly on quantitative considerations. In this post I’m going to look at some of the more qualitative aspects of Apple’s business.

Cause and effect

Let’s elaborate on the first point above by looking at AAPL's financials. As we do this, keep in mind that the need for growth is why Apple is on the innovation treadmill. During the last 10 years, Apple’s revenue has increased at a rate of about 20% annually (from $5.9B in 1998 to $24B in 2007). Net income has increased much faster—at a rate of 30% annually (from $309 million in 1998 to $3.5B in 2007). This is phenomenal. The difference? Growing margins. In 1998, Apple Computer was strictly a computer company—making computers and, for the most part, the software as well. Their market share was in the low single-digits and their margins were about 5%. In 2007? Margins are running at about 15%. Again, this is phenomenal. To increase margins, Apple Inc. is focusing on high-margin businesses (iTunes, videos, etc.). In short, they had to reinvent their business, and the reinvention runs deep: They even changed their name last year, to reflect their expansion beyond the computer business.

In the meantime, Apple has wisely focused on value pricing their products—getting top dollar for products that appeal to the under 30 segment (and those of us who wish they were under 30) based on visual appeal and perceived innovation. They have used the halo effect from their music player/music distribution franchise to launch phones and reinvigorate their computer products. Can it go on? That gets me to the 2nd point.

Cash is king—for two reasons

AAPL is on an innovation treadmill. The cash it's sitting on serves two purposes. First, it provides an insurance policy (a hedge of sorts, if you will) in case they make a bad bet. Second, the cash might come in handy in case Apple has to make a major acquisition. Let’s look at the insurance policy part with an analogy: MSFT and the XBox. How much has Microsoft (NASDAQ:MSFT) plowed into the XBox? Has it paid off? The jury is still out. At some point they will obtain the return they seek or they will exit the business, possibly selling it off. Regardless, Microsoft placed their bet and it may or may not pay off.

In a similar way, Apple has made some good bets recently. To continue on their trajectory, Apple has to plow the earth to retain their prime mover status. In other words, to retain their fat margins, Apple must continue to take risks and innovate, continuing to push the envelope. In the eyes of consumers, as they expand their space beyond computers, Apple will have to use its brand (its promise to its customers) as collateral. They will have to increasingly risk their name to grow their business (remember the “New Coke”?). There is a high likelihood that Apple will eventually get in over their heads and the odds will catch up with them. In other words, Apple will eventually come up snake eyes—does anyone remember Betamax? How about the Newton? The Corvair? Polaroid? Their cash helps them fund these types of ventures, especially the ones that don’t pan out.

Getting back to Apple’s results, my sense is that 20% earnings growth for the next 10 years would be remarkable. At that rate, I’m estimating the intrinsic value at about $90/share (see my prior post). If you really want to, you can pile on the cash and deferred revenues and you might get about $20 to $25/share which puts you closer to where the stock is currently trading. Is it a bargain? At best I think it's priced at fair value with a ton of execution risk.

Name your poison

Looking at it pragmatically, Apple is priced roughly 20% above its intrinsic value because the cash should be kept on hand to continue funding growth. Why? At some point, they will be large enough that 20% growth in revenue won’t come easy (in fact, they may already be there) and Apple will have to make a major acquisition. Funding options will include: (1) issuing more stock (potentially diluting the value of their stock), (2) paying with cash, or (3) assuming debt. This is why the roughly $20/share of cash/deferred revenues on AAPL’s books will likely be gobbled up by the growth treadmill. In short, Apple is (rightly) holding on to cash to fuel further growth, but I wouldn’t get too excited about this. It’s not as if they have a choice. Without growth, their stock would quickly tank.

What’s a value investor to do?

As Apple’s products (iPods, computers, phones) mature, the company will have to enter new markets. We have already seen some cracks in the foundation (we don’t know yet if they’re structural or cosmetic). For example, Apple has found it much harder to incorporate movies than music into their iTunes platform. In fact, iTunes has become “the establishment” that it once competed against. Others are now challenging this distribution model, and the availability of free music is continuing to grow.

How will Apple continue to grow? They will have to figure this out. Their business will become more complex and scaling it successfully will be a challenge. Meanwhile, the value of the company is what it is. At times, Mr. Market will undoubtedly become exuberant and overestimate the value, especially after favorable ‘analyst reports’. Conversely, Mr. Market may also become pessimistic and underestimate the value, creating a bargain. One thing is for sure: without continued growth in earnings, which will get increasingly harder and riskier as Apple expands beyond its core (no pun intended), the value of the enterprise will drop.

Disclosure: The author is long AAPL, AIRT, 6 iPods and 4 Macs

Source: Apple: On an Innovation Treadmill