Friday, April 29, 2011

The Apple Decade

Apple's (AAPL) success in recent years is not exactly news but what they've accomplished financially is more than a little bit impressive.

Probably seems strange but just a decade ago Apple was struggling to generate positive earnings.

By 2003, the company was making money but still not able to break through $ 100 million mark in earnings during that year.

Certainly progress, but financially not even close to being in the same league as other big cap tech companies.

In 2004, Apple had grown earnings to $ 276 million. For comparison, Amazon (AMZN) earned slightly more than 2x what Apple earned that year at $ 588 million.

That same year Microsoft (MSFT) earned $ 8.16 billion.

So fast forward to this year. What will Apple likely earn in 2011?

Nearly $ 23 billion or so without even breaking a sweat.

An 83-fold increase in 7 years and, for the first time since 1990, slightly higher than Microsoft.

Company |2011 Est Earnings| Enterprise Value*
Apple        |     $ 22.9 billion    | $ 258 billion
Microsoft|    $ 21.8 billion      | $ 186 billion
Amazon   |    $    1.2 billion     | $ 81 billion

So based upon current estimates, Apple will earn every ~19 days what Amazon will make in a year yet market prices imply that Apple is only worth a little bit more than three Amazon's.

Amazingly, considering its star status (at least as far as the stock goes) Amazon has barely been able to double earnings since 2004.

Strong free cash flows and growth prospects are generally the two arguments I hear most often to justify Amazon's valuation.

Amazon's free cash flow** looks unimpressive to me while year over year earnings growth is expected to be ~17%.

Solid.

Sales growth is more impressive at 38%.

Apple's not exactly a slouch when it comes to growth. Apple is growing as fast as just about any business never mind one that's already a giant.

So why no premium for Apple?

Its earnings growth is expected to be more than 60% this year.

Actually, Amazon's earnings growth rate has been less than supposedly stodgy Microsoft since 2004.

Company |2004 Earnings |2011 Est Earnings|% Growth
Amazon   | $ 588 million   |   $ 1.2 billion         | 109%
Microsoft | $ 8.16 billion   | $ 21.5 billion        | 163%

With an enterprise value to earnings of 8.5x, there's nothing wrong with Microsoft's earnings growth. It doesn't need to grow much at all to justify that valuation.

Amazon is no doubt a fine business. The problem is that 67x enterprise value to earnings multiple. Quite a premium to pay for promise that's yet to be realized. I don't doubt that Amazon has a decent probability of eventually growing into that valuation but no one invests to just get their money back. In fact, the likelihood is there that Amazon will actually grow into that valuation and then some at some point down the road.

That's still not necessarily enough to justify current prices.

The question is: At current prices, does the Amazon investor have a good chance of being compensated for the risks relative to investment alternatives?

In my book paying that kind of multiple takes away the necessary cushion for the inevitable unexpected thing or two going wrong.

Apple naturally has its own set of risks but has been growing and continues to grow earnings faster than just about any business. Yet, Apple has an enterprise value to this year's expected earnings of 11.3x. In contrast to Amazon, it seems Apple has that cushion against the unexpected. So somewhat oddly (considering all that has been accomplished) at current prices there's still no apparent premium in Apple's equity.

At the end of its most recent quarter, there was ~$ 66 billion of cash and investments on Apple's balance sheet that will easily grow to more than $ 80 billion by the end of 2011.

The company has no debt.

A remarkable situation, but there's still just no technology business that I'm comfortable with as a long-term investment. Occasionally, certain tech stocks have sold at enough of a discount to be worth the headache of ownership, in small quantities, for my own portfolio. They will always remain, at most, very small positions. Most tech businesses are involved in exciting, dynamic, and highly competitive industries. That's precisely what makes them unattractive long-term investments.

No matter how good business looks today (or how high the expectations are), it's just not that easy to predict their economic prospects many years from now.

With the best businesses that's not the case.

Adam

Long positions in AAPL and MSFT

* Enterprise Value = Market Capitalization - Net Cash
** Basically, much of Amazon's free cash flow comes from growth in accounts payable relative to accounts receivable. While a company is growing fast that's a fine source of  "float" but not exactly the highest quality operating cash flow.
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