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Ignore the Media Hype... Buy Apple!

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.


Apple (NASDAQ: AAPL) released its first quarter earnings this week and the company's stock promptly dropped by over 10%. Since reaching a high of $705 back in September, Apple's shares have fallen almost 40% to close the week under $440 per share. Despite this sharp decline, the media frenzy continues with Apple being labeled as a "toxic stock," described as the victim of "the $500 billion market cap curse," and as having problems that can only be fixed by firing CEO Tim Cook. What catastrophic change to the investment thesis must have occurred to warrant such a sharp swing in valuation and sentiment? Well, there wasn't one. Before panicking, investors should take a deep breath and revisit the facts behind Apple's recent results.

The investment thesis is intact

The investment thesis hasn't changed since Apple was declared a top 10 stock just two months ago. Take a step back and think about that; despite losing almost $250 billion in market capitalization, the story hasn't changed. Apple reported another record quarter, sold over 75 million iOS devices, and continues to execute a broad plan for further growth. In looking at the results, the market focused on revenue that narrowly missed expectations and a conservative outlook for next quarter as the signal that the end is near for Apple's growth.

There are several problems with this knee-jerk judgment. First, Apple reporting "only" 18% growth is a bit misleading given that the most recent quarter had 13 weeks, while the same period a year ago had 14 weeks. Eliminating the impact of the extra week drives comparable revenue growth up to 27% over the prior year. This growth was driven by record sales of the iPhone and iPad. To reiterate, these were the highest quantities of iPhones and iPads ever sold. Furthermore, the iPhone continued to gain market share in the U.S., rising 6% to 51% of the smart phone market. When combined with record revenues from iTunes and the app store, every data point favors the conclusion that Apple's popularity and the halo effect are continuing to strengthen. Add in the expected 2013 growth from product refreshes, expansion (including a likely deal with China Mobile), and potentially new products and there really is no indication that double-digit growth will stop anytime soon.

The valuation just doesn't make sense

After beating analysts' earnings per share estimates by $0.37 and generating a staggering $23.4 billion in cash from operations during the quarter, Apple now trades at a remarkably cheap valuation compared to its peers:

  AAPL GOOG MSFT AMZN HPQ
CAPS Rating 3 stars 4 stars 3 stars 2 stars 2 stars
Share Price $450.50 $750.77 $27.63 $273.62 $17.01
Market Cap (in billions) $414.8 $247.6 $234.7 $128.6 $33.1
Dividend Yield 2.4% 0.0% 3.3% 0.0% 3.1%
           
TTM P/E 10.00 23.12 15.07 3,380.83

N/A

TTM P/S 2.57 4.94 3.21 2.16 0.28
TTM Free Cash Flow Yield 11.33% 5.38% 12.4% 0.90% 20.7%
Forward P/E 8.61 14.03 8.77 164.16 4.87
PEG Ratio 0.73 1.16 1.17 4.39 N/A
           
Note: Data as of January 25, 2013

By any of these metrics, Apple's shares are under-priced. Add in the fact that Apple remains debt free and currently boasts around $140 per share in cash and investments on the balance sheet, and these metrics point to even more upside to Apple's shares. Apple's management apparently agrees with the conclusion that the shares are undervalued; Apple instituted a share repurchase program during 2012 and repurchased almost $2 billion worth of its shares during the quarter.

An interesting takeaway from the chart above is just how similarly the market is valuing Apple and Microsoft (NASDAQ: MSFT) right now, with free cash flow yields north of 10% and forward P/E ratios of less than 9. While there is certainly a case to be made for an investment in Microsoft, there is a pretty dramatic reason why Apple remains a better buy. Apple has grown earnings by 70% per year over the past five years compared to Microsoft's 10% annual growth. While analysts expect Apple's growth to slow to around 14% per year over the next five years, that still beats the 8% expectation for Microsoft. As a result, Apple boasts a wildly lower PEG ratio than Microsoft.

Sure, there is risk ... but isn't there always?

A common trend in the "sky is falling" articles predicting Apple's impending doom is the threat of competition.  Microsoft remains the entrenched top-dog in PC operating systems, has rolled out its attempt to gain a material piece of the smart phone and tablet market, and even offers functionality that Apple does not through the Xbox.

Google (NASDAQ: GOOG) remains the largest threat with its Android operating system. While Android is the most popular mobile OS worldwide, it hasn't quite matched Apple's ability to create a halo effect of connected devices and seamless integration. However, analysts do have a point when they contend that Google might not need to achieve its own halo effect to be successful; a simple combination of high penetration in the mobile device market and users' continued migration towards Google's increasingly ubiquitous apps (e.g., Search, Maps, GMail, YouTube, etc.) might be all Google needs to thrive.

Google's Android has also lifted Amazon.com (NASDAQ: AMZN) into the middle of the mobile device war with its Kindle Fire. The Kindle Fire presents a unique threat to Apple given the company's desire to attract as many customers as possible into its own eco-system, even at the cost of losing money upfront on the sale of hardware. Like Google, Amazon has also found ways to successfully generate revenue on iOS devices through apps that offer comparable music, movies, and books as those offered on iTunes.

Meanwhile, Apple's legacy computer business did run into a bump in the road this quarter with a decline in unit sales of 1.1 million Macs. Based on commentary during the conference call, it appears as though this drop is more the result of supply constraints than it was competition from Hewlett-Packard (NYSE: HPQ), Dell, and Samsung. In fact, Hewlett-Packard's recent struggles in the wake of the Autonomy acquisition debacle and Dell's decline opening the door for taking the company private would seem to be an opportunity for Apple to capitalize on competitor weakness and pursue market share gains.  Next quarter should provide the answer as to whether Apple's recent results were a one-time delay or the first signs of weakness.

Competition will not go away anytime soon. However, the market opportunity is so immense that there is no reason that several competitors (including those mentioned above) will be able to generate growth for the foreseeable future. As a result, the simple existence of competition should not be a deterrent to investment.

All things considered, it was a great quarter

It is pretty difficult to reconcile a record-breaking quarter and no long term changes to the long-term investment thesis, with a loss of over $250 billion in market capitalization since September. As a result, any investor should take time to evaluate whether the recent decline in Apple's share price is really warranted. Based on the analysis above, it would appear as though this is a classic market overreaction from media hype rather than a rational reaction to the facts. As always, it is important for each investor to draw a conclusion based on their research and risk profile.

In the meantime, Apple remains a "top 10" stock.


BrewCrewFool owns shares of Amazon.com, Apple, and Google. The Motley Fool recommends Amazon.com, Apple, and Google. The Motley Fool owns shares of Amazon.com, Apple, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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