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Brian Grosso
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Current sophomore accounting student, regular financial writer, DIY investor, uncle, and avid reader. Pursuing an internship/career in investment management in the Greater NYC area. Email: bggrosso@buffalo.edu LinkedIn: http://www.linkedin.com/profile/view?id=226695501
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  • Apple-Fest 0 comments
    Feb 19, 2013 9:56 AM | about stocks: AMZN, BBRY, GOOG, MSFT, AAPL

    It's Apple picking season! Apple's (AAPL) recent fall from its high of $700 in September is something to get excited about if you're a value investor. This is a quality company at a cheap price. It has many of the characteristics that Peter Lynch, Warren Buffett, and David Dreman- three of the most respected investment strategists of our time, look for in a company. So what do they look for exactly?

    Peter Lynch

    Peter Lynch is an earnings guy. He focuses on the bottom line and how it has changed in the past and will change in the future. He looks to buy companies that sell at a P/E that is significantly lower than the historical and projected EPS growth rates. In the past 5 years, Apple has grown earnings 60% annually. In the next 5 years, Apple is projected to grow earnings at 19% annually, a conservative estimate given the company's track record, but because of the loss of Steve Jobs, the sheer size of the company now, and the fast-paced, unpredictable industry that Apple operates in, we will go with 14%. Apple trades at a P/E of 10.43, lower than both these growth rates. From this, one might see Apple as somewhat undervalued, but maybe not providing a large enough margin of safety to warrant investing. That's not the whole story though. Peter Lynch also subtracts net cash and investments from market cap in his P/E calculations. Since the investor is essentially getting these resources as a bonus and can expect the money to either be reinvested to grow earnings or distributed in the form of dividends or stock buybacks, it makes sense to calculate stock price in such a way as to favor companies with tons of cash. Apple certainly has tons of net cash and investments, $137 billion to be exact. When we subtract this number from market cap and adjust P/E as a result, we get a P/E of 7. That's half the fair value of Apple if we were to price it based on estimated earnings growth at a P/E of 14. You'd be hard-pressed to find another company the size and quality of Apple priced with a 50% margin of safety.

    Warren Buffett

    Warren Buffett is more of a qualitative investor. He looks for companies with a durable competitive advantage; what he calls an 'economic moat.' The moat surrounds and protects a company's business from competitors. I believe Apple certainly has a competitive advantage. Some qualitative proof of its competitive advantage is the app ecosystem Apple has built up. It serves as a barrier to entry into the smartphone and tablet markets for other technology companies like Microsoft (MSFT) and BlackBerry (BBRY), because these companies lack app ecosystems to unlock the usefulness of their products. More people own iPhones and so it is more profitable for app developers to develop for iOS because their apps will get more publicity and downloads, and they as a result will make more money for their efforts. Apple also makes many apps in-house and has been very successful in doing so. Google's (GOOG) Android operating system also has a vast app ecosystem but Apple has proven that it can be quite profitable even with a small percentage of the smartphone market, roughly 21% in Q4 of 2012. While were talking about Google, it seems relevant to mention that the company pays Apple approximately $1 billion per year to remain the default search engine on iOS devices. Even Google is investing in Apple's future. Going forward it looks like the smartphone market will continue to be a duopoly between Android and iOS and I think Apple can continue to be profitable in that environment. Another competitive advantage of Apple's is their other digital content stores. ITunes recently sold its 25 billionth song. The biggest competition to iTunes is Spotify, Amazon (AMZN) Music, and illegal peer to peer file sharing. The Federal government has made many efforts recently to reduce illegal file sharing. The efforts have had some success, but it's important to recognize that consumers have been doing this since before iTunes existed and yet still the store has risen to the tremendously profitable level it exists at today. Users of torrents and Amazon Music also typically still use iTunes software to manage and transfer their music. This is what really gives iTunes some staying power. As long as iTunes is still the preferred content management software it will have a competitive advantage on other content stores because it is easier to download straight through iTunes without having to transfer content to another service. Spotify does pose a threat to Apple, but not as much as many people think. Spotify is pretty different from Apple in that it is a subscription service whereas iTunes is structured so that you pay only when you download new content. With Spotify, when users stop paying for the subscription service, all of their downloaded content is deleted whereas with iTunes, the content is permanently owned by the user. This fundamental difference has split the market by payment preference. Users like one or the other. There are barriers to entry because iTunes, Spotify, and Amazon Music have such massive collections of content that other competitors cannot compare with and will not be able to without throwing tons of startup money into their service and negotiating with plenty of musicians and other content creators. I see this situation as very similar to the iOS vs. Android situation in that these services will probably continue to profit and maintain their market share. Another moat of Apple's is provided by the ecosystem of Apple products. Through iCloud and Apple TV, the consumer can view and transfer content across Apple products very easily. Many Apple products also operate very similarly. If you know how to use an iPhone, you will have very little difficulty operating an iPad or iPod Touch. No other technology company has a hardware ecosystem comparable to this. Microsoft has tried to do so by making Windows 8 the operating system on both PCs and their mobile devices but the attempt hasn't been very successful. The final competitive advantage I think Apple possesses is brand power. Customers associate the Apple brand with quality and ease of use and the brand has a very loyal consumer base. People swear by their Apple products. What's amazing is how successful the company has been in building up its brand with very little advertising expenditures. Apple did not pay for Super Bowl ad this year like Samsung and Microsoft. You don't really see too much Apple advertising today. That's not to say they don't advertise, just not all that much compared to their competitors. The company spent $1 billion on advertising in fiscal 2012 compared to $156 billion in revenues. Compare that to Samsung who spent $4 billion on advertising in 2012. (click to enlarge)

    The numbers speak for themselves. Apple also enjoys a higher net profit margin than its competitors, including Google and Samsung. Warren Buffett has always said that a higher profit margin is a fundamental sign of a competitive advantage. Many investors believe Apple is just another technology company living from product to product, but these competitive advantages suggest the company is in a much more powerful, stable position than people think. Warren Buffett also is big on free cash flow. He disregards earnings in his valuations, preferring free cash flow, the money that goes into improving the value of a business. Based on fiscal 2012 FCF, the company trades at a P/FCF of 10.1. Whether you value Apple through EPS of FCF, its undervalued.

    David Dreman

    David Dreman is a contrarian investor. He looks to buy quality companies when everyone else is selling them. A true value investor is able to go against his instincts and buy when he is emotionally uncomfortable but logically confident in a company's value. A few good measures of how a stock is being traded are RSI and moving averages. Generally when a company has an RSI under 40, it is considered oversold. Likewise, when a stock is trading significantly below its short term moving averages it is also considered oversold. Apple currently has an RSI right around 40 and trades about 20% below its 200 day moving average.(click to enlarge)

    Not only is this stock oversold right now, but it's also very volatile. 3% price daily price changes are becoming typical of the stock. The price has declined 35% in less than 5 months. That is a very big move for a company the size of Apple. The stock price seems to be incredibly dependent on market sentiment, which lately has been changing quickly and often. Normally value stock picks take time and patience to appreciate - sometimes as much as 3 to 5 years. In Apple's case, I wouldn't be surprised if the move up only took a few months. I believe market sentiment will shift dramatically when Apple announces a new product release, which could be quite soon considering the company's large cash reserves and increased R&D budget. We're already hearing rumors that 100 of the company's best designers and engineers are working on the iWatch and the iTV isn't so far away either with those in the know suggesting late 2013 as a time to expect an announcement. In March the Apple TV is expected to be opened up to outside developers through SDKs so it could replace the Xbox and Playstation as the king gaming console.

    Concluding Remarks

    So what are Apple's critics saying? The biggest criticisms of Apple right now are slowed earning growth, lack of innovation without Steve Jobs at the helm, and increasing competition. It's true that earnings growth will be slower in the future. A company already earning over $40 billion cannot repeat past growth. Yet the company and analysts still believe the company capable of achieving 19% growth in the next 5 years. That's plenty more than the P/E of 7 we calculated before. Even if you don't believe 19% is likely, at 10-14% growth the company is still significantly undervalued. As for the absence of Steve Jobs, he was a very big part of the innovation at Apple, but he didn't do it alone. Much of the credit is due to Jony Ive, the lead designer of all of Apple's well-known hardware, both when Jobs was around and now. Jobs wasn't known for accepting the ideas of others, but he accepted plenty of Ive's ideas and they all worked out wonderfully for the company. CEO Tim Cook isn't much of a product guy, but he is a supply-chain genius and is often not recognized for the fact that he basically was CEO in the last year and a half of Jobs' life. Jobs picked him as his replacement. Plenty of talent is in place. Competition is increasing but as noted before, Apple has plenty of competitive advantages that provide protection against new competitors. The fact is that at a net P/E of 7, Apple is priced for the worst case scenario and then some. I am amazed that a company of this size could become so undervalued an irrationally priced. Some of the most respected, intelligent professionals in the investment community have openly said how undervalued they think the company is. Aswath Damadoran, the Business Valuation professor at NYU's prestigious Stern School of Business, has said that Apple is worth at least $600 per share. David Einhorn of Greenlight Capital has about 13% of his portfolio in Apple and added to his holdings in the most recent quarter before Apple even got down to $450. George Soros bought in as well. I personally think the company is about 50% undervalued and worth as much as $900 per share but it all depends what you assume Apple's growth percentage will be going forward. If you believe the analysts, then Apple deserves a P/E of 19. As previous calculated, Apple's net P/E is stands around 7 now after accounting for all that cash. So if you believe the analysts, then Apple is even more than 50% undervalued. I do recognize that there is some uncertainty here and that the stock is unlikely to appreciate that much, but it doesn't have to go up 100% to provide an outstanding return on investment. Even half of that is more than impressive for a few years. Google trades at a P/E of 25 with a forward P/E of 15. Even Google's forward P/E that is probably based on far from conservative earnings estimates is still over double the net P/E of Apple. There is no way around it- Apple is cheap, really cheap. Its also a really good company. That is what value is all about.

    Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: I have no positions in MSFT, GOOG, AMZN, or BBRY, and no plans to initiate any positions within the next 72 hours.

    Themes: long-ideas Stocks: AMZN, BBRY, GOOG, MSFT, AAPL
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