Apple on an innovation treadmill

Why are we so excited?
My recent analysis comparing Apple Inc. (AAPL) to a microcap stock, Air T, Inc. (AIRT), has definitely drawn the ire of Apple fanatics. The analysis leads me to believe AAPL is priced at or somewhat above its intrinsic value. In saying this, I’m focusing strictly on earnings and basing this on: (1) it will be extremely challenging for AAPL to grow earnings at 20% annually for the next 10 years, and (2) AAPL's on a major product development treadmill. In the analysis, I focused strictly on quantitative considerations. In this post I’m going to look at some of the more qualitative aspects of Apple’s business.

Cause and effect
Let’s elaborate on the first point above by looking at AAPL's financials. As we do this, keep in mind that the need for growth is why Apple is on the innovation treadmill. During the last 10 years, Apple’s revenue has increased at a rate of about 20% annually (from $5.9B in 1998 to $24B in 2007). Net income has increased much faster—at a rate of 30% annually (from $309 million in 1998 to $3.5B in 2007). This is phenomenal. The difference? Growing margins. In 1998, Apple Computer was strictly a computer company—making computers and, for the most part, the software as well. Their market share was in the low single-digits and their margins were about 5%. In 2007? Margins are running at about 15%. Again, this is phenomenal. To increase margins, Apple Inc. is focusing on high-margin businesses (iTunes, videos, etc.). In short, they had to reinvent their business, and the reinvention runs deep: They even changed their name last year, to reflect their expansion beyond the computer business.

In the meantime, Apple has wisely focused on 'value pricing' their products—getting top dollar for products that appeal to the under 30 segment (and those of us who wish they were under 30). They have used the halo effect from their music player/music distribution franchise to launch phones and reinvigorate their computer products. Can it go on? That gets me to the 2nd point.

Cash is king—for two reasons
AAPL is on an innovation treadmill. The cash it's sitting on serves two purposes. First, it provides an insurance policy (a hedge of sorts, if you will) in case they make a bad bet. Second, the cash might come in handy in case Apple has to make a major acquisition. Let’s look at the insurance policy part with an analogy: MSFT and the XBox. How much has Microsoft plowed into the XBox? Has it paid off? The jury is still out. At some point they will obtain the return they seek or they will exit the business, possibly selling it off. Regardless, Microsoft placed their bet and it may or may not pay off. In a similar way, Apple has made some good bets recently. To continue on their trajectory, Apple has to plow the earth to retain their prime mover status. In other words, to retain their fat margins, Apple must continue to take risks and innovate, continuing to push the envelope. In the eyes of consumers, as they expand their space beyond computers, Apple will have to use its brand (its promise to its customers) as collateral. They will have to increasingly risk their name to grow their business (remember the “New Coke”?). There is a high likelihood that Apple will eventually get in over their heads and the odds will catch up with them. In other words, Apple will eventually come up snake eyes—does anyone remember Betamax? How about the Newton? The Corvair? Polaroid? Their cash helps them fund these types of ventures, especially the ones that don’t pan out.

Getting back to Apple’s results, my sense is that 20% earnings growth for the next 10 years would be remarkable. At that rate, I’m estimating the intrinsic value at about $90/share (see my prior post). If you really want to, you can pile on the cash and deferred revenues and you might get about $20 to $25/share which puts you closer to where the stock is currently trading. Is it a bargain? At best I think it's priced at fair value with a ton of execution risk.

Name your poison
Looking at it pragmatically, Apple is priced roughly 20% above its intrinsic value because the cash should be kept on hand to continue funding growth. Why? At some point, they will be large enough that 20% growth in revenue won’t come easy (in fact, they may already be there) and Apple will have to make a major acquisition. Funding options will include: (1) issuing more stock (potentially diluting the value of their stock), (2) paying with cash, or (3) assuming debt. This is why the roughly $20/share of cash/deferred revenues on AAPL’s books will likely be gobbled up by the growth treadmill. In short, Apple is (rightly) holding on to cash to fuel further growth, but I wouldn’t get too excited about this. It’s not as if they have a choice. Without growth, their stock would quickly tank.

What’s a value investor to do?
As Apple’s products (iPods, computers, phones) mature, the company will have to enter new markets. We have already seen some cracks in the foundation (we don’t know yet if they’re structural or cosmetic). For example, Apple has found it much harder to incorporate movies than music into their iTunes platform. In fact, iTunes has become “the establishment” that it once competed against. Others are now challenging this distribution model, and the availability of free music is continuing to grow.

How will Apple continue to grow? They will have to figure this out. Their business will become more complex and scaling it successfully will be a challenge. Meanwhile, the value of the company is what it is. At times, Mr. Market will undoubtedly become exuberant and overestimate the value, especially after favorable ‘analyst reports’. Conversely, Mr. Market may also become pessimistic and underestimate the value, creating a bargain. One thing is for sure: without continued growth in earnings, which will get increasingly harder and riskier as Apple expands beyond its core (no pun intended), the value of the enterprise will drop.

Intrinsic Value - Pt. 2: Air T vs. Apple Inc.

Intrinsic value in action
To better help us understand Intrinsic Value, let's look at two completely different companies. Both are making money and doing fairly well. One is well known and one is not. The first one is Apple Inc. The second one is a small ($70 million in annual sales) company that focuses on regional delivery of air freight and aircraft servicing equipment (such as deicing and catering lifts). For simplicity, we are not going to look at their balance sheets. Instead, we are only going to focus on earnings. To summarize their earnings picture:

• Apple's 2007 earnings increased by 71% ($4.04/share vs. $2.36/share in 2006); trailing 12 month earnings are $4.56/share
• Air T's 2007 earnings increased by 22% ($.94/share vs. $.77/share in 2006); trailing 12 month earnings are $1.29/share

If we were to take these numbers and extrapolate them for the next 10 years, AAPL would have earnings of $567.57/share and AIRT would be earning $7.72/share. This is probably not realistic, especially for Apple--just consider how many computers and iPods have already been sold.

How much growth?
If instead we assumed earnings growth of 20% per year for the next 10 years for each company, you would get the following (I'm discounting using 5%, which is roughly the current yield on high quality corporate bonds):

AAPL:

• Year 10 earnings of $28.11/share, present value is $17.26/share
• The discounted earnings for the next 10 years add up to $101.74/share

AIRT:

• Year 10 earnings of $9.42/share, present value is $5.78/share
  
• The discounted earnings for the next 10 years add up to $32.26/share

Keep in mind that we are not looking at any assets as part of intrinsic value, just earnings. While it would cost money to do so, the Apple brand clearly has a lot of value (goodwill) that could be monetized through licensing, royalties, etc.

Is this good or bad?
What does all this mean? As of yesterday (2/5/08), AAPL closed at $129.36/share and AIRT was at $10.83. Assuming these companies can grow earnings at 20% per year (10 years is a long time--life in prison sometimes lasts only 7 years), we can say the following:

• AAPL's current price, about $130, indicates it's going to grow earnings at about 25% for the next 10 years
• AIRT's current price, about $10, implies it's going to grow earnings at about 1% for the next 10 years

How fast are earnings going to grow? This is where stock research comes into play. Clearly 71% is not a sustainable rate of earnings growth. For 10 years, I would say that 20% is more likely. At this growth rate, earnings in 10 years would be a little over 6x higher than today. If AAPL kept the same margins, their sales in 10 years would make them as large as GE today. Why not 25%? At 25% earnings growth (assuming the same margins), AAPL would be approaching the size of today's Wal Mart--I'm having a little bit of trouble seeing this.

This leads me to believe that even 20% earnings growth may be optimistic. Still, let's leave the 20% earnings growth estimate for both companies. Here are some additional thoughts, starting with Air T Inc:

• If 20% earnings growth is sustainable, AIRT is currently priced at about 40% of its intrinsic value
• Even if earnings grow at only 3% per year, AIRT is still about 10% below its intrinsic value
• AIRT has a great financial position (see my previous post) which, combined with the upside potential, provides a nice margin of safety
• About half of AIRT's business depends on Fed Ex (risk); with that being said, they have been working with Fed Ex since 1980 (stability)
  

Here are some thoughts on AAPL:

• Assuming a 20% earnings growth for 10 years, at $130, AAPL is still priced about 30% above its intrinsic value
• At $130, AAPL's earnings will have to grow at about 25% for the next 10 years to justify this price (i.e., for the Intrinsic Value to be about $130/share)
• AAPL also has a great financial position, although it needs lots of cash to constantly reinvent itself and its products (I have 4 Apple computers; each one was only sold for about a 6-7 month period before being replaced by a newer model)
  
• Ten years is a long time; about 10 years ago, rumors of AAPL's demise and even bankruptcy were widely circulating

Summary
While I am inherently bullish on both companies, AAPL has lots of execution risk and most (if not all) of the upside is already built into its current price. As it's currently priced, AAPL's earnings will need to continue to growing at about 25% despite economic downturns, competitive pressures, and shrinking margins--not to mention the vagaries of consumer likes and dislikes. In contrast, AIRT is priced very attractively. Even at modest single-digit earnings growth, AIRT is below its intrinsic value. The company's strong financial position also provides a nice margin of safety.

Intrinsic Value - Pt. 1: Why So Important?

One of the most elusive and least understood investment terms is Intrinsic Value. You can go to Investopedia, a great source of information, and see their definition here. From an owner's perspective, the Intrinsic Value of a company is the true measure of the worth of an enterprise. With that being said, let's consider several additional points:

• The market may or may not be valuing the company based on its intrinsic value (for example, undervaluing the company based on its intrinsic value creates a value investing opportunity)
• The book value may or may not be related to the Intrinsic Value (book value is the current value of assets less liabilities)
  
• Determining the Intrinsic Value usually requires consideration of qualitative (subjective) and quantitative (measurable) aspects of the company
  

Let's look at one of my favorite ways of explaining Intrinsic Value. This example comes from the Berkshire Hathaway Owners Manual (that's right, Warren Buffet actually put together a 5 page guide to owning shares--talk about expectation setting). You can find it here. In his explanation, Buffett illustrates the intrinsic value of a corporation by comparing it to the intrinsic value of a college education. He calculates the intrinsic value of a college education as follows (I'm paraphrasing here):

The difference in earning power over a lifetime of working, in current dollars, less the cost of the college education, in current dollars

In other words, to calculate the intrinsic value of a college education, you would consider the wage differential over a work career of, 40 years, and covert it to current dollars. Let's say this is $1 million. If a college education currently costs $100,000, the intrinsic value of the college education is $900,000.

For a company, you would similarly determine how much cash you could pull out of the company in the future (profits, earnings, dividends, etc.), and discount this to determine current dollars (in $/share). This amount would then be compared to the current share price. These two amounts can then be compared on an apples-to-apples basis to determine the attractiveness of a stock.

In my next post, I'm going to take a look at a couple of different companies and contrast their Intrinsic Value. This will help us see the importance of future earnings on calculating Intrinsic Value.