AAPL: Hargrave



Apple (AAPL), interestingly enough, suffers from a couple problems, none of which are all that bad to have. One is its new industry classification. Its $400 billion plus market cap puts it into a unique category; a ‘new’ industry that includes mega-cap stocks. Something strange happens when stocks hit a market-cap above say $200 billion; they stop trading in line with their industry and generally trade at depressed multiples.

The other fundamental issue for Apple is its cash. A problem that a number of companies would love to have. It’s such a problem that billionaire investor and hedge fund manager David Einhorn is suing the company in hopes of forcing the company to put its cash to work for shareholders. Einhorn explains Apple’s inability to spend its cash as a mental issue…

It has sort of a mentality of a depression. In other words, people who have gone through traumas … and Apple has gone through a couple of traumas in its history, they sometimes feel like they can never have enough cash.

It can be argued that the depreciation in the stock has resulted in part from the lack of capital returned to Apple’s shareholders. Apple has over $136 billion in cash and available-for-sale securities on its balance sheet. It needs to find ways to effectively use those assets. Returning cash to shareholders in the form of dividends or stock buy-backs is a good start. In lieu of dividends and stock buy-backs, Apple can also implement an aggressive acquisition strategy with all its cash. Apple can acquire technology and talent to make its competitive advantages durable in its ultra-competitive industry. Either way, shareholders need to see some tangible effects of an increasing horde of cash.

Interestingly, Steve Jobs, before his passing, consulted with Warren Buffett on what to do with all of Apple’s cash. Warren Buffet’s reasons for investing in IBM (IBM) can be good reasons for Apple to implement a more liberal dividend and share buyback plan. Although IBM has only grown its revenues a little over 2% per year on average for the last 10 years, its earnings per share (EPS) has grown close to 12% per year over the same time frame. The reason for the disparity is the effectiveness of IBM’s financial engineering – stock buy-backs and dividends. IBM rewards its shareholders handsomely, so the shareholders stick with the company. When the stock declines, the buy-back policy effectively buys more shares and causes a larger upside for long-term shareholders when the stock normalizes. In the case of Apple, if many investors agreed that its stock was undervalued at $700, they will surely agree that it is undervalued at $500. Therefore, a buy-back program could be more advantageous than ever at this point with the drop in price of Apple’s stock.

Fundamentally speaking. Although Apple’s stock price has dropped precipitously recently, the underlying fundamentals of its actual business appears solid. Its margins remain healthy and its revenues continue growing. Apple’s returns on equity have been over 40% for the past two years. The same is true for its returns on invested capital. Apple has no debt on its balance sheet and minimal other types of long-term liabilities. Apple remains highly liquid and solvent with current, quick, and financial ratios at 1.54, 1.31, and 1.54, respectively, as of last quarter end. Remarkably, Apple has had a negative cash conversion cycle every year since 2003. Its current CCC stands at -57 days.

One disturbing trend from Apple is that its research and development (R&D) expenditures are decreasing as a percentage of its revenue. Apple’s industry is constantly changing so innovation is paramount. Apple cannot rest on its laurels and brand loyalty. The iPhone and iPad are hip and loved today but a year or two from now could be considered obsolete. Apple holds many competitive advantages with its financial strength and past innovation, but the durability of those advantages is what matters. Nokia, for example, used to be the leader in mobile phones but is now struggling to make a turn-around. Its decline was rapid because of the nature of its industry. Apple has to continuously innovate to stay ahead of the pack and not suffer the same fate as Nokia.

The trend is our friend. Apple’s hallmarks are its brand loyalty and the premiums it charges for its products. iPhone captures around 10% of the worldwide market for mobile phones, and Apple plans to introduce an iPhone for value-conscious buyers to capture more of the market. During the last quarter, Apple was the top seller of phones for the U.S. market – a positive trend. Its market share for tablets is decreasing due to more competitors foraying into the market. This trend is understandable as Apple was one of the pioneers in the tablet market and competitors will inevitably take some market share. Apple also plans to introduce the new version of its iTV and generate more revenues from the booming media-streaming market.

Apple has many competitors because it competes in many different markets. Samsung, Microsoft, Google, BlackBerry, and Hewlett-Packard are all formidable foes. Apple is one step ahead of most of these companies but it is difficult to remain so. Apple has to be watched closely to see whether it maintains its economic moat and innovates on a grander scale.

The orchard is still fruitful. Apple CEO, Tim Cook, does indeed have incentive to continue growing Apple’s profits. Cook was granted one million shares of Apple’s stock that vest over ten years when he became CEO. So, a decline in Apple’s stock hurts the company’s leader, Tim Cook, just as much as it does any other shareholder. Cook will most likely pursue policies to grow Apple and curry favor with investors. Analysts’ opinions on the stock are overwhelmingly positive. Twenty-one analysts recommend Apple as a strong buy and twenty-six others recommend the stock as a buy. Seven analysts have Apple as a hold, two as under-perform, and only one as a sell.

So what’s Apple’s biggest problem? Continued ability to capture market share. Microsoft has entered Apple’s markets with Windows Mobile operating systems and a tablet device. Google’s Android operating system still remains the most popular worldwide, and Samsung has been showing solid progress in hardware, both in mobile devices and tables.

Apple’s issues in the nineties pertained to its inability to continue gaining market share relative to Microsoft. Steve Jobs’ big fix was to downsize Apple’s product portfolio and focus on specialty. So should Apple trim its product offerings, not at all. To make the move toward greater market share, Apple will likely have to sacrifice some of its 50% plus gross margins by cutting prices. Other possibilities include putting its cash to work to make keynote acquisitions that will integrate nicely with its products.

So what will be Apple’s YouTube? Could it be Twitter or Dropbox? Google purchased YouTube in 2006 for $1.65 billion, and a back of the hand valuation (based on revenue contribution and total market cap) by Value Walk in 2012 suggests the value could be upwards of $8 billion.

Valuation and the new industry classification. There’s a 101 different ways we can value Apple — feel free to do a quick search on Seeking Alpha and I’m sure you can find quite a few, so I’m not going to dive into the various value, but what I do want to do is look at Apple’s valuation with respect to the mega-cap stocks, a $200 billion plus market cap criteria. This illustrious industry includes:

($ in billions) Market Cap (approx.)
Apple $400
Exxon $400
Google $250
Wal-Mart $230
General Electric $230
Microsoft $230
IBM $225
Chevron $225
Procter & Gamble $200
Johnson & Johnson $200

As I mentioned, once companies grow to a certain size (market cap) the idea of trading in line with the industry is somewhat abandoned, including those of the tech industry. Their market-cap may indeed continue its rise, but a return to historical average multiples should not be expected, even so, I believe the case can be made that Apple is a buy.

Outlined below are the major tech companies trading north of a $200 billion market cap, Google, Microsoft and IBM. When Microsoft’s market cap begin rebounding in 2009, its P/E multiple did not follow:

(click to enlarge)

IBM has also saw its market cap begin to outpace its P/E multiple expansion in 2009.

(click to enlarge)

Google’s break came in mid-2010:

(click to enlarge)

Apple just started seeing its market cap to P/E multiple dichotomy in mid-2011, and it is taking investors some time to accept this, although many still refuse to and feel that Apple should trade two times the S&P and near its 5-year high:

(click to enlarge)

Apple shouldn’t be treated any differently than these other mega-cap stocks, but what I will argue is that Apple should trade with similar multiples as the mega-cap industry.

Since Apple now trades north of a $400 billion market cap, there is no reason to believe it will trade a typical tech price to earnings multiple. Apple appears to be one of the best positioned mega-cap stocks but has little respect in terms of valuation:

Rankings Return on Equity Current P/E Price to Cash Flow 5-Yr. EPS Growth (expected)
Apple 2nd (highest) 2nd (lowest) 2nd (lowest) 1st (highest)

Relative to the other nine $200+ market cap companies, Apple has the second highest return on equity and highest five-year expected EPS growth, BUT trades at one of the cheapest valuations, second lowest P/E and P/CF multiples.

($ in billions) Market Cap (approx.) Return on Equity EV/EBITDA 5-Yr. Low P/E 5-Yr. High P/E Current P/E Price to Cash Flow 5-Yr. EPS Growth (expected)
Apple $400 36% 7.9 10.0 38.1 10.4 9.3 13.7%
Exxon $400 27% 4.4 8.0 17.5 9.3 7.2 0.8%
Google $250 16% 13.3 16.7 42.5 23.7 23.2 13.7%
Wal-Mart $230 23% 7.6 12.0 18.1 14.7 9.6 9.2%
General Electric $230 12% 7.4 4.7 18 16.1 10.5 11.0%
Microsoft $230 22% 5.6 8.6 18.2 15 12.3 8.0%
IBM $225 81% 8.9 9.4 17 14 11.4 10.0%
Chevron $225 19% 3.3 5.3 15.9 8.7 5.7 0.0%
Procter & Gamble $200 17% 11.5 13.1 20.8 19.5 14.1 8.0%
Johnson & Johnson $200 17% 12.1 11.0 16.1 19.5 15.2 6.0%
Average 27% 8.2 9.9 22.2 15.1 11.9 8.0%

While the case can be made that perhaps the tech industry as a whole is overvalued, does Apple deserve to trade below the likes of Wal-Mart, GE or P&G? All the while boasting a more impressive growth profile and return metrics.


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