Personal Computers and Mobile Communication Devices
NASDAQ symbol AAPL
Before we begin
Hello loyal readers (all five of you). Thanks for coming back again. I wanted to take a moment to share my plans for the next week or two. I received some great feedback from all of you. As you all know, I make no money doing this, so my time is limited by my job and other commitments. Because of this, some of these changes may take a little while. Please be patient and know that I am working on them as fast as I can.
1) I will be updating the page which shows what is on by buy and sell lists, which is currently titled “Picks and Puts.”
2) I’ve had many requests to add some visuals like graphs to illustrate total returns to this page. My hope is to add an interactive, real-time return visual. Unfortunately I’m not the most tech-savvy guy in the world. I’m teaching myself some tricks, and if I can figure out how to do it, I will. Until then, I hope text is enough here.
3) I’ve heard several requests for a glossary of finance and stock market terms. I love the idea, and I’m writing one right now. I promise to put it up soon and add to it frequently.
4) Many of you have asked for more lighthearted links and visuals, particularly the funny youtube clips I used to add to every article. Finding clips and fun links like those adds a certain amount of time to the writing process that I don’t always have. I loved doing it, I think pictures and video make the blog more interesting and help to break up the text. I will do my best. If you have any clips or comics that you think would be good to add, email them to me! I love requests! email@example.com
5) Several people have given me suggestions for companies and articles I should look into. All of them have been really interesting, and would/will undoubtably make the blog better. The problem is a lot of them are given to me over lunch, or while I’m in my carpool to and from work. As a result, I forget many of them. Keep the suggestions for articles and companies coming, but if you can email them to me, or write them down and hand them to me, I’d appreciate it.
Speaking of requests, let’s get down to business (ha-ha! pun!) and look at a company my dad requested I analyze: Apple, inc.
The Short Version
Increased competition and the loss of Steve Jobs have concerned some investors, but Apple, inc. continues to sit at the head of its field. Its focus on user experience and its excellent branding are invaluable assets and its products are extremely accessible. With a rock solid balance sheet and over $100 billion in cash and liquid assets, the company seems like a safe investment, and could be fairly valued at $600. Until Apple hits $500 per share, it is worth buying.
The Long Version
Over the last few years, its been impossible to look at investing news without seeing or hearing Apple mentioned at least twice a week. The company’s stock had a meteoric rise since 2007, and just a few months ago it earned the title of most highly valued company in history. However, this year Apple has broken its fair share of hearts. Apple headlines shifted from “Apple will hit $1000!” to “Apple will go to $200!” Mr. Market’s wild mood swings seem to have kicked in at last for the late Steve Jobs’ baby. Since hitting its top at $780, the stock cratered to $440, where it has been hovering for a few weeks now. However, when a value investor (like me) sees an American icon drop and shareholders going nuts, it starts to look like a potential opportunity. Then Dad asked me if I could look into AAPL stock, and that sealed it – my next project was the world’s largest computer company. I powered up my old MacBook, plugged in my iPod, and got started.
Looking at Apple as a company, it is obvious that it is well organized and second to none in marketing and branding. Even after the passing of Steve Jobs, the greatest nerd communicator of all time, the company has remained the coolest brand on the market. The apple logo is universally recognized, and the company has fierce brand loyalty among many of its users. Looking around the coffee shop I am writing in, there are seven people with laptop computers here, and all of them are Apple products. While Tim Cook (Apple’s current CEO) may not have his predecessor’s charisma on stage, his marketing department still makes Apple look like the best brand on the market. Anyone who pays attention to consumer sales, or watches the show Shark Tank (fantastic program by the way) knows how invaluable a good brand is. Even Warren Buffett keeps a close eye on his company’s brand, though he refers to it as reputation. This helps Apple’s case as a potential investment.
Aside from just branding, Apple also has the advantage of having its own retail outlets. Unlike Microsoft, Google, and Samsung, who all rely on other companies to sell their material to consumers, Apple has built its own retail chain. Granted, retail is usually a tough, competitive field with low margins (which is why most tech companies have avoided it), but Apple’s retail gets all of its products into the hands of consumers. More importantly, Apple uses its retail outlets to help educate and serve its customers. If you have a problem with your iPad, you don’t have to wait on hold for customer service for an hour, you can simply carry it into the store and talk to a live person. If you don’t know how to use a program or an app, just go ask one of the geniuses, and they’ll be happy to explain it to you. If you have trouble with your google android phone, you have to search the whole internet for help, and it can be hard to weed through all of the information available to find what you need. That’s not a problem with Apple. Google and Microsoft are starting to look into developing their own retail chains, but even if they decide to follow through, Apple has a huge head start. Another qualitative point for Apple.
Not everything is rosy for Apple though. There are two major qualitative concerns with the company right now; the loss of Steve Jobs, and the looming shadow of competitors.
There is no question that Steve Jobs made Apple what it is today. His genius and vision defined the way we look at technology. Since he died, a lot of people (on and off Wall Street) have started to question whether the company lost its secret sauce. The last time Steve Jobs left Apple, the company started to struggle, and eventually lost out to Windows based machines. This time, Jobs can’t come back to save the company. The company has not introduced any products that weren’t inspired by Jobs, and is now facing competition from similar looking products made by Microsoft, Samsung, Amazon.com, and others. No one seems to have developed any game changing technology that will drive Apple’s product line into the ground, but without Steve Jobs, Apple’s rocket-powered growth is unlikely to return, and that worries some investors. However, Apple is still investing in R&D, and has great products and amazing brand loyalty, all of which will at least buy some time and keep the company competitive for the foreseeable future. It is also worth noting that Apple still has Philip Schiller (a fellow BC Eagle), who has been Apple’s senior vice president of Worldwide Marketing since 1997. Even without Steve Jobs presenting new Apple products in a black turtleneck, the company still has the same marketing mind that has built the Apple brand over the last ten years.
The second, and more troublesome concern I have with Apple is not internal, but external. Apple reinvented the way we listen to music, redefined the way we look at and use laptops and desktops, made the standard smartphone by which all other phones are now judged, and (for all intents and purposes) invented the tablet market. All of this has made Apple dominant in the tech field, and until recently, they were the only player in most of these industries. That is quickly changing. Google’s Android platform has taken the smartphone market by storm. Microsoft has started manufacturing its own tablets (the first hardware line developed by Microsoft). The increased competition was bound to happen – the amount of money Apple was (and is) making naturally attracted attention from other players in the tech field. This will make future growth for Apple difficult. Especially considering the resources that these companies have at their disposal. Both Microsoft and Google have considerable amounts of cash, and armies of bright, hardworking tech nerds working on making the best products possible. Apple is going to have to keep playing its A game if it wants to compete in the future, and will have to find a way to differentiate itself from competitors. For the last few years, Apple was the only real name in the smartphone market, the tablet market, and was the only computer brand that was considered reliable. None of those things are true anymore, so Apple has to find a new way to stay unique.
A third qualitative concern is the way Apple allocates its assets. Currently, Apple lists over $100 billion in liquid assets on its balance sheet, including a substantial amount of money in various investment securities. This worries me, especially nearly 12 billion in mortgage and asset backed securities, 5.5 billion in non-U.S government securities, and 46.26 billion in corporate securities. Not that these are silly things to do with spare cash – I might have bought some of these myself – but if the company isn’t using this cash, shouldn’t it go to investors? The investors own the company, and therefor own the money that the company has. If the company can’t find a good use for its cash, why not let the investors have it as a return on their investment? However, Tim Cook has started to fix this problem by declaring a quarterly dividend of $2.65 per share, and authorizing a $10 billion share buyback to help increase share value and return cash to investors.
One more important quantitative note: the company continues to take risks, even without Steve Jobs at the helm. Some of these risks have been unsuccessful (the Apple Maps fiasco comes to mind), but still the company shows that it is actively looking for new opportunities. Most recently, rumors have started to circulate about iPhones being sold in China to 1.2 billion potential consumers. This is all excellent news. Yes, Apple Maps was a failure, but at least Apple is still trying to innovate and improve. Some of those innovations will be flops, but those are part of the cost of doing business. If the company keeps taking risks in trying to develop new markets and products, some of those risks will pay off big time. In baseball, it is impossible to hit a home run if you don’t take a swing. You might miss a few, but at least you have a chance to hit a home run. If you don’t swing, you’ll strike out anyway. Quantitative points for effort at Apple.
I almost decided to give Apple the qualitative thumbs down. Not because anything was a deal breaker, but because I see a lot of competition looming on the horizon, and beyond good branding and marketing, I couldn’t see how Apple would hold other players at bay. Sure the company makes good products, but in the tech market now, making good products is the bare minimum. However, my opinion changed after a brief conversation with my friend Alex. Alex is one of those very tech-forward people who actually understands what a processor does and whatnot. I asked him what he thought of Apple products as compared to others in the marketplace. His response was very interesting, and important.
Alex told me that the way Apple designs its products is different from the way other companies do. Apple focuses on user experience instead of device power. Most companies in the tech market, especially in the mobile market, will simply try to cram as many specs onto a device and sell it that way – the fastest processor, the biggest memory, etc. Apple, however, is more concerned with how end users interact with their products. Apple products are designed to be easy to use and accessible to anyone who picks them up. Want to sync your iPad to you computer? Just plug it in! Your iPod? Also one simple step. Got 4 devices with calendars on them? No sweat, we’ll wirelessly link them all up for you. So Apple might not have the most powerful machines on the market, but in real terms, they are just as good (the extra half second it takes to load Angry Birds will not cost the company any customers), and much simpler. Sure, the really high-tech users who need to digitally remaster videos and work real computer magic might go for the Lenovo yoga tablet, but the average med school student, lawyer, salesman, etc. will reach for an iPad because it is simpler and sleeker than the competition. Apple has figured out that the medical students and cupcake artists of the world don’t need the fastest gadget, they need the easiest gadget, and the company uses this knowledge to separate itself from the competition. That’s why Apple puts so much focus on its retail outlets: they help make Apple products easy to understand and use. Suddenly the concerns I have about Apple’s increased competition didn’t bother me as much – Apple looks a lot safer in the future. Sure, there will be competition, but Apple looks ready to fight.
With this new information in mind, Apple looks like a qualitatively good company. It has great branding, great products to back the brand up, and an excellent ability to attract new customers by being the best experience on the market. Apple gets the qualitative thumbs up. Now all that’s left is to look at the numbers. How hard can that be? The company only has $178 billion in assets….
Looking at Apple’s numbers, it is easy to see why Wall Street was in love with this company for half a decade. The company has gone from earning less than $6 per share to over $44 – an increase of over 700%! Thanks to innovation in the way we listen to music, communicate, and use technology, the company has become a dominant player in the tech marketplace, and remains the standard by which all of its competitors are judged. That said, the company still needs assets, cash, and sustainable earning power to be a worthwhile investment. Time to check out the books.
I decided to start by looking into the company’s balance sheet. One of the things that has made Apple so popular on Wall Street has been the massive amount of cash that the company is sitting on, and the safe financial position of the company. Sounds great right? Well, I never take headlines at face value without looking into the details myself. Looking into the company’s financial reports, it turns out that the company is, in fact, as financially secure as possible – the company carries absolutely no long-term debt, and has liquid assets in excess of $100 billion! Even if sales drop to zero next quarter, the company is not in danger of going under. That would be a disaster, but it wouldn’t wipe out shareholders (fortunately, it does not look like Apple is going to have zero sales next quarter). First measure of safety checks out.
Looking into share value, however, I found my first real quantitative concern. When you look at the balance sheet, without adjusting for goodwill and other intangible assets, Apple carries a book value of $125.04 per share. That is certainly better than the negative book value that Clorox carries, but compared to its market price of $450 per share it seems low. This means that the stock trades at 3.6 times its book value, and has a significant amount of risk for shareholders (to give some perspective, Berkshire Hathaway trades at about 1.2 times its book value). However, book value is not the only way to value a company. The idea of holding a company is that the whole is greater than the sum of the parts. In order to really establish value for AAPL, we have to look to the company’s earning power.
Establishing the earning power of a company like Apple is tricky – for the last few years, Apple has been a real growth company. Earnings have gone up by as much as 50% each year. That kind of pace is unlikely to continue, seeing as Apple is the single biggest tech company in the world. Valuing the company as a growth company would be reckless and speculative. However, trying to value the company the way you value GE or Berkshire Hathaway is difficult because Apple has not had ten years of earnings as a tech giant, so you can’t look at the average earnings of the past and expect a reasonable picture of future earnings. What to do? Well, let’s apply some common sense, look at the present, and see if we can discern anything about what is likely to happen.
Looking through the annual report, the company is very upfront about costs, revenue, and profit margin. That was extremely helpful for a qualitative analysis. It turns out that last year, Apple had a 43.9% profit margin. Not bad! This was driven by the fact that Apple has established many of its retail outlets and production facilities, and has not had to invest in new equipment or real estate. These factors are unlikely to change. Looking forward, the company recognizes that competition and supply costs are likely to increase. On page 35 of their annual report they conservatively project that next year’s profit margin should come in around 36%. A big drop to be sure, but still a healthy number. Let’s use this to make some assumptions. If we assume that this margin is correct, and that the company experiences exactly zero growth this year in terms of revenue, we can get a rough sketch of what earnings will look like when the next annual report rolls out.
Taking this 36% margin and applying it to the company’s current revenue, it turns out that the company would earn $59 per share before income tax and other costs. Once all of those costs are deducted, that leaves a diluted EPS of $30. If we were to use a price to earnings multiplier of 20 (remember, that’s the highest P/E ratio acceptable for an investment grade security), that means Apple would be fairly valued at $600 per share next year. That leaves us with a current margin of safety of $150 per share. Not too bad. Granted, this is based on projections and estimations, which could be wrong, but keep in mind – this assumes no growth at all for Apple. I doubt the company will have 50% growth again, but I wouldn’t be surprised to see it have 10% growth in revenue, maybe more. Also, the past few years have been hard on consumers, and yet Apple has stayed strong. If and when the economy starts to get better, Apple’s growth will get the same boost as everyone else. I think that with an American icon like Apple, no growth is a safe and conservative projection, and you could (therefore) safely value the company at $600 per share based on earnings.
All of this does assume that the company will continue to sell, but that is what the qualitative analysis is for. Apple looks good for the future, and its consistent investments in R&D, even without Steve Jobs, should produce some really cool new gadgets in the future. Just to play Devil’s advocate, what if I’m wrong? What if things start to deteriorate for Apple? Fortunately, Apple is priced at a discount by my current evaluation. Even if Apple doesn’t hit $600, or starts to struggle, the company is not going to crater to $0 tomorrow – there’s a $150 margin of safety behind my earnings valuation. That’s not a bad cushion, and since Apple is still marketing better than anyone else in the tech field, I feel comfortable saying Apple is a safe buy. It might not hit $1000, but it won’t drop to $200 either.
With all of this in mind, I’m giving Apple the quantitative thumbs up. Sure, there’s some competition and future innovation to worry about, but as Peter Lynch pointed out, there is always something to worry about. Odds are that Apple will keep earning money for a while.
Apple has new and different challenges ahead. New leadership and new competition will make the already dynamic tech market even more difficult to navigate, but the company seems well positioned to handle the future. Yes, things could go wrong, but things could go wrong for any company. Apple’s rock solid balance sheet and focus on the end user experience will keep Apple safe, and the company generously earns enough to justify its price. Until Apple hits $500, it’s a buy in my book.
- The Filosopher in Phinance
Disclosure - I have no financial interest in Apple. I have no plans to buy it only because I have no cash on hand for it. That may change though.