Wednesday, January 25, 2012

Apple's Strong Earnings

Apple's (AAPLquarterly earnings were released yesterday and it looks like the company's stock will open at all time highs.

Check out these numbers:

$ 13 billion
That's Apple's quarterly net profit. One quarter. Net profits more than doubled from $ 6 billion a year earlier. Five years ago Apple earned $ 3.5 billion for the entire year. Now it has earned nearly 4x that much in one quarter.

Consider that Apple now earns nearly twice as much per quarter as Microsoft (MSFT). Not too long ago Apple's earnings was a mere shadow of Microsoft's.
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$ 97 billion
The amount of cash and investments that Apple has on its balance sheet. No debt. It ended the previous quarter with $ 81 billion. A $ 16 billion increase. The reason cash and investment grew faster than net profits comes mostly down to free cash flow exceeding net profits.
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$ 395 billion
Apple's market value as of yesterday's close.

Exxon Mobil's market value is still slightly higher at $ 423 billion (that may change today based upon Apple's pre-market price). The integrated oil company is expected to earn roughly $ 40 billion this year. After earning $ 13 billion in just one quarter, it seems reasonable to think that Apple will earn even more than Exxon Mobil.

If so, that means Apple is selling at a lower multiple of earnings than Exxon Mobil (XOM). That is true even before you back out the nearly $ 100 billion cash on Apple's balance sheet.

So, even if this past quarter is some kind of slight anomaly on the high side for earnings, it seems likely that Apple still sells at a single digit multiple of this year's earnings.

Now, not surprisingly considering the capital intensiveness, Exxon Mobil needs roughly 10x more capital than Apple to run its business and generate those profits. Exxon Mobil's return on capital is more than respectable for an integrated oil company. Having said that, return on capital for Apple is pretty much off the charts (easily over 100% by my math). So the two companies operate in a totally different economic universe.
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What will be Apple's very long run profitability? I think, unlike some businesses in less dynamic industries, it's a tough call. At a minimum, any estimate of the intrinsic value of Apple has to have an extremely wide range.

Earnings power could end up being much higher, at least for a while, but who knows. At this point it's tough to bet against them.

Gauging the intrinsic valuation of something has to be based upon some conservative estimate of a very long run stream of cash flows. Valuation can't be based upon a few years of stellar earnings that then drop off. That's a recipe for paying too much and permanent loss of capital. Trying to estimate the future stream of cash flow for Apple seems to me nearly impossible. So it's somewhat speculative in that sense.

Will Apple become the first company actually worth a trillion dollars? Will, instead, the economics begin to hit a wall?

Both of those very different outcomes still seem at least plausible. I'm sure some others see the upside or downside with more certainty (and may very well end up being right).

Today, Apple's economics are driven by what is essentially a product cycle business (this may change over time, of course). The future always comes down to successfully inventing and executing on great new products and anticipating a very dynamic competitive landscape. Seeing things others haven't imagined. That's not often a recipe for a great long-term investment. In contrast, I'm pretty sure people will be buying Coca-Cola (KO) and Pepsi (PEP) products even if they don't innovate. Sales may suffer a bit but they'd probably do okay economically.

I'm not saying that Coca-Cola or Pepsi's business is easy. No business really is.

It's just that in the world Coca-Cola and Pepsi operate, the competitive landscape changes relatively slowly and they have tremendous durable competitive advantages. They may get beat up a bit from time to time (or beat each other up...at least in beverages) but the essential economics remain more knowable while the range of likely outcomes seem at least relatively narrow compared to Apple.

Now, plenty of speculation* occurs in shares of subpar businesses with questionable long-term prospects. Apple is far from being something like that.

It's well established that the company is capable of setting the standard with brilliant innovation and design yet there's much more to the story. It's also a business with formidable supply chain strengths that lead to cost advantages. Those supply chain strengths also feed into the superior product design. The brand equity they've built through their innovative products have also led to substantial pricing power.

The list of advantages doesn't end there but all of these qualities interact in ways that don't seem exactly easy to replicate. The result is superior economics by any measure.

The above characteristics are not usually associated with a business selling at a single digit price to earnings ratio (P/E). Generally, single digits P/E's are associated with businesses that have questionable economics or troubled businesses experiencing no growth or even decline.

Somehow, even at its substantial size, Apple continues to grow as if a smaller company (and growth that has been achieved with just ridiculous return on capital).

Apple has obviously been a tremendous stock over the past decade yet, somehow, the explosive earnings growth of Apple actually seems to have outrun the stock price.

Considering how well the stock has done it probably doesn't seem possible but the E may have actually, at least based upon what can be known up to this point, outrun the P.

The company's many strengths in combination provide at least for some kind of economic moat...at least for now. The problem I will always have is what that moat will be like five and especially ten years from now.

So Apple's never going to be the kind of business that's really in my comfort zone but it's hard not to be impressed.

For my own money, it's worth owning some shares of Apple when the valuation is low enough.

The economics are, for now, exceptional.

The valuation still not at all high given what's knowable.

Yet, I still consider it somewhat speculative. So, unlike businesses with more clear long-term durable competitive advantages, it will always be kept on a shorter leash.

Adam

Long positions in AAPL, MSFT, KO, and PEP all bought at much lower than recent market prices.

* Along with speculative prices. In fact, shares of quite a few seemingly inferior businesses in recent times were/are selling at 50x to 100x earnings or more. Oh, and some pretty good businesses also sell at very high P/E's.
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