Apple: A Compelling Buy?
Board: SAS: Apple
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Last week I had the unique opportunity to have lunch with a gentleman who manages 3 billion dollars for private investors and institutions. Since an opportunity like that does not happen everyday (at least not to me) I was excited to get insight in to his strategy, as well as debate the merits of different companies. I say debate because as a primarily growth investor I was breaking bread with someone who was mostly a value investor, although he does own several growth companies. We did agree on some long terms investment trends which I will elucidate in a later post, but I do want to discuss the topic of our debate: Apple.
While he liked Apple as a company he was not comfortable with the market capitalization (how many i-phones can they continue to sell?) or the nature of the company as a tech innovator, which is essentially innovate or die. When he considered both he was not comfortable with the ability to continually innovate at it’s current pace on a 5-10 year investment horizon. He did not say they won’t but had concerns about that view. This is not unlike something Warren Buffet would say-in fact the investor I was dining with was cut from a similar mold. I like the Apple story, in fact it is my largest core position, so I obviously disagreed with his position, but I did respect his view. To ignore the thoughts of a very successful investor without thinking about his assertions would be pretty dumb.
On the MF boards there are prolific posters who often provide bull cases for stocks, but the story is often not objective analysis. I prefer those that provide a balanced view, including the risks, and yes (apropos of recent discussion) the valuation so I will attempt to stick to that credo. I first considered the current market forces, product cycle, the ecosystem, the valuation, and the risks. The reason I am writing this is:
A. An attempt to practice what I preach in terms of how looking at valuation and other external factors when considering an investment.
To hopefully provide additional color for other fools that want to dig deeper and be more comfortable with their investment.
Current Market Forces
Market timing is folly. However, when you have been exposed to a market downturn it is worth considering why and how it has effected your investments. Apple started its pullback before the overall market, and has accelerated to the downside since then. Certainly, some investors are not comfortable with the large market cap, and other “traders” see upcoming quarters that have decelerating growth (seasonal) so they do not see any need to be in the stock now. So, you have a panoply: an overall market pullback, the momo traders exiting, and questions about whether Apple can continue outsized growth and innovation with their core products going forward. The latter is the most important, but in my opinion, this has a created a great opportunity when one considers the valuation, product cycle, and the risks.
Product Cycle (will try to get too long-winded)
I am not going to get in to when they release products, suffice to say they have been diabolical geniuses, and anyway that would be akin to market timing. What is worth discussing is what do they have planned to sustain growth and market share. The I-phone 4S and Siri has been a great success and growth in China is just beginning where the demand is off the charts for anything Apple. They are currently in negotiations with China Mobile which would open the market to another 650 million users! The I-phone 5 will likely be released later this year and one can only speculate that it would include 4G LTE which would certainly motivate a large replacement cycle in developed markets because of the increased amount of data we all use.
The I-pad has a stranglehold on the market and while I certainly think Samsung and even Google will eventually try to compete the only real competitor to date has been the Kindle Fire which by most accounts is not really a competitor at all in terms of quality-it really is a spruced up E-reader, but it is less expensive and more portable. This is not unrelated to rumblings about a smaller I-pad to be released soon.
The pundits do not discuss Macbooks much because it has not accounted for much of Apple’s recent growth, but you should think about it. Why? Apple simply makes the best hardware and software, but historically macs have not been adopted by corporations because they were running proprietary software that utilized PCs. This has been changing and continues to change at a rapid pace. With companies running most of their software in the cloud the corporate field is becoming more open to the apple OS. The I-pad has been aggressively adopted by industry because companies like CRM are making apps to make mobile business more powerful. As their products becoming increasingly more affordable (aggressive discounting to corporate clients, the corporate landscape changes, and companies see the power of apple ecosystem, I expect this in the coming years Apple will have greater market share.
Apple aggressively markets to students with discounting. This is not out of kindness. Apple wants to expose them to the Apple ecosystem early and gain lifelong customers. The younger generation of entrepreneurs are using Apple-not Dell. These are the next decision makers. On a lesser timeline, I expect there will be updates later this quarter or the next to the Macbook Air and Pro (lighter, thinner, more power, and bang for the buck) which should ramp up growth in the short term.
Apple TV could be a home run but I am not speculating about that as part of my investment thesis. Mr. Jobs alluded to his finger prints being all over it, so let me speculate that it might be a game changer, but my investment thesis does not include it other than as a potential catalyst.
I mentioned it above,and this can be a very overused word, but not when it comes to Apple. The app revolution continues to grow and has now extended to the computers. For personal use, every device now works in concert with another with I-cloud. Your whole life (music, email, phone, photos, contacts, calendar) are all tied in-why would you want to have another product that would be an outlier?
It is becoming the same with corporate. The I-phone is becoming increasingly adopted by companies, and the I-pad has especially become a very powerful tool for many companies-thank you cloud based applications. This trend will only continue, and this adoption will bleed over to the mac computer products.. It is not an accident that the OS of the Macbook is increasingly looking like that of it’s mobile brethren.
Apple is dirt cheap. I agree that the market cap is high, but let’s take a quick view of the numbers. It has a P/E (TTM) of 13.49, and a peg ratio of .68. The forward P/E of 11.3. Consider that is for a company that grew EPS last quarter 92% from the same quarter a year ago, and has almost 65% eps growth over the last 5 years. What makes this even more compelling is the cash on hand is now over 100 billion dollars! That is not factored in to the above analysis-take the cash out and you have a growth stock, masquerading as a value stock.
The above growth is not sustainable in perpetuity-let’s get that out there right now because while true but it is not like the P/E is suggesting gangbusters. Apple’s valuation is cheaper than most Dow industrials that have sub 10% growth rates. In fact, if you use the back of the envelope calculations often used by wall street, a (tech) stock with a 10% growth rate would generally be fairly price at a P/E of 20. That is obviously a generality but when a stock is trading at 11. 3 P/E (not counting cash) and the company has shown outsized growth every year, you must surmise it is currently valued for a very sharp decline. Even if sales slowed to half of what they have been over the last 5 years the stock would be grossly underpriced.
Apple makes over $600,000 in revenue per employee which is mind-boggling when you consider the size. Combine that efficiency with a 49% growth margin and you have a cash machine-the cash flow is incredible! In September they start paying a dividend, which at current prices will account for almost 2%, plus they will institute a 10 billion buyback. That won’t even put a dent in their cash position which means if they need acquisitions at some point they will have more than ample fire power. I looked at several companies, and I cannot find anything close when it comes to the value proposition versus growth. What other company pays you 2%, is buying stock, will offer outsized growth with a valuation that suggests mediocre growth at best?
There is no company without risk, especially a company that is based on innovation. In the long term, the loss of Steve Jobs is certainly a risk that would be dumb to overlook. Getting back to my discussion with money manager, he is ultimately right. One failed product and the company’s fortunes could change. It is not an apple to apple comparison (pun intended), but Sony was once the bell of the ball. The Walkman was the forefront of consumer product demand, and they were market leader in television.
Can Apple continue to innovate 10 years out? At what point will the phones be so good that the replacement cycle will be longer (it has already extended a bit)? Will someone else upstage them with a better product? Will phone carriers at some point revolt against the huge subsidies they pay to Apple in order to be successful? Will Apple TV be innovative enough to get people to spend enough money to replace what has become an increasingly less expensive and profitable commodity? Can Apple continue to create products we never knew we had to have without the Genius of Steve Jobs to become the worlds first Trillion dollar company?
These are real risks which is why someone like Warren Buffet will not invest because the future in technology has a lot of unknowns and large money managers are somewhat illiquid. That is where you have an advantage. If the fundamental story changes at some point, you can sell, but I don’t think that scenario is likely soon.
Let’s be clear Apple cannot keep up 90+% growth, but this is not CSCO or MSFT that was priced at 100 times earnings in the dot com bubble-we know what happened to those stocks. I think Apple has a strong future, and I think Tim Cook is a great CEO. While there is no way for me to know about innovation years in to the future, the pipeline for this company is visibly very strong for the next couple years at least.
From my perspective, on of the important aspects that I believe portends for longevity is the the growth in product integration and the ecosystem-they all work together, so unlike many product companies it is not based on just one product or several different products, it is based on how they work collectively to change how we all work, play, and organize our lives. I don’t think that kind of power can be understated. If Apple TV is to be a great success, it won’t just solve the annoyance of multiple remotes, it will further integrate your whole life in to your living room including what you watch-how you watch it, play games, social media etc further becoming an anchor in how we live. I think there are much more compelling things to come, but you should always consider the risks and what you are willing to pay in light of them(this is where valuation plays a role). As discussed, Apple is currently priced for modest expectations at best which in my opinion makes it a very attractive current entry point and risk reward scenario. If the story changes at some point I would consider selling, but right now I am happy with my position and have added to it at current prices and see more growth ahead. I hope at least some of you found this helpful and/or interesting.