Apple: On an Innovation Treadmill 19 comments
-
Font Size:
-
Print
- TweetThis
Why are we so excited?
My recent analysis comparing Apple Inc. (AAPL) to a microcap stock, Air T, Inc. (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 (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
Related Articles
|
Find People on SA
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largest
increase in followers
in the last 7 days-
1
David Fry
-
2
Philip Davis
-
3
Bill Gross
-
4
Tyler Durden
-
5
TraderMark
Fastest Climbers » -
1
-
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most activeSee all
Instabloggers.
Top Instabloggers » -
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
This article has 19 comments:
Apple can easily continue to grow at 20% over the next 10 years. In fact, Apple's growth rate is INCREASING.
Your comments and concerns about growth are quite valid. However, you have the wrong company. You confused Microsoft and GE, mature companies, with Apple
I'm not saying you don't have good points, and I haven't drunk the Kool-Aid (yet :)). I'm just wary of situations like this, where prior performance is NOT, in my view, indicative of future profits.
It's obvious you understand little about the business when you refer to iTunes and Videos as "high margin". Apple has to pay out most of the revenues from that to the content creators and they have said they run iTunes at just above break-even. It's simply a conduit to get consumers to buy more hardware.
I still do not fathom how liking a product and buying their stock are the same thing. Being in love with a stock only clouds your judgement, thinking it's so wonderful that it will grow quickly forever when in fact it's just a company , like all other companies and it's sole purpose is to make money.
Come to think of it, when I buy a stock my sole purpose is to make money too.
Ok, yes I am def an apple fan, but I would also like to think I bought the stock because they, along w/ google will continue to eat Microsoft. Not just because I think the hardware is better.
( remember whose on both company's board of directors )
"Hence the entire foundation of a company is hinging on a single individual who has an aversion towards building an ecosystem around Apple products. You have to compare this strategy against Microsoft which has built a strong channel partnership and ecosystem around Windows software"
Sorry, dead wrong here. Jobs does control apple very tightly, but they are also fairly strategic with Google for obvious reasons. Steve Jobs has all but said at various macworlds that, yes, he too ( like any good CEO ) wants Apple to dominate every piece of technology you own.
If you need any evidence, just ask yourself why Apple moved to Intel Chips and all but encourages its users to run windows along with Leopard, and really doesn't care how many times you install their operating system.
Have you seen/used the new features in Leopard ? They are alot of things that are potentially very damaging to MCRST control of the business space and all but killing the need for your local networking IT man, because I hate to break it to you, but you aren't needed if the software always works and remains very simple to use. No more frustrated fun calls from the secretary.
Jobs hasn't been loud about it yet, but remember we are only talking about OSX 10.5 here, not 11.0.
What do you think all of the one-click screen/file sharing features are for ? Graphic designers and hipsters ? I don't think so. Once small business find out how easy apple makes networking they will be wondering why they ever used windows in the first place. Do you not think this will propagate into bigger and bigger businesses as more and more people use apple computers?
But, besides this , the reason you are dead wrong is that Microsoft got where it was because THEIR strategy hinged on a single individual named Bill Gates and he was very good and they made alot of money.
Now he is gone and Mr. Ballmer seems determined to run the company into the ground.
It's pretty clear he has no idea what to do, all he knows is that Microsoft is going to be the industry's " first n-trick pony " , well that sounds nice and profitable, but I am pretty sure you have to fight an n-front war to do that.
Is the X-box 360 beating Nintendo ? ( the first X-box was a loss-leader...) How is the Zune doing ? Is Microsoft gaining any ground against Google ? They can't even buy a small dying search engine - Yahoo. Do I need to mention Vista ?
Google bought Youtube for what 1 billion ?... I think that is working out quite well for them. Google seems to have a near monopoly on this whole internet thing anyway, why else would Microsoft be so desperate to buy Yahoo? They could and should use that cash to build server farms/infrastructure and hire better engineers.
I understand that in terms of cash Microsoft may still be the 800-lb gorilla, but a fool and his money are soon parted ( even that much ), It seems to me the current CEO is a bit of a desperate fool, especially if he thinks he can even afford to fight an "n-front" war in the technology space. Especially when Google and Apple are involved. Nevermind ALL the other startups and the nature of the business in general, Microsoft can't exactly just go and kill netscape like they did before ( also now working with google BTW ...ever heard of firefox or seen their "homepage" ? )
Microsoft's past strategy worked because the internet was not nearly as important as it used to be and Gates knew exactly what he was doing, even when he did have to rely on DOS ( UNIX IS BETTER/MORE MODERN/BUILT FOR MULTIPLE USERS/ ETC... anyone willing to argue with that ? )
I don't think Microsoft even understands how to defeat google, let alone do it. don't forget geo-politics either... If you were a tech company would you rather be in the bay area or seattle ?
Coming to your point, Apple and Google are both scrambling for growth in coming years. Google's core IP is Search technology and they are better off doing that and making money. Google will not power the universe with super-duper computer, lest developing an Operating System. Yahoo's core strength is web portal and they do it well. But the analysts always compare Yahoo and Google and managed to drive down Yahoo's stock price. There are areas where Yahoo excels and Google has faltered and vice-versa. Coming back to Daniel's analysis - can Apple grow? My target price for Apple is below $90 by end of 2008 - Seriously.
What sustains Apple is the unknown and unexpected. it is called breakthrough. What is not in the equations or in this discussion is the power to invent products that create undeniable power and appeal, and the existence of a company/team that can do that. if there is even a small chance that Jobs and his partners can come up with breakthrough products, it is worth investing in.
To judge a company that is dedicated to innovation and breakthrough value to its customers by the life cycle of its current products is so narrow. The question to ask is: In the age of knowledge (use, accumulation, distribution,) as an engine of evolutionary import and wealth creation, what products and services could leap out and totally surprise and delight 500 million customers. Jobs, and others are out to explore and answer that question and perhaps they have the capability to do it. That's why I own aapl; not because their ipods are famous.
Tom Jackson
Apple is entering two markets that are huge and still largely untapped: handheld mobile personal devices, and home digital entertainment devices. If done right, these two markets will grow in the same way that the PC market grew over the last 2 decades. Again if done right, there's no doubt that they can grow 20% a year for the next decade. And that's not even including the fact that they have just a small part of the PC market and there's lots of room to grow there.
You are living in a dream world. All the Microsoft techs are running scared to death of Apple. They are literally freaking out in total FUD mode, but it's not working, Apple is rapidly gaining marketshare. Just last summer, no one would believe it, now already no one will deny it. Real people (including the bosses in charge) are waking up to realize what a total and utter sham Microsoft has pulled. Microsoft has always been devoid of ethics, they have screwed their 'channel partners' time and time again. No one likes Microsoft. No one.
Apple has totally eclipsed any OS that Microsoft could ever produce. They have also been quietly building their own Office replacement. Every application on the Mac can read any of the proprietary MS Office formats, even the new formats that Microsoft has so desperately shoe- horned into Office 2008. Microsoft programmers are dullards that only ever COPIED (badly) the work of others. That was enough before, but it's not enough now.
The other shoe is about to drop. The only reason the Apple stock has dropped is because it's a great time to reload. I think the reloading began today on myriad new rumors each of which holds far greater potential than Microsoft's old routine. Time for Ballmer to do another 'Monkey Dance' and throw some more chairs.
I agree. But, they can do a LOT better than 3% global market share. And growth could come fast, once DOS-cultists in Enterprise start retiring.
Brewer, I am sorry for your friend-Al Gore. He should have minimum won his home state of Tennessee and Bill Clinton's home state of Arkansas. In that case Republicans would not have bothered about Florida votes. Bill Clinton literally left Gore high and dry in 2000 and just compare the Republican machinery which worked during the same period. Al Gore paid a high price for his association with the Democratic party which remained silent during the recounting days of Dec. 2000.
Basically, Gates bought the original DOS from its developers (there is debate as to who the genuine developer was, Tim Peterson or Gary Kildall) after IBM had expressed interest but failed to secure the OS.
Teaming with the Deep Pockets of Deep Blue and its large sales force allowed his MS-DOS to become known far beyond the realms of geekdom. His remarkably astute decision to license DOS to anyone who'd pay the price, combined with his cut-throat marketing and business practices, gained him another large swath of the market, so that he eventually surpassed Apple (then the "Big Dog" of personal computing).
However, DOS and its successor, Windows (a poorly crafted knock-off of the Mac desktop), were (and remain) inferior platforms, even before Apple came out with OS X, which blows Windows out of the water. This is not just Mac Addict hype - I actually started with and used DOS from 3.0 forward, Windows through XP, and UNIX, and worked as a systems administrator.
As to expansion - more and more people are realizing Windows is a dead-end, and switching to Mac - now that it is possible to run both, why not? (FYI: XP loads and runs faster, better, and more smoothly on my Mac - for reasons I have yet to decipher. I haven't tried Vista, and have no intention of even getting it.)
Likewise, many life-long DOS / Windows users - incl. IT pros - are switching as they find the benefits of the Apple OS - and yes, I have heard engineers and others saying; "I wish I had switched 20 years ago." or (re; Vista) "I waited six years for THIS?" and have switched.
Small businesses and even larger ones are either switching or introducing Macs as Net servers - they play nicely with the Windows machines and are easy to network to both - and they serve as a much more secure, stable, and smooth device to link to the Net, among other things.
That said, Mr. Jobs is something of an aloof control freak - however, he is also a visionary and has taken home computing to a new level.
From a strictly market POV, it is going to be a long, rough ride for all businesses and there will definitely be some shaking out. Whether even the best companies can weather the storm remains to be seen - but Apple's large cash horde makes it a better bet - if the dollar doesn't collapse completely...