Growth Stock Priced as Value Stock?

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

The last year has seen Apple (NASDAQ: AAPL) shares rise nearly 75% to over $700 and subsequently fall by a third to $450. And while you can read any number of theories explaining this, you don't need to know why prices are volatile, only that they are! And, this provides opportunities to value investors!

Sustainable Economic Moat

The winners in the Internet and e-commerce space are finally becoming clear:

Google (NASDAQ: GOOG): With a dominant Internet search product (60% of worldwide market share) as its foundation, Google has built an impressive portfolio (mobile operating system and browser) to unify users' experience as they move from one device to another.

eBay (NASDAQ: EBAY): Broad commerce functionality, including mobile shopping applications and payment services, in-store PayPal point-of-sale tests, and  partnership with Discover, have helped create a leadership a global commerce facilitator for years to come.

Amazon.com (NASDAQ: AMZN): Low-cost operations, network effect, and laser focus on customer service have made Amazon the most disruptive force in shakeout among traditional brick-and-mortar retailers.

Given the short product cycle and intense competition and thus the need to continually develop superior products, Apple is considered as to be more vulnerable in the medium/ long term. The list of once-great consumer electronics companies is of course, long. However,  Apple has staying power because it has built an ecosystem of applications and content spanning multiple devices, creating a relationship that survives any single device. Starting with iOS (operating system), Apple's economic moat may be widening with iCloud ( online storage and synchronization across iOS devices). Once multiple devices are in place, the switching costs are magnified, with people reluctant to replace their phone, tablet, music etc.  at the same time. Here Apple maybe more like Microsoft (with Windows), than Blackberry or Motorola (with Razor)

Demonstrated in Strong Financials

Here Apple has no comparison.

  • Cash flow as % sales of:  Apple generates strong cash flows of 25 – 50% of sales. This higher than not only other fast growing internet and e-commerce companies but also the more mature cash cow tech companies – Cisco, IBM and Microsoft.
  • Return on invested capital (ROIC): At 35–35%, Apple generates higher ROIC higher than both other fast growing internet and e-commerce companies (20-30%) as well as the mature cash cow tech companies (15–25%).
<table> <tbody> <tr> <td> <p><strong><span><span>Company </span></span></strong></p> </td> <td> <p><strong><span><span>Industry</span></span></strong></p> </td> <td> <p><strong><span><span>Stock Style</span></span></strong></p> </td> <td> <p><strong><span><span>Earnings Growth Next 5 Yrs</span></span></strong></p> </td> <td> <p><strong><span><span>Free cash flow % sales</span></span></strong></p> </td> <td> <p><strong><span><span>RoIC</span></span></strong></p> </td> </tr> <tr> <td> <p><strong><span><span>AAPL</span></span></strong></p> </td> <td> <p><strong><span><span>Computer systems</span></span></strong></p> </td> <td> <p><strong><span><span>Large Growth</span></span></strong></p> </td> <td> <p><strong><span><span>19%</span></span></strong></p> </td> <td> <p><strong><span><span>25 - 30%</span></span></strong></p> </td> <td> <p><strong><span><span>35 - 40%</span></span></strong></p> </td> </tr> <tr> <td> <p><span><span>GOOG</span></span></p> </td> <td> <p><span><span>Internet content</span></span></p> </td> <td> <p><span><span>Large growth</span></span></p> </td> <td> <p><span><span>15%</span></span></p> </td> <td> <p><span><span>25 - 30%</span></span></p> </td> <td> <p><span><span>15 - 20%</span></span></p> </td> </tr> <tr> <td> <p><span><span>FB</span></span></p> </td> <td> <p><span><span>Internet content</span></span></p> </td> <td> <p><span><span>Large growth</span></span></p> </td> <td> <p><span><span>28%</span></span></p> </td> <td> <p><span><span>10%</span></span></p> </td> <td> <p><span><span>20%</span></span></p> </td> </tr> <tr> <td> <p><span><span>AMZN</span></span></p> </td> <td> <p><span><span>Speciality retail</span></span></p> </td> <td> <p><span><span>Large Growth</span></span></p> </td> <td> <p><span><span>33%</span></span></p> </td> <td> <p><span><span>< 5%</span></span></p> </td> <td> <p><span><span>20 - 30%</span></span></p> </td> </tr> <tr> <td> <p><span><span>EBAY</span></span></p> </td> <td> <p><span><span>Speciality retail</span></span></p> </td> <td> <p><span><span>Large Growth</span></span></p> </td> <td> <p><span><span>15%</span></span></p> </td> <td> <p><span><span>15 - 20%</span></span></p> </td> <td> <p><span><span>15 - 20%</span></span></p> </td> </tr> <tr> <td> <p><span><span>CSCO</span></span></p> </td> <td> <p><span><span>Communication equipment</span></span></p> </td> <td> <p><span><span>Large Core</span></span></p> </td> <td> <p><span><span>10%</span></span></p> </td> <td> <p><span><span>20 - 22%</span></span></p> </td> <td> <p><span><span>12%</span></span></p> </td> </tr> <tr> <td> <p><span><span>IBM</span></span></p> </td> <td> <p><span><span>Computer systems</span></span></p> </td> <td> <p><span><span>Large Core</span></span></p> </td> <td> <p><span><span>10%</span></span></p> </td> <td> <p><span><span>15%</span></span></p> </td> <td> <p><span><span>30%</span></span></p> </td> </tr> <tr> <td> <p><span><span>MSFT</span></span></p> </td> <td> <p><span><span>Software Infrastructure</span></span></p> </td> <td> <p><span><span>Large Value</span></span></p> </td> <td> <p><span><span>10%</span></span></p> </td> <td> <p><span><span>35 - 40%</span></span></p> </td> <td> <p><span><span>18 - 22%</span></span></p> </td> </tr> </tbody> </table>

 

But, Short term outlook clouding price

The sharp decline in Apple's price have been attributed to no. of issues including – (i.) hedge funds selling to book profits, (ii.) slow down in growth, (iii.) lower gross margins, etc.

Others talk of the fact that – (a.) Apple last quarter had 1 short week compared to previous period (like many retail firms - Apple defines its fiscal quarter not as 3 months but as 13 week periods. To compensate for the 1 or 2 day shortfall it adds an extra week every 5 or 6 years), or (b.)  with $145 per share of cash and $45–50 of EPS over each of next 5 years, Apple appears undervalued today.

Further, Gartner expects the smartphone market to essentially double from 2011 to 2014, so Apple could see tremendous revenue growth even if it only grew at the market rate

 Providing excellent long term buying opportunity

At current prices of $450, Apple appears to be trading at a a substantial discount based on both intrinsic and relative valuation.

  • Intrinsic value: Based on Morningstar analysis – Apple currently trades at 75% of Fair Value estimate, much lower than peer fast growing internet and e-commerce companies (100%+), as also the more mature cash cow tech companies (80% - 90%).
  • Relative value: Similarly it trades at a forward PE of under 8x and a PEG payback of under 5 years – vs. over 8 years for fast growing internet and e-commerce companies  and Forward PE in excess of 10x  for the  more mature cash cow tech companies.

 

<table> <tbody> <tr> <td> <p><span><strong>Company</strong></span></p> </td> <td> <p><strong><span>Price / </span></strong></p> <p><strong><span>Fair Value </span></strong></p> </td> <td> <p><strong><span>Forward </span></strong></p> <p><strong><span>PE</span></strong></p> </td> <td> <p><strong><span>PEG </span></strong></p> <p><strong><span>ratio</span></strong></p> </td> <td> <p><strong><span>PEG </span></strong></p> <p><strong><span>Payback</span></strong></p> </td> </tr> <tr> <td> <p><strong><span><span>AAPL</span></span></strong></p> </td> <td> <p><strong><span><span>$ 455 /600</span></span></strong></p> <p><strong><span><span>= 76%</span></span></strong></p> </td> <td> <p><strong><span><span>8.1</span></span></strong></p> </td> <td> <p><strong><span><span>0.5</span></span></strong></p> </td> <td> <p><strong><span><span>4.5 yrs</span></span></strong></p> </td> </tr> <tr> <td> <p><span><span>GOOG</span></span></p> </td> <td> <p><span><span>$ 775 / 740</span></span></p> <p><span><span>= 105%</span></span></p> </td> <td> <p><span><span>15.7</span></span></p> </td> <td> <p><span><span>1.2</span></span></p> </td> <td> <p><span><span>8.1 yrs</span></span></p> </td> </tr> <tr> <td> <p><span><span>FB</span></span></p> </td> <td> <p><span><span>$ 30 / 30</span></span></p> <p><span><span>= 94%</span></span></p> </td> <td> <p><span><span>38.0 </span></span></p> </td> <td> <p><span><span>1.2</span></span></p> </td> <td> <p><span><span>8.2 yrs</span></span></p> </td> </tr> <tr> <td> <p><span><span>AMZN</span></span></p> </td> <td> <p><span><span>$ 265 / 250</span></span></p> <p><span><span>= 106%</span></span></p> </td> <td> <p><span><span>60.6</span></span></p> </td> <td> <p><span><span>1.4</span></span></p> </td> <td> <p><span><span>8.3 yrs</span></span></p> </td> </tr> <tr> <td> <p><span><span>EBAY</span></span></p> </td> <td> <p><span><span>$ 57 / 53</span></span></p> <p><span><span>= 108%</span></span></p> </td> <td> <p><span><span>18.7</span></span></p> </td> <td> <p><span><span>1.5</span></span></p> </td> <td> <p><span><span>9.3 yrs</span></span></p> </td> </tr> <tr> <td> <p><span><span>CSCO</span></span></p> </td> <td> <p><span><span>$ 21 / 24</span></span></p> <p><span><span>= 88%</span></span></p> </td> <td> <p><span><span>10.0 </span></span></p> </td> <td> <p><span><span>2.8</span></span></p> </td> <td> <p><span><span>7.7 yrs</span></span></p> </td> </tr> <tr> <td> <p><span><span>IBM</span></span></p> </td> <td> <p><span><span>$ 205 / 208</span></span></p> <p><span><span>= 99%</span></span></p> </td> <td> <p><span><span>11.5</span></span></p> </td> <td> <p><span><span>1.1</span></span></p> </td> <td> <p><span><span>6.9 yrs</span></span></p> </td> </tr> <tr> <td> <p><span><span>MSFT</span></span></p> </td> <td> <p><span><span>$ 28 / 35</span></span></p> <p><span><span>= 80%</span></span></p> </td> <td> <p><span><span>8.6</span></span></p> </td> <td> <p><span><span>1.4</span></span></p> </td> <td> <p><span><span>6.1 yrs</span></span></p> </td> </tr> </tbody> </table>

(*) Fair Value using Morningstar estimates.

 Conclusion:

Apple is amongst the most recognizable, valued and admired brands in the world. More importantly it has the “pricing power” to translate this into a sustainable business model with free cash flow and high ROIC.  Yes, it cannot continue to grow at a pace of the last 10 years, but, it is still growing at a healthy rate (2x the mature tech cash cows). Yet it is priced as a value stock - providing both a margin of safety and good chance at earning high returns.


yourrule72 has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Apple, Cisco Systems, eBay, Facebook, and Google. The Motley Fool owns shares of Amazon.com, Apple, eBay, Facebook, Google, and International Business Machines.. 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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