Taking stock of Apple

The other day, a friend (who was one of my professors) asked me if I thought she should buy some Apple stock. Ironic, since the same day my brother asked the same thing. Being that I’m a wordy sod, and she was one of my teachers in business school, I felt I not only had to give an answer, but explain and support my answer.

The short answer is that I’m sitting on my Apple stock, but would still rate it as a “buy”, and told my teacher and brother as much. Of course at over $70/share it is not as good a buy as it was last year at $20. But just because it is that high doesn’t mean that there’s no upside left. Quite the opposite, now that it has proven itself, there may be a lot more room to move. (Growth investors will know what I mean).

It is hard to compare Apple to it’s peers because it has none. Apple isn’t quite a Dell or a computer manufacturer, because there’s far more loyalty in Apple’s brand and products than PC clones, and Apple’s software business supports and increases the loyalty of their customers. And Apple doesn’t just slap parts from other makers together; they actually designs and integrates computers, which few PC makers do (Sony is the closest). No other PC company has Apple’s level of integration; making the OS, designing the hardware, and selling the products through their outlets. So Apple should be valued higher than anyone else in the Computer segment. And while Apple is often seen as computer manufacture, it is in many other (higher performing) segments as well. Apple is has a consumer electronics business, but with higher margins, a top name, and it’s own direct retail. Apple is a new-market dot-com type company, like a Yahoo or a Google, because they do a ton of business on the Internet (.Mac, iTunes Music Store, QuickTime), and in an industry (digital music) that they just own and is growing explosively. The tangible products (physical devices) means they don’t have the margins or a pure dot-com or software company, but that gives them diversification that makes them more stable and “brick and mortar” as well as nearly pure virtual. Apple is also a retailer with over 100 locations and growing, with both the assets and liabilities associated with that. So it is a little of everything, and that breadth has confused wall street, resulting in a way low valuation — but they’re starting to get it. So I see this last year’s growth as just the start of the correction (upwards), as the analysts’ vision continues to clear, and they start to get Apple.

Investors

There are two types of investors; value and growth.

Value seekers are hunting the downtrodden and undervalued “hidden gems”. These underdog lovers believe that eventually people are going to catch on to what they see as valuable, and bring these stocks up to their true value. They believe that efficient market theory is behind the curve, and they are ahead of the next big adjustment.

Growth investors aren’t looking for growth of the company or industry as much as in the stock. It is about trying to ride on the coattails of an exploding stock and ride the hype or investment trends upwards (and get off at the top).

In both cases the fundamentals can make a case, but may not be as important as some think they have to support the story, but only to a point. The dot-coms had fundamentals trailing stock performance by years or decades, but that didn’t stop investors from making money on the rising evaluations. And even with corrections, many outperformed the market at large. So you can make money, or lose money, using either investment reasoning. In fact, if you’ve got a diversified portfolio and some patience, it isn’t that easy to lose money on the market.

Why Apple is a good growth stock

Now the fundamentals have to back up growth investors stocks, and Apple’s do but the growth buyers are looking for stock trends. Growth hunters are often chart-men — those looking for a stock to break out above of a previous high water mark with high volumes (points of resistance). Add in lots of institutional investors because they tend to be stock squatters, eating up large chunks of outstanding shares, and tend to think long term. The idea being the laws of supply and demand; if more people want a stock based on its past growth and lack of supply (as much of the supply is already gobbled up and tightly held), then the demand will drive up the price. Of course they usually want to play with leaders in an industry or segment, because that’s where the real growth potential rests; the “out-performing” nature of that company in it’s segment means that an unequal number of people looking to be in that segment will pick that stock (thus more demand).

By those criteria, Apple looks pretty good. 71% held by institutions. Compare this to 64% for Dell, or 11% for Google. (Google’s is offset by high insider ownership). And you look at numbers like how much volume is being done — a lot of activity, and few outstanding shares for Apple. It hints to chart-watchers that there could be a lot of competition for the remaining outstanding shares, sending the stock rocketing skyward.

Growth guys look at stock targets, and how likely a company is to make or exceed them; encouraging others to jump on board (and drive the value up). Well, analysts target Apple from $75 to $105 and are constantly revising those numbers up — a good indicator. And Apple has exceeded their expectations and beaten the street almost every quarter for the last couple years. There are certainly some bears as well, but the consensus is positive, the trends are positive, the demand for their stock is going up, and the puts have been going down, the institutions and insiders squatting is high, thus a growth guy would be likely to say, “good pick”.

Why Apple is a good value stock

Far more investors are value investors; those that want to buy a stock when it is undervalued or likely to grow. They tend to be more numbers focused and love to look at ratios (and less about stock trends). So let me rattle off a few of the fundamentals and statistics.

P/E is the stock value divided by the earnings; the lower P/E means the stock is trading low for the earnings (meaning undervalued and there is more growth opportunity). Trailing P/E is for the last 4 quarters, projected is for the next 4 quarters. Apple’s trailing P/E is at 55, which is a little high compared to Dell at 33. Compared to new-market companies like Google or Yahoo, this is miniscule (often a P/E of 100 or more). Apple was at 95 recently, but their earnings grew so quickly, that the ratio has plummeted. (Showing more growth potential). So trailing earnings is for backwards thinkers; the market is about the present and future. In fact, if you look at their forward-looking earnings and P/E, they are in the low 30s. That’s assuming they don’t beat the estimates (which they’ve been doing a lot lately). So Apple looks great.

Earnings Per Share (diluted) shows what they are making, divided by number of shares. Higher is better (they are undervalued). Apple’s 1.22 is good compared to Dell’s 1.21, not to mention the anemic .8 or .3 for Google or Yahoo. New markets tolerate lower earnings because of future potential, thus the Google and Yahoo story. Well Apple’s in a major new market (digital music) AND they have a higher EPS. If you corrected Apple to these other companies levels, they’d be trading much higher.

Total cash per share (the dollars backing up each share in case of crisis) has Apple with nearly $16, while Dell has only $3 and Yahoo is at $2. And with low debt and $6.5B in the bank, Apple is very cash rich and shares are seriously backed up. Apple has 22% of their entire valuation in the bank, as compared to 7.5% for Dell, or 3.5% for Google. Apple is so rich, that I’d like to see Apple lean it up a bit, and put that money to work more. But the point is by this metric Apple should be trading 3-6 times the current levels ($210-420/share).

Price to Book value is what the stock is trading for divided by how much value (assets) are in the company. So lower means the stock is less valued compared to the assets. And Apple is way low (good value) at 4.8, versus Dell at 17, or Google at roughly 20 and Yahoo at roughly 8. Apple’s stock would have to be trading above $250 to be valued equally with some of those other stocks. And truth be told, I see a lot more growth potential for digital music and what Apple does than what Dell does (package other people’s components up and ship them). Long term, there’s no doubt that Google and Yahoo are on a rising tide but Apple is selling services that people want on the Internet; like the largest music store, one of the largest consumer product sales sites, and a huge hosting service (.Mac). Frankly, Apple’s internet business has more growth potential than Google or Yahoo.

In total valuation, Apple is running way low. A market cap of $28B, while Dell with many lower performance numbers and growth numbers nearly 4 times that at $100B. Google and Yahoo are both valued at nearly twice as much as Apple at $54B and $50B. So Google and Yahoo make $3B a year (net) and are valued at twice Apple which nets over three times as much (at over $10B)? At least with Dell the net revenues are high (nearly $50B). But if you look at growth trends Apple is the better story than any of them; most of Apple’s earnings werer in the last quarter and rising hugely, gross sales is growing practically exponentially, margins are holding and improving.

Now there are many other indicators; some positive and some negative, but these are some biggies for me. There’s always ROE (Return on Equity), ROA (Return on Assets), but those are rearward looking indicators. That’s fine for looking at the past — but in a forward looker. They also may be false indicators as they are showing how much room for improvement a company has, while other show that they are peaked (and fully lean). ROS (Return on Sales) is another popular one, but I’m more concerned with trends (which are positive) than with present or past. Apple earnings growth is phenomenal at 300%, compared to Dells 24%. Better if you start breaking it down by segment.

The point of this mumbo-jumbo is that Apple certainly has some numbers to pique the value investors interest, and imply there’s a ton of room for growth in Apple’s valuation.

Why do I think Apple is a good stock

Now I’m not a pure growth or value investor; I’m a private investor. We factor in many other things, what the company does, what Apple does, how they do it, speculation on the future of society and how it is reacting, as well as operational and business trends within the company. So tell me a story, and make it a good one; why should I bet on AAPL? Or why do I want to own a piece of what they do?

Business wise, I’ve seen operational improvements in the company (with room for more). I’ve mentioned already that Apple’s iPod sales are growing explosively. But I think the trends of digital music (as well as movies next) are going to be a radical shift for society. We are only beginning in this area, and Apple has proven to be the pioneer (so far). Factor in future options like video (if/when the bandwidth/infrastructure options catch up), and Apple’s ties with entertainment, and that’s a good piece of the story.

The Internet is exploding, and Apple is everywhere on the Internet. They sold most of the top selling items on Amazon, and that’s not counting running one of premier electronic sites on the Internet. People discount the Online Apple-Store because they are selling mostly their own goods, but they’re selling a lot of them; more than most other sites. Will they expand this opportunity? I suspect so. Add into that .Mac, and the iTunes music store, and Apple has a heck of a lot of experience and success in the internet, and is making more money off it than the Internet companies people are gobbling up because of what they might do in the future.

Apple had like 370% growth in digital music year over year, and they own 60% of the market (and the 40% was all in the memory stick version of players) — but Apple just released a product to own that segment of the market as well. So I expect similar sales growth and significant marketshare gains, in an exploding societal trend. I still consider Apple medium risk in this area, in that a good music competitor could totally pop the bubble. But realistically, it would have to be a lot better to break the brand recognition they already have.

I already mentioned the Apple as a computer sales company. Apple did well last year and they had a bad year in computer hardware (supplier constrained a few times, few major new models), and still had significant year over year gains. They had no major OS releases, and a few applications/upgrades. Imagine what this year can bring.

Apple has a major new version of the OS coming out (with guaranteed revenue stream) years ahead of Microsoft, and that means Application refreshing, with the associated revenue streams. Apple has improved supply chain problems, and suppliers like IBM have gone through their major transitions in process technology (which others are trying to catch up on). Apple has lots of room to refresh the PowerBook and iBook line, a high margin segment of their business, and one of the highest growing areas of computers. Apple has proven they crush the competition in design and portability. Apple has a ton of headroom in moving upscale in higher end servers and workstations, right as they are starting to get acceptance in enterprise. Imagine how much better Apple can do this year, just by keeping on top of demand (or staying close), more model refreshments, and a few partnership agreements. Apple and IBM could do some interesting things in enterprise, Motorola in cellular, Sirius Satellite Radio and iPod integration (an audio version of a DVR?), Sony’s multiple failed attempts in competing with Apple could result in them joining with them, and so on.

And there’s lots more to the story; Apple is getting a halo effect and computer sales are going up because of iPods, again a market that should be two to four times as large as it was last year (conservatively). Apple released their lowest price machine ever (low margins but high volumes will stabilize perception). Already demand is exceeding optimistic forecasts. Add to that technology boosts. IBM and Motorola (Freescale) both have major leaps in processors, with multiple processors in a singe package/chip expected this year well ahead of Intel, whose also stated their intent to head in this direction.

Apple gets the future of technology and has always led. Apple’s past failures weren’t because of predicting trends they almost always led on those, they just failed to successfully promote their ideas or follow through on the business side. Steve Jobs has changed that, with some room for improvement. Still, buying Apple is not only based on what they are doing well today, but what new trends and industry segments they might dominate tomorrow. Based on their recent past, there’s a lot of argument to buy the company on that alone. But the Computer industry has become more commoditized and more mature. They are buying machines to solve problems, and realize in many areas, Macs are better (security, cost of ownership, ease of use, reliability) and they’re making strides with software compatibility. Many are frustrated with Microsoft and Windows, and looking for an alternative that Apple may be able to fulfill.

I’m not a stock analysts, but I have done fairly well with my own stocks, hence the reason I think people ask me what I think. Of course I’m not telling you what you should do, I’m just explaining the reasoning behind why I’m doing what I do. Given all those things I’ve mentioned so far, I’m putting my personal target for Apple at $110-120 by the end of the year. I wouldn’t be surprised if they hit $140 and split early next year. Personally, I’ll gladly take 100% a year on a relatively low-risk investment… but that’s just me.

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