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Tuesday, October 20, 2009

Taking A Bite Out Of APPLE? No, But Impressive Results Show Positive, Fundamental Shifts for Powerful Franchise

Someone asked us the other week what we thought of Apple (AAPL, $198). We essentially came back with the following:

At a high level, we might summarize the consensus view and key positives as following:
  • "cult"-like following and many portfolio managers (PMs) see AAPL as a core holding (similar to GOOG, QCOM, RIMM)
  • numerous positives that PMs hang hat on such as
  • (1) increasing Mac adoption by disgruntled PC users (we bought one a few months ago - great so far, although not as strong for Excel modeling),
  • (2) iPod and iTunes dominance with expanding, entrenched customer base,
  • (3) growing iPhone penetration of smartphone market,
  • (4) App Store growing by leaps and bounds, creating virtuous, sustainable ecosystem (related to points 2 and 3),
  • (5) significant free cash flow generation, large cash pile and no debt
However, at 27x [then] consensus F10E EPS of $7.00 and 33x TTM earnings, much of the good news is seemingly now reflected in the share price. We derived three-, five-, and ten-year average historical multiples across many metrics (e.g. EPS, EBITDA, BV). Over the past three years (during iTunes success and renewed "love" for Apple), AAPL traded at an average of 37x normalized TTM earnings, slightly above current levels. On a EV/EBITDA basis, the three-year average was 20x, in-line with the current level of 19.5x. Finally, price to book - three-year average of 7x, in-line with current levels.

Thus, shares generally appear fairly valued, especially if growth slows in F10 as the law of large numbers take hold in new product categories (i.e. iPhone). Of course, as with many stocks in a myopic, momentum driven Market, the primary question is upside/downside to numbers. If a solid case can be built for either direction, that will influence the stock. We include Apple's five year stock chart below:

Well, yesterday's results tell the story: massive upside to numbers and impressive Mac/iPhone growth: revenue up 25% Y/Y to almost $10 billion (international sales of 46%), gross margins up 190 basis points Y/Y to 36.6% and GAAP profit up 45% to $1.7 billion ($1.82 per share versus consensus estimate of $1.42). Further, deferred revenue related to iPhone, Apple TV, and AppleCare/Other sales increased an incredible 88% Y/Y to nearly $15 billion. The jump is largely because of iPhone sales, where cash is received upfront but the majority of revenue deferred and recognized over the estimated life of the product/contract (costs are also amortized over the estimated useful period). If the impact of "subscription accounting" is eliminated, Apple reported non-GAAP EPS of $3.12 versus $2.29 in the year ago quarter.

Looking briefly at unit sales for the September quarter:
  • 3.05 million Macintosh® computers (+17% Y/Y)
  • 10.2 million iPods (down 8% Y/Y)
  • 7.4 million iPhones (+7% Y/Y)
More information can be in the countless media reports on Apple -- one from Reuters here.

A few conclusions from where we sit:
  • Recession not impacting Apple and at least some consumers are alive/kicking. While the economy remains weak, if things were truly dire, we wouldn't see results such as those reported by Apple.
  • The five positives outlined above are legitimate and have legs. Secular and company specific trends bode well for Apple for 2010 and beyond.
  • Numbers go higher. Bullish Wall Street analysts will adjust their forecasts and raise target prices (back of envelope, simple approach without considering seasonality and product cycles: annualize the reported $1.82 for $7.28 forward EPS; applying P/E multiple of 30 times yields target price of $218; applying three year average P/E multiple of 37 times yields $269).
Yet, given our preference for out of favor, lower priced "merchandise" (stocks), we remain uninvolved in Apple shares. We write this largely for general interest and because we find amazing what Apple has achieved -- and continues to achieve -- as a powerful franchise.

Happy investing,

Jeffrey Walkenhorst

Disclosure: no position.

© 2009 Jeffrey Walkenhorst
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