Wall St. discounts Apple's growth potential

Apple, with its $50 a share in cash, could earn as much as $17 to $20 a share in 2011, which means the stock is trading at a cheap 12.5 times next year’s earnings. Cramer said even if Apple hits his $300 target, the stock will still be cheap trading at just 15 times earnings.

“That’s less than almost every single growth stock I follow,” Cramer said, “and even less than the S&P 500’s multiple.”

via Jim Cramer Predicts Apple Inc. (NASDAQ:AAPL) will hit $300 a Share | Madd Money.

S&P forecasts the S&P 500 average P/E for 6/30/2010 at 22.57.

Readers of this blog may recall that I noticed Apple’s discounted valuation several times.

Known by All, Understood by Few

Erick Maronak, manager of the Victory Large Cap Growth Fund, says Apple is the best-run company in the U.S.

I would add it’s also almost the biggest and at the same time least understood. A lack of understanding is reflected in a high risk rating, which is itself shown in the company’s Beta.

All told, that makes Apple the fourth largest market cap in the US with the volatility and apparent risk of a startup.

Asymmetries of information don’t get better than this.

Apple, Little Understood, Is Best-Run Company | Mutual Fund Center | Financial Articles & Investing News | TheStreet.com

The Apple of Traders Eyes

Of all the world’s companies, Apple ranks as the 11th most valuable. As a technology company its market capitalization is second only to Microsoft.

Of the top 20 largest companies, all of which are above $150 billion in market cap (listed in graph above), Apple has the highest volume of trading as measured by dollar value (average volume multiplied by last share price is $5.2 billion per day–see graph). In fact, it’s more than twice as popular as a traded equity than the next highest, Google and 2.6 times as popular among traders as Microsoft.

This trading volume might also be reflected in its beta (the correlation of price with the market with 1 meaning perfect correlation). Apple’s Beta is 1.59, nearly the highest of the super-large caps and the highest by far of the tech large caps.

Surely, this confirms that Apple is not only huge but hugely popular and highly visible among investors. Suggestions that its current discounted value is due to obscurity among IT buyers translating to obscurity among investors does not wash.

Source: Google Finance

Apple’s Enterprise Value Peaked in 2007

On Christmas Eve 2007 to be precise. That’s when the Enterprise Value/share was $181.5. These days it’s around $150. The Enterprise Value (EV) measures the value of future cash flows excluding current assets and is a better indicator of the potential of a company than its current overall value.

As you can see in the graph above, the cash per share (in green) has grown to $43 while back in late 2007 it was less than half that. As a result, although the market value for Apple peaked at $215 on 19th January this year (the blue line), the EV/share was only about $178 (the red line), below the all-time-high in 2007.

As Apple’s cash continues to grow, the gap between EV and MV will also grow. If the MV remains low (as the P/E is indicating) then the Enterprise Value, i.e. the net present value value of future cash flows, drops.

Did Apple’s prospects peak in 2007–six months after the iPhone was first launched–or is the current valuation still a function of sentiment of the overall economy, independent of the company’s fundamentals?

Apple Ten Times more Profitable than Dell

Apple’s profit of $3.38 billion for CQ4 was slightly more than 10 times bigger than Dell’s $334 million on nearly equal Revenues of 15.7 billion and 14.9 billion.

In other words, Apple kept about 20% of its income while Dell kept 2%. Also worth noting is that Dell’s gross margin onconsumer PCs was 0.2% while Apple’s Mac margin (mostly sold to consumers) was around 28%. So on consumer PCs Apple’s margin was 140 times higher.

It should not be a surprise then that Apple is worth 6.5 times Dell.

To recover some of its margins Dell is rumored to be readying its iPad competitor.

I can’t wait.

Apple as Macroeconomic Counter-Indicator

Following up on the Apple Valuation Entry, I went to the data and pulled the historical P/E for Apple back to include all of 2004 (in blue) and did the same with the S&P P/E (in red).

A few notes:

  • Apple’s P/E was consistently above 30 until mid-2008
  • Apple’s P/E was consistently and substantially above the S&P until mid-2008 by at about 10 to 30 points.
  • A reversal occurred at that point with S&P P/Es reaching record highs (actually at over 120 in May) and Apple’s reaching record lows of 11 at a time when the S&P P/E was over 60.
  • Since the reversal, Apple’s P/E has been consistently below the S&P’s and indeed has stayed near historic lows while the S&P is returning to historic averages.

This reversal happened during a time of recession when, in contrast to most companies, Apple kept growing. The spike in the S&P P/E is due to a dearth of earnings, while Apple had increased earnings, sometimes to new records.

As a “premium” brand it’s perhaps perplexing that Apple seems to be acting as a counter-indicator to macroeconomic conditions.

Expectations for Apple to decline in times of economic contraction did not come true and as recovery seems near, Apple appears to be discounted.

In other words, when times are bad, Apple surprises and does well so therefore when times are good Apple should do badly.

Apple's Valuation Dredging Bottom

The fact that AAPL is less valuable — in terms of the P/E ratio — than the average S&P 500 company continues to baffle me.

Apple’s P/E is a bit misleading because of the price “P” a large part is cash which should not be considered “at-risk” capital.

The logic of a P/E ratio is to measure how many years it might take to recover one’s investment. The cash on the balance sheet is not at risk for this calculation. Therefore the Enterprise Value /Free Cash Flow is a more accurate measure of company value creation. Until the recent re-statement the FCF and Earnings were divergent. They have since become equivalent.

Therefore, if you take cash out, (currently $43/share) the Enterprise Value / Free Cash Flow for Apple is about 15. It had bottomed at 7 (now that we have restated data we can go back and re-calculate this).

The graph above shows the traditional P/E in blue and the EV/FCF in grey (using restated financials).

On a forward basis the EV/FCF is probably around 12 to 13.

Also of note is that Apple’s EV/FCF is lower than the S&P 500 (at 23.52 at the end of Q4 2009.)

If we continue to use the S&P as a comparable, I looked up the estimates for quarter-end P/E for the S&P 500:

12/31/2011 17.15

09/30/2011 18.35

06/30/2011 19.97

03/30/2011 21.61

12/31/2010 23.00

09/30/2010 24.43

06/30/2010 22.57

03/30/2010 21.54

12/31/2009 23.52

Apple EV/FCF (and also traditional P/E) are lower than S&P on current and forward bases.

How do we read this? Is the market considering that Apple’s prospects are less than the average large company? This does not quite make sense to me. What other theory could be at work to explain this valuation?

S&P estimates are sourced from:http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS

Estimating iPhone’s Nosebleed Gross Margins

Apple’s latest re-statement of financial statements eliminated subscription accounting for the iPhone not just for the past quarter but for the entire history of the product, back to mid-2007. This allows a more precise estimate of the gross margin of the product and the results are eye-watering.

Apple does not reveal the margin for any product. They do provide an overall margin for the company (shown in the dotted line above).

The only challenge is to “back into” the GM for iPhone based on what we know of the margins for the other product lines and filling in the iPhone as the last piece of the puzzle.

To do so, we need to have some idea of what the other products’ margins are. Fortunately, this is not that hard.

We start with the easiest and work up:

The Software products business line ($2.4 billion last year) is easily the most profitable on a unit basis as software does not require much cost in manufacturing. A solid ballpark estimate is 80% GM (which is what Microsoft typically gets.)

Next, Music ($4.2 billion revenues). The estimate for music is fairly straight-forward. Apple and the industry have leaked the terms many years ago. Apple pays the labels most of the revenue of the music and keeps about 10% to operate the store. On the App Store there is a 30% margin off the selling price but that is offset by higher direct costs (shipping billions of free apps and free updates). I stick with 10% margin for the Music business line.

Third, Peripherals. The peripherals business is not particularly large for Apple, but they do a fair amount of peripherals with $1.5 billion last year. My estimate for peripherals margin is 45% based on some comparables.

Fourth, the iPod ($8.1 billion). The iPod has had a fairly well understood cost structure. The main variable is the cost of the memory, which, as a commodity, varies greatly quarter to quarter. Nevertheless, there is a strong consensus that iPod margins have kept around 29% to 30% over a few years. Teardown analysis coupled with spot pricing for memory chips gives a consistent average.

Fifth, the Mac ($14.7 billion). The Mac is a difficult product to estimate margins for due to the relatively wide variety of SKUs in the market, the complex components, various quality/warranty issues, transportation costs and the point in the life cycle of any given Mac. The best estimates however hover around the same as the iPod: 30%.

Once these values are available, and knowing the proportion of sales attributable to the iPhone vs. the other products, we can get an estimate of the gross margin.

Recent GM estimates are all shown in the graph attached. Here are a few observations:

  1. The overall GM was tied very closely to the Mac/iPod prior to the iPhone.
  2. Gross Margin has been increasing since the iPhone
  3. The iPhone GM is consistently above 60% and is chiefly the reason for the increasing of the overall GM

The expanding margin for the whole of Apple is quite a story in itself (especially vis-a-vis the tragicomedy of the other PC vendors). However, what really stands out is how high the iPhone margin is.

Knowing why it stays so high in the face of an assault of “iKiller” devices is a clue to how Apple creates value.

When to Sell

I would sell AAPL when hateful articles are no longer written. When the consensus that Apple is dominant is overwhelming then sell. When computing has de-facto shifted to mobile, then sell.

When there are no more iKiller wannabes and when competitors no longer seek to “take on the upstart” then sell.

As long as there are doubters, whether due to ignorance or reactionary fear and loathing, the stock is underpriced.

If you doubt and hate Apple, please post and comment and give me the confidence to hold.

Yahoo Finance “Key Statistics” Are Wrong

Deagol, one of the most accurate forecasters of Apple’s financial performance rages against the failure of mainstream databases to correctly report financial data. Having witnessed incompetent analysis and lapses of basic fact checking from paid and certified financial professionals, I’m not surprised.

As the theme of this blog goes, there is an asymmetry of information in the world. Take advantage of it.

Read Deagol…