Some Thoughts on Apple Stock AAPL

If you read this blog, then you have probably seen me allude to the fact that everyone should own Apple in their PA. There has been a bit of news on the stock in the past 2 days, and I thought it would be helpful to revisit the name.

First of all, on Monday Apple announced that CEO Steve Jobs is taking a leave of absence for unspecified medical reasons. Further, there was no mention of how long he would be gone. Steve Jobs, who founded Apple in 1976, is considered by many to be the best product development manager ever. CEO of the decade, you name it, he single-handedly poured his life into designing their computers, the iPod, the iPhone, etc etc. He could be considered the most important CEO to any company out there. Without Jobs, there is great risk that product development languishes. And the world of mobile computing is notoriously cut throat. Motorola was the king of mobile phones in the early to mid 1990s, and eventually lost out to better designs. That stock has only gone down in the past 15 years since it peaked.

So, the question is, has AAPL peaked? The stock has rocketed from $75 / share 5 years ago, to $345 today. Jobs' job may be on the line, and competitors like the new Microsoft phone and Android are actually pretty decent. Can Apple continue to grow?

The good news is, the company reported earnings yesterday. I don't think it was a coincidence that they reported good quarterly earnings the day after Jobs took his medical leave. They are managing the newsflow. This is also the 3rd time in 5 years that Steve Jobs has taken a medical leave. None of those episodes were explained either. I find it a little irresponsible of the company not to better explain the management situation, but Apple respects his privacy more than the shareholders' right to know. Enough said.

The first indicent, it turned out Jobs had a pancreatic tumor, and he recovered and was pronounced cancer free. The second time, he told the world after the fact that he had a liver transplant. That was 2 years ago, and he took 6 months off. His COO, Tim Cook, handled the day to day management of the company. Tim Cook is considered an apt manager though, and I have read more and more that Wall Street is comfortable with Cook running the company during Jobs' absence.

So, the question is now, is the stock cheap? Does it discount the risk to losing Jobs? Well, AAPL reported December earnings yesterday after the market closed, and by almost any metric, they were phenomenal. Sales were up 71%. EPS was up 72%. Sales of iPhones were up 88%. iPads generated 4.6BB in sales in the quarter on 7.3mm units sold. They had zero iPads a year ago so you can't measure growth. And so on.

So, in the calender year 2010, Apple generated $76BB in total sales, vs only $46BB the year before. iPhones and iPads and applications and iTune downloads continue to grow at very high growth rates. I asked myself though if growth has peaked. It cannot accelerate, although in the last 5 quarters, EPS growth has been 50%, 89%, 78%, 70%, 72%. Strong. And revenue growth amazingly appears to be accelerating, growing in the last 5 quarters: 32%, 49%, 61%, 67% and 71%. Wow.

So, what is the market saying about Apple. Well based on its Q4 earnings, the company first of all has $59BB in cash. That's $64/share. So I am going to subtract that from the share price and calculate what the business generates in earnings. At 346/share, less $64 leaves me buying the business at $282 per share. And on a TTM basis, they did $18.10 in EPS (excluding interest income which was nil). That means I am paying 15.6x earnings. Compared to the S&P, the market essentially trades at a 15.2x P/E ratio. That is a very negligible premium compared to the market. Furthermore, GS calculates that AAPL has traded on average at 23x earnings over the past decade, much higher than today. I dont quite get it honestly. Perhaps it's just a case of the stock not keeping up with earnings in a volatile world.

Clearly it's also that the law of large numbers has to hamper growth here. But if S&P earnings are expected to grow by 9% in 2011, shouldn't Apple still trade at a much better multiple? Why does it languish at a market multiple when the numbers suggest that AAPL will grow EPS by 40-50% in 2011?

Finally, I did some math to figure out if there really is growth left. Based on guidance for the next quarter, annual revenue through March 2011 will be $85BB. Thats pretty much in the bag. Now everyone knows that finally the iPhone is coming to Verizon. That date is February 10th. Based on some surveys I saw online, an astonishing 26% of Verizon users expect the switch to an iPhone. Count me in that category. We plan to be dialing on an iPhone on the 10th. Further, there are 93mm Verizon wireless subscribers. That means you have a potential of 24mm unit sales of iPhones over the next say 2 years as contracts roll off. Now you could argue that Verizon sales will cannabilize AT&T sales, but really of the 9omm total iPhones sold worldwide, about 15-20mm are US AT&T models, I estimate. 80% of iPhone sales are international.

I have read that VZ expects to sell between 7-13mm iPhones in the first year. I think 10mm is a reasonable number. At $625 a pop, that is 6.25BB more in revenue in 2011 just from the VZ iPhone. We didnt count the AT&T users who plan to switch to Verizon because the network there is notoriously bad. So, if Apple has $85BB in sales pretty much in the bag, and you throw in another 6.25BB from the VZ iPhone, and add a full year of the iPad (add another $3BB), then that gets you to $94BB of annual sales. Translating that to EPS gets me in the $22-23 per share range. That is awfully close to where the street is forecasting EPS for 2011 too.

And then there is China. They only did $3BB of their sales to China last year. The US generated $20BB in sales last year on a $14 Trillion economy. China's economy was $5 Trillion, so it seems there is much room for further growth. This is heavily generalized but, in fact, in December the quarterly numbers show that revenue was up 175% in Asia Pacific compared to the year before. Its just starting to take off there.

Finally their quarterly numbers were hampered by production backlogs. They cannot make enough iPhones and iPads. It appears that the iPad shortages have been resolved, and they now plan to add 15 more countries this month to their existing list of 46 countries where the iPad is available. More sales growth.

I almost hate to agree with the sellside on a valuation. But I think this stock is worth 15-17x its 2011 EPS number. Figure that they'll build another $12 per share in cash, that means you will have 76/share in pure cash, and a business doing between 22-24 in EPS. You are in essence paying $269/share for a business that will do $22 per share in earnings. That is 12x forward earnings! Note that RIMM trades at 10x 2011 earnings, and given that 40% of Apple iPhones are sold to enterprises, that could seriously dampen Blackberry sales.

I am not surprised that GS and JPM just raised their forecast for the stock. They peg value at $450/share, which to me is not crazy. 375/22 in EPS implies that the stock can get to a 17x multiple by year end, still below its historical average. That is 30% upside.

As a final gut check, I always focus on cash earnings. Here I took CF from operations, and subtracted capex. That is REAL cash flow, unmanipulated for the most part. (D&A, depreciation and amortization is the biggest driver of manipulated earnings along with "non-recurring items"). Anyway, here is what I get per year in cash vs GAAP earnings:

Cash EPS GAAP EPS
2008: $9.20 $6.78
2009: $9.94 $9.08
2010: $17.25 $15.15

As you can see, Cash EPS is higher every year. I haven't done the forensic accounting to figure out why, but I note that they deferred a lot of revenue (ie the cash comes in, but not booked until as late as possible). The balance sheet shows almost $4BB of deferred revenue as of the end of September. Probably also some inventory management going on. Doesn't really matter. But this also brings up the point of returns on equity (ROEs). ROEs were around 29% last year, but the company's ROA, if you take out the cash would be an astronomical 58%. And in fact if you used CASH earnings, the number goes even higher. Very impressive. You cannot find a better, cleaner company from a balance sheet and reported earnings perspective.

Now, the negatives to the stock should also be pointed out. I have no idea what they do for growth beyond 2011. Steve Jobs may not come back this time, let's hope he does. But if his health has finally caught up with him, then there is real product development risk. The established base of devices is high, but then always subject to declining market share and cyclicality. Near term the quarter benefitted from a lower tax rate of 25% from 29%. That could go back the other way again impacting earnings.

And finally, sentiment is very high for Apple. I assume you have heard of a short squeeze before, but there is also such a thing as a long squeeze. That is, NOBODY is short apple stock. The short ratio is 0.6%, or about 6.8mm shares short out of 915mm publicly traded. That number is also down from almost 20mm shares short last February. You need a good short base to generate some buy orders when the stock falls. If not, you need to find new buyers of the stock to support it. Long holders keep pushing it down with no support. Feels like its happening now actually. If the short interest ever gets back to 20mm shares again, then probably that would mark a bottom.

So, do you buy here? I don't really know. I already own it, I'll probably look to buy more if it falls 5% from here, which is around $320-325 a share. One study showed that tech companies that get new CEOs, fall on average 10% in the 12 months following the change in management. If Jobs has to fully resign, then history suggests this stock falls to $300 a share. Could be worse though given his importance to the company. If it works and he comes back to work in a few months, then I think $450 is a reasonable upside in 9-12 months.