Can Investors Pocket Big Gains From Apple’s “Innovation?”

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

I am quite sure that I was no different from most people in my thinking of Apple (NASDAQ: AAPL) as one of the most innovative businesses in the world. However, upon closer investigation, it is pretty easy to find that many of Apple’s supposedly innovative advances actually resulted from acquisitions. The current McIntosh operating system was built around NeXT, which was acquired in 1996 from Steve Jobs, who returned to Apple as part of the deal, and the touch sensitive technology was obtained with the 2005 acquisition of FingerWorks, which had invented and patented it, and the voice recognition and speech technology, Siri, was acquired in 2010. How Apple acquired these technologies is unimportant; how it applied them is critical to its market leadership.

Apple is cheap as it is

Future prospects are an important consideration prior to making any investment and are almost universally considered, while present value is often given insufficient weight by investors. What we pay for a business when we enter a position is just as important as the future value when it comes to investors’ profits. Apple is cheap today at a price to current year earnings multiple of 11.2. However, after discounting this ratio for the approximate $140 billion in cash and short-term investments held offshore, the P/E multiple for 2013 is a ridiculously low 7.4 times earnings.

As if that would not be enough to entice most investors, the projected five year earnings growth rate for Apple is a robust 15.1%--more than double the current P/E ratio after subtracting cash on hand. It is almost unimaginable that one of the iconic brands of our time could be valued so cheaply, but it is. If Apple simply used its $140 billion in cash and sold $275 billion in bonds at 4% interest, it could buy all of the company’s shares at the current price, pay the $11 billion per year in interest, and still have around $26 billion left over; providing it with an 18% return on the $140 billion. While this will not happen, it provides an excellent example of how inexpensive the current market valuation of this business is; it could double in value and still not be expensive.

Buying more innovation

While Apple is not going to buy itself, the current market presents some wonderful opportunities for Apple to acquire its next round of innovative technology at bargain basement prices. A quick review of Apple’s suppliers revealed two names that I think would fit quite well with the past acquisition strategy of Apple and contribute enormously to its future growth and product advancement. In order to meet this criteria, these potential targets need to be leaders in the technology they provide and have products and services that will contribute effectively to Apple’s future growth and profitability as well as its continued leadership in introducing innovative products and services to its customers. I believe that Cirrus Logic (NASDAQ: CRUS) and Nvidia (NASDAQ: NVDA) are two businesses that meet the criteria for very distinct reasons.

Portable devices require effective power management

Cirrus Logic is mainly known for its products related to the audio aspects of portable devices and its converters that handle signal conversion from analog to digital and digital to analog. While this aspect of its product offerings and technology would be a good fit for Apple, it has less known cutting edge products for energy management in portable devices and LED lighting as well. As tight control over the energy use of portable devices vastly improves the usage time for the device between charges, both of these product lines would afford Apple a competitive advantage in the market today. As Cirrus currently derives over 85% of its sales from Apple, there would clearly be a path for a smooth transition and many synergies available for cost savings.

With Cirrus’ current market capitalization at only $1.15 billion and a P/E ratio of 10.11 times the current years’ consensus estimate, Apple could pay current shareholders a 100% premium, $2.3 billion, to the existing price and still be making an attractively priced acquisition. Another key aspect of this acquisition would be the potential denial of new leading edge power management products to its competitors as well. This acquisition would not even put a dent in the cash hoard of Apple.

Leadership is all about vision

Market leadership is all about having a clear vision of the future direction of your markets. In consumer electronics, what the consumers see determines in large part the purchasing decisions they make. When it comes to visual graphics on consumer devices, there are few names that would come to mind sooner than Nvidia, the maker of the high-end graphics chips used in computers and mobile devices. It is the brand name that is demanded by many serious users of video games played both individually and online.

While the current share price is not inexpensive, it is not ridiculously high and Apple could pay a premium of 25%, about $10.5 billion, to the current shareholders and still only be paying double the projected five year earnings growth rate of 11.9%. It would be hard to think of a more appropriate acquisition for the leader in mobile devices to acquire the leader in graphics chip technology and the acquisition would also give Apple cost advantages over its competitors for these products and early access to new developments in these critical products, helping to assure them of continued market leadership.

Even without an acquisition, Nvidia is a growing company and a leader in its industry, priced at a very reasonable valuation for such a strong brand. It is an attractive investment all on its own when considering the future direction of technology and mobile graphics.

Final thoughts

For investors seeking long-term profits through investments in the technology leaders of today and tomorrow at prices that range from fair to dirt cheap, all three of these businesses would be exceptional candidates for investment. Both Cirrus and Nvidia would be easy, prudent acquisitions for Apple and could deliver quick profits for the shareholder of those businesses.

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Ken McGaha owns shares of Cirrus Logic, short June 2013 $19 puts on CRUS and short June 2013 $435 puts on AAPL . The Motley Fool recommends Apple and NVIDIA. The Motley Fool owns shares of Apple and Cirrus Logic. 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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