Poetic Portfolios

I stepped into an Apple store before Christmas, and I have to say that I was amazed. I hadn’t really taken the time to browse their products before that visit. I’ve admired the company since their “rebirth” almost a decade ago. They have impressed me with their strong branding and smart products. So, after visiting the store, I began to keep a close eye on their stock. It has plummeted from $200 per share at the first of the year to the $130s. Based on this information, some speculators may think it must be a bargain, while others may believe the growth story is broken. I want to take a closer look.

About the Company

My first exposure to Apple was my beloved Apple IIc that my parents purchased for our family when I was a kid. I wore that machine out with games, programming, and even plugging my baseball stats into spreadsheets (some things never change I guess . I was disappointed when the machine stopped working. Apple had decided to focus on the Macintosh. I never really enjoyed working with the Macs. It was too distant from what I was used to, I guess.

After that initial surge of growth and success, though, I think Apple really drifted while the PC came to dominate the business world and then the home users. Today, Apple is the insurgent upstart capturing market share from the PC and creating other successful devices and services. Apple’s brand has once again become synonymous with innovation.

Apple Inc. designs, manufactures, and markets personal computers, portable digital music players, and mobile communication devices and sells a variety of related software, services, peripherals, and networking solutions. The Company sells its products worldwide through its online stores, its retail stores, its direct sales force, and third-party wholesalers and resellers. In addition, the Company sells a variety of third-party Macintosh (‘‘Mac”), iPod and iPhone compatible products, including application software, printers, storage devices, speakers, headphones, and various other accessories and peripherals through its online and retail stores. The Company sells to education, consumer, creative professional, business, and government customers.

Apple’s Recent History and Earnings

Apple has demonstrated some pretty amazing growth over the past several years. The iPod has been a star performer, and the Mac continues to gain market share as compared to the PC. The table below demonstrates a nice three-year trend for the company.

(in millions)	2007	2006	2005
Revenues	$24,006	$19,315	$13,931
Cost of Goods Sold	$15,852	$13,717	$9,889
Gross Profit	$8,154	$5,598	$4,042
Research & Development	$782	$712	$535
SG&A	$2,963	$2,433	$1,864
Total Operating Expenses	$3,745	$3,145	$2,399
Other Income/Expense	$599	$365	$165
Taxes	$1,512	$829	$480
Net Earnings	$3,496	$1,989	$1,328
Depreciation & Amortization	$317	$225	$179
Capital Expenditures	$735	$657	$260
Owner Earnings	$3,078	$1,557	$1,247
Shareholder Equity	$14,532	$9,984	$7,466
Shares Outstanding	889	878	857
Owner Earnings Per Share	$3.46	$1.77	$1.46
Gross Profit Margin	34.0%	29.0%	29.0%
Net Profit Margin	14.6%	10.3%	9.5%
Return on Equity	35.0%	26.6%	26.2%
YOY Rev Growth	24.3%	38.6%	68.3%
YOY Earnings Growth	75.8%	49.8%	381.2%

My first thought after looking at these numbers is “wow.” I may be wrong, but I think it is pretty rare for a company of Apple’s size to demonstrate growth rates like that. This leads to a question: how long can growth like that continue for a company of Apple’s size? This seems to be the question investors are asking.

The iPod market seems tapped out. It would be unrealistic to expect the iPod to reach another level of sales. They are beautiful and elegant devices, but who else wants one that doesn’t already have one. Maybe there’s room for additional international sales. The iPhone certainly looks like it could still have some upside, but how much? The Macs are taking market share from the PC, but there’s a ceiling on that growth as well. For Apple to continue its amazing growth, it will have to continue to innovate. That’s a difficult task, even for Apple.

Valuation

The average analyst 5-year growth projection for Apple is 22%. These seems a bit optimistic, but it is a good place to start. Assuming 22% 5-year growth, followed by 9% growth for five years, a sale at a P/E ratio of 18, discounted back at 10% results in an intrinsic value of $143 per share. Apple has $21 per share in cash on its balance sheet as well. Adding cash to the present value of the cash flows noted above results in a value of $164 per share. This value assumes more of the same from Apple with pretty steady growth from all product lines. Apple could certainly outperform this estimate, but I would not want to make a purchase based on that outperformance.

In their most recent quarter, Apple reported year-over-year revenue growth of 35% and year-over-year earnings growth of 57%. This was during a supposedly weak holiday season. This year could turn out to be 30% higher than last year, but I’m going to assume 28% growth in owner earnings this year, followed by 18% growth for years 2-5 and 9% growth for years 6-10. I get an intrinsic value of $135, only slightly lower than the analysts estimates. I would discount this value by 25% for a purchase point and then add back the $21 per share in cash. Here I purchase point of $122.

A negative scenario could assume a permanent change in Apple’s growth rate. Here I will assume 28% growth this year, followed by 12% growth for years 2-5, 7% growth for years 6-10, and a P/E of 14 at year 10. This results in a value of about $89 per share. Add back cash for a value of $110 per share. Events could certainly be more negative than this scenario, but I think a more painful situation is unlikely given how well Apple has been managed in the recent past.

Conclusion

It certainly seems that the recent sell-off in Apple shares is overdone. It would only take a couple of solid quarters of continued growth for a $130 share price to seem like a bargain. The exceptional returns are likely behind Apple, but it could still outperform the market at its current share price. I will look for a bit more margin of safety to purchase Apple shares.

Full Disclosure: No position in Apple.

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This entry was posted on Thursday, January 31st, 2008 at 8:50 pm and is filed under Apple. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.