Thursday, October 30, 2008, 08:00 am
Apple more undervalued than others tech heavyweightsAs the U.S. equity markets continue the long process of making a bottom in what is now consider to be one of the worst bear markets in history, tech investors should begin to shift their focus on a comparative valuation analysis of the leaders in the tech industry.
Tech companies with solid balance sheets, large cash hordes and solid growth rates will fair a lot better in a market recovery than those whose valuations did not dramatically deflate over the past year. Of the nine big tech companies Ive reviewed, Apple stands out as being the most radically undervalued in the tech sector on an objective basis.
Apple has more net cash than each of the nine big tech stocks, zero debt, trades at the lowest price-to-cash ratio of only 3.79, grew earnings faster than every other tech company except for RIMM, and is generating almost $3.00 per share in free cash flow every quarter. Just to get an idea of how undervalued Apple is compared to others in the tech sector, one need only to consider where these other tech companies would stand if they were valued in the same way as Apple, i.e. if those same companies were met with the same general bearishness with which Apple is faced.
A lower price-to-cash ratio literally indicates the level of bearishness in a stock price. A price-to-cash ratio of 1 indicates that the market believes the company will not be profitable in the future. A price-to-cash ratio of less than 1 indicates that the market believes that the company will contract in the future by pricing in a future loss of cash. Out of the nine companies listed in the table below, the market is most bearish on Appleconsidering the highly deflated price-to-cash ratio.
Apple Compared to the Four Horsemen of Tech
Below, I offer a comparison of Apple to the four horsemen of tech to help illuminate the degree to which Apple is undervalued. Apples stock price is devalued significantly more than Google, Research in Motion and Amazon:
Apple v. Google
Apple grew its adjusted earnings at a pace of 78.5% in 2008. Google, on the other hand, grew its 2008 earnings at a pace of only 31.33%. Apple has $24.49 billion or $27.57 per share in cash while Google only has $14.41 billion or $45.87 per share in cash. Yet, even though Apple grew its earnings at more than twice the pace of Google, Apple trades at about half the trailing P/E that Google trades at. What is even more surprising is that Apple trades at less than half the price-to-cash ratio that Google trades at. Google currently trades at 7.81 times its cash position while Apple trades at a depressed value of only 3.79 times its cash position. If Google traded at the same price to cash ratio that Apple is trading at, Google would be valued at $173.84 per share. Yet, setting aside the price-to-cash ratio, if Google even traded at the same deflated P/E ratio that Apple is currently trading at; Googles shares would be priced at $262.91.
Based on these metrics, Apple is far more undervalued than Google on an objective basis. There is no reason why Google should have a larger market capitalization than Apple especially when Apple is producing more in operating cash flow ($9.69 billion v. $7.42 billion) than Google, grows its earnings at more than twice the pace of Google, has almost twice the cash position of Google, and makes more in revenue than Google does. Wall Street is certainly irrational when it comes to comparative valuation, and this case is certainly no different.
Another way to think about this is to consider which of these companies an investor would buy if he or she had $110 billion in cash. Which seems to be a more obvious investment? Is Google a better buy at $103.54 billion or is Apple a better purchase at $92.9 billion? Remember, Google has only $14.4 billion in cash while Apple has $24.49 billion in cash. This means it would literally cost the investor only $68.38 billion to buy Apple while it would cost him/her $89.13 billion to buy Google. It would take that investor 7 years to pay off his/her investment in Apple while it would take over 13 years to pay off his/her investment in Google. Such an investment would make no sense considering the fact that Apple produces more in free cash flow than Google and produces more in cash earnings.
Apple v. Research in Motion
Based on the numbers above, Apple is clearly a much better investment than Research in Motion. First, AAPL trades at almost half the price to free cash flow that RIMM trades at. Also, RIMM doesnt grow at a sufficiently higher rate than AAPL which might justify giving RIMM a price-to-cash ratio of 17.45 while giving AAPL a price-to-cash ratio of only 3.79. Secondly, RIMMs market capitalization is simply too large when compared to AAPL. When backing out cash positions from market capitalization, AAPLs net market cap is at $68.38 billion while RIMMs market cap is at $25.49 billion. Considering the fact that AAPL produces $9.69 billion in operating cash flow while RIMM produces a relatively meager $1.73 billion, Apple is simply a significantly better investment. If RIMM were given the same price to cash ratio that Apple is currently trading at, RIMM would be trading at $10.42 a share -- nearly 80% lower than where RIMM trades at today. If it were given the same deflated P/E ratio, RIMM would be trading at $42.89.
Apple v. Amazon
This comparison is laughable. I simply cannot understand how the market could give a retailer such as Amazon a 39.02 P/E ratio while giving Apple, a company that has clearly demonstrated that it can withstand a slowdown better than most, a 13.97 P/E. Amazon has only $1.86 billion in net cash, produces less in operating cash flow than even Research in Motion, holds one of the highest price-to-cash ratios (10.49) of any other tech giant, and grew its earnings at a rate significantly lower than Apple and RIMM. Moreover, Amazon also has the highest price to operating cash flow ratio than any other tech giant in the sector (20.66). Of the nine companies listed in the table above, Amazon presents with the least attractive valuation. The market has too much trust in Amazon and I havent seen enough bearishness in the stock to justify an entry relative to others in the tech sector. Im not saying that Amazon isnt undervalued in on an objective basis, but its just less undervalued than GOOG, RIMM, MSFT, AAPL and others.
In terms of a comparison, Apple has $24.49 billion in net cash versus Amazons $1.86 billion. Apple trades at 3.79 its cash position while Amazon trades at 10.49 times its cash position. Apple trades at 7.06 times operating cash flow while Amazon trades at over 20.6 times cash flow. Amazon has a net market cap of $22.54 billion while Apple has a net market cap of $68.38 billion. Amazon grew earnings at a pace of 67.82% in 2008 while Apple grew its adjusted earnings at a pace of 78.5% in 2008. There is no reason why Amazon should deserve three times the P/E ratio given to Apple. Apple grows its earnings at a faster pace than Amazon, has 12 times the amount of cash of Amazon, makes far more in net income than Amazon, trades at less than half Amazons operating cash flow ratio, trades at roughly 1/3 the price-to-cash of Amazon and is better situated than Amazon going forward. While the market might not figure this out over the next few months, eventually the market will realize that Apple is a far better investment and will likely revaluate the companies accordingly. Im not arguing that Amazon is not undervalued, but that it is far less attractive at current levels than others in the sector.
Why the Market is Bearish on Apple
The data above merely indicates that the market is extremely bearish on Apple. Yet, it does not explain why the market happens to be bearish and whether the market is right in its assessment. There are several reasons why the market happens to be particularly bearish on Apple. Yet, some of those concerns are way overblown, and some are outright irrational. Below are list of reasons why the market is bearish and whether the market is right in its assessment.
1. Major Concerns regarding the Health of the Consumer
The main reason that the market is particularly bearish on Apple has to do with overblown fears regarding a consumer-lead slowdown affecting Apples business. The idea here is that since consumer spending and sentiment are hitting multi-year lows, Apples business cannot function at any reasonable level. Many in the market have argued that since Apple is supposedly entirely consumer discretionary, that the consumer is going to cut back its spending on products such iPhones and iPods. Many have asked: how can anyone possibly afford to buy an iPod when they can barely afford consumer staples?
This concern is obviously overblown beyond epic proportions. First, while economists have been drumming the recession 2008 beat, Apples Mac sales, iPhone sales, Mac revenue, iPod revenue, total revenue, EPS, net income, free cash flow, cash growth and iTunes revenue have all been accelerating. Not just growing, but accelerating. There is nothing in Apples 2008 quarterly earnings reports that have indicated that the consumer has slowed down. At best, the 2008 "recession" has had only a negligible if any impact on Apples business. The market destroyed Apples stock price in January over these very same concerns which never materialized. Even in Q4, analysts were extremely cautious on Apples earnings, taking the stock down from a high of $180 to a low of $148 post Q3 earnings due to concerns regarding Apples fourth quarter -- concerns, which once again, never materialized. While the market was busy falling off of a cliff in June on concerns of stagflation, people were lined up around the block to buy iPhones -- not tickets into homeless shelters as the media had investors believe.
Moreover, the market has already priced in a complete destruction of Apples business. So any slowdown that may or may not occur is already fully priced in. This is clearly evident by the analyst consensus estimates for 2009. The analysts are modeling for Apple to earn $5.36 in EPS on $37.61 billion in earnings for 2009. Apple earned $5.36 in EPS on $32.48 billion in revenue in 2008. Thus, the analysts are literally modeling for 0.00% growth in earnings for 2009. As an analyst, I have never seen more irrational consensus estimates in my career.
First, the numbers are not even consistent. The analysts are modeling for Apple to earn $5 billion more in revenue for 2009, but nothing more in EPS. This has largely been the result of overblown concerns regarding Apples gross margin for 2009. Gross margins will probably rise rather than fall in 2009 as discussed in Turely Mullers article entitled Apples FY09 Gross Margin Expectations Are Too Low. Turley Muller, a chartered financial analyst, makes a persuasive case that Wall Street cannot seem to wrap their heads around.
Second, the revenue estimates for 2009 are simply out of touch with reality. For starters, Apple entered into 2008 with only $346 million in currently deferred revenue from sales of the iPhone and Apple TV. That means that Apple got an $86.5 million revenue boost each quarter in 2008 -- current deferred revenue is recognized over the course of the year. Yet, entering into 2009, Apple has a whopping $3.518 billion in current deferred revenue that it gets to recognize in its earnings reportsthats $880 million in revenue that Apple gets to automatically recognize each quarter in FY09. Said another way, the analysts believe that Apple is only going to make $1.958 billion in new revenue in 2009. That is a bold statement considering the fact that Apple just sold 6.9 million iPhones in Q4 2008 amounting to $3.787 billion in revenue. If Apple sells just 10 million iPhones in all of fiscal 2009, the deferred iPhone revenue from those sales alone would result in Apple earning the $1.958 billion in revenue difference even if Apples growth rate was flat across all of its operating segments and in all of its primary operations for the year.
2. The false perceptions regarding Apples dependence on iPod Sales
As I argued earlier this week, iPod sales made up only 14.2% of Apples total revenue in Q4 2008. As a matter of fact, iPod revenue is making up an ever decreasing portion of Apples overall revenue. Moreover, even if Apple were as dependent on the iPod as many would have investors believe, iPod revenue actually accelerated in 2008 indicating that the consumer opted to buy more expensive iPods in 2008 than it did in 2007. And it did so with more enthusiasm than between 2006 and 2007 -- hence the revenue acceleration. Most market participants invested in Apple know so little about the company that they automatically assume that all Apple does is sell iPods. Nothing can be further from the truth as indicated by the 14.2% number for Q4.
3. Particular Events leading to Apples Stock Collapse: A Week by Week Detail
Most of Apples recent fall in share value from $180 in August to $85.00 in October can be attributed to four particular events. While the stock would have undoubtedly been beaten with the rest of the broader market in this recent crash, it was far more beaten down due to events outside of the general correction. First, Apples September iPod event amounted to nothing more than sell the rumor, sell the news. The stock got hammered from $170 from the date of the press release of the event to $152 on the day of the event itself -- concerns over Steve Jobs health trumped an otherwise average media event. The broader market barely started to correct at that time. As a matter of fact, the DJIA was actually flat during that week.
After Apples 5-day sell-off from $170 to $152, Apple headed into the next week with the bankruptcy of Lehman Brothers on Monday and the imminent collapse of AIG on Wednesday. Apple was simply the victim, as was every other stock in the market, of general liquidations, bearishness and panic selling. The stock price fell from $152 on Monday to a low of $120.00 that Thursday before participating in a two-day market rally sparked by a ban on short selling, which helped bring Apples stock price back up to $140.92 that Friday. That $12.00 fall in share price that week was due to general bearishness in the market and was part of the process of Apples correcting itself with the indices.
While the following Monday was largely uneventful for the market, Apples stock took a $10.00 tumble after Kathryn Huberty of Morgan Stanley cut her price target on Apple from $192 to $179 citing general weakness in the global economic environment. After struggling to stay afloat, Apple closed the week at $128.24. The following Monday, just one week after Kathryn Huberty cut her price target on Apple from $192 to $179, she allegedly felt that something fundamentally changed in five days that would warrant a second downgrade of Apple in as many weeks. She cut her price target from $179 to $115 citing the same nonsense she cited the week before. Apples stock price took a blood bath gapping down from $128.24 to $119.00 before collapsing into a death spiral where panic selling took the shares down $28.00 before it rebounded to $115.00 in inter-day trading. Unfortunately for Apple, congress decided not to pass the bailout bill that day which led to another $10.00 drop in the stock price before the close of trading. So in all fairness to Huberty, Apple would have probably taken a bath, but I doubt it would have collapsed $23.00 due to the failed bailout plan. Most stocks fell around 10% while Apple fell close to 20% that day.
The rest of the sell off from $105 to $85 was largely due to the collapse witnessed in the market in the ensuing weeks where 800 point down days in the DJIA became a thing of the norm. The reason I outline the specific details regarding the fall in Apples stock price is because its important to parse out exactly how much of the breakdown was due to the sell-off, P/E contraction and revaluation in the broader market, and how much of the collapse was owing to specific identifiable selling events which might have pushed Apples stock price lower than where it would have otherwise landed if not for those events. Its important because Apples current stock price might not be a general reflection of the market sentiment regarding Apples fundamentals, but rather the adverse result of a series of identifiable extra-market selling. If much of the fall was due to selling events rather than to revaluation and general contraction, then the current stock price might simply be the result of Apples inopportunity to retrace losses against broader market selling rather than the result of a bearish valuation. A case can be made here considering the fact that Apple has outperformed the market for the month of October. On a market rebound, one might expect the stock price to rally harder than the broader market. Whatever the case might be, Apples current valuation presents one of the best investment opportunities for 2009. More to come.
Disclosure: Long Apple, Google, RIM. The information contained in this blog is not to be taken as either an investment or trading recommendation, and serious traders or investors should consult with their own professional financial advisors before acting on any thoughts expressed in this publication.
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