How can Apple, the stock with the biggest market cap in the world, possibly be cheap? (But it is)

02/24/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

After Apple (AAPL) blew away analyst consensus earnings estimates of $10.07 a share on January 25 by announcing December quarter earnings of $13.87, Wall Street analysts rushed to push up their price targets for Apple stock. FBR Capital put in a one-year target of $525. Morgan Stanley said $515. Citigroup went wild and said $600 a share.

How quaint.

The stock, which closed at $446.66 before the company announced earnings, hit $509.46 a share on February 14. It pegged a high of $526.29 the next day. And despite some amazing volatility recently, shares closed at $516.29 on February 23.

Wall Street analysts rushed back to their models. $570 a share said Oppenheimer. Credit Suisse upped that with $600. Morgan Keegan and Canaccord went to $650.  Searching on February 22, I found a price target on SeekingAlpha.com of $790.

It’s enough to remind you of the heady days just before the dot.com crash in 2000 when analysts raced to see who could get 15-minutes of Internet play by topping the audaciously higher target price of yesterday with one even more outrageous today. In October 1998 it was Amazon.com (AMZN) to $400. By December 1999 it was Qualcomm (QCOM) to $1,000.

We all know how that came out. The technology-laden NASDAQ Composite Index hit its all time closing high of 5048.62 on March 10, 2000—and then fell off a cliff. By May 2007, it had clawed its way back to half of its 2000 high. On February 22 the index closed at 2933.17.

Investors who remember the technology crash of the NASDAQ fear that if they buy Apple now they’re jumping in just before the plunge. And even more frightening, some investors who remember the 2000 crash also think of Apple as company built on fashion. They worry not just about a replay of 2000 but what happens when Apple misses the next fashion trend.

To these investors I’d say, Hey, it is different this time. Apple stock cheap right now. Yes, you heard me, cheap—because of these very worries. I think $600 a share is a very conservative target price for Apple. I think you have to go out to $650 before you come up with any barriers that might limit the stock—and even then the barriers are mostly in the heads of investors.

Apple sports the biggest market cap of any company in the world--$478 billion--but it trades at just 12.1 times projected fiscal 2012 earnings per share. (Apple’s fiscal year ends in September.) Take away net cash of $100 billion (yes, that’s billion) and the stock is even cheaper. Sales grew by 66% in fiscal 2011 and Standard & Poor’s forecasts 48% sales growth in fiscal 2012. And gross margins are climbing, not shrinking, with size. Standard & Poor’s forecasts that 2012 gross margins will climb in fiscal 2012 from Apple’s 40% in fiscal 2011. This isn’t a stock trading at 100 times revenue and on the distant promise of earnings.

Here you’ve got a company that has grown earnings per share by 82.7% in fiscal 2011, by 66.9% in fiscal 2010, and by 69.4% in fiscal 2009, and it trades at a trailing 12-month price to earnings ratio of 14.6? The price to earnings/growth rate (PEG) ratio for this stock on the projected five-year earnings grow rate is just 0.62. (The PEG ratio divides the PE ratio by the earnings growth rate to give an investor an idea of how cheap of expensive a company’s growth is.) Know what kind of companies have trailing 12-month PE ratios like that? Solid but stolid Blue Chips like 3M (MMM) at 14.72 or electric utility like American Electric Power (AEP) at 12.77. And you know what the PEG ratios on projected five-year earnings growth are for these stocks? For 3M it’s 1.38—growth at this stock costs more than twice as much as at Apple. The PEG for American Electric Power is 3.37.

If there’s an expensive stock in this bunch, it’s not Apple but that solid utility stock.

And to these investors I’d say, despite all the hype around Apple, I think it is one of the least understood stocks on the market. Apple isn’t a gadget company at the whim of fashion. It has built at least two major competitive advantages. It keeps investing heavily in each. And it looks like each advantage is just getting stronger. I don’t see anyone out there ready to eat away at Apple’s two major edges.

And what are those advantages?

First, Apple has built an extraordinary hardware/software ecosystem that yields products that better integrate hardware and software, that therefore presents a significant difference in the quality of the user experience, and that gives the company a way to introduce what are in many ways products pre-sold to consumers.

Apple designs and controls the production of its own hardware and software. That control may rankle companies that work with Apple but it means that the company’s app store is cleaner and easier to navigate than the Android store, that it’s products are easier to set up out of the box than the conglomeration that is a Microsoft/Intel/Hewlett-Packard PC, and that it’s products—to an imperfect but still extraordinary degree—work with each other.

To really, really compete on this level Google (GOOG) would have to not just buy Motorola Mobility (for $12.5 billion) but also find a way to finesse its relationships with all the companies that produce their own flavors of Android phones.

Importantly for investors, Apple understands its advantage here and is building on it. Take the new iCloud product. Are consumers really prepared to differentiate the quality of one cloud-based service from another? Not really—short of a service producing massive outages or data losses. But they do know how easy it is to access cloud-based storage, upload, and download, and how easy it is to use the service from any of their multiple devices. iCloud comes with my iPad and iPhone? Sure, I’ll try it. And once the consumer has tried it, every use makes changing a bigger and bigger hassle.

Or take the new operating system for Apple’s Macs, Mountain Lion, due this summer. It won’t try to make the Mac experience just like that on the iPhone or iPad—that would actually be disruptive to loyal Mac users. But it will move the computer and mobile operating systems into closer alignment so that users of any device will feel that flash of recognition that this too is an Apple environment.

Oh, and industry rumor has it, Mountain Lion will have improved hooks to Apple TV. Anybody really think that Apple TV, in some form, isn’t Apple’s next big product direction?

Second, Apple is one of the technology industry’s great manufacturers—although it makes almost nothing in factories that it owns itself.

Apple’s integration of hardware and software doesn’t just happen, especially for a company that manufactures so little itself of what it actually sells. One of Apple’s biggest areas of investment each year is in its supplier network as the company spends billions to make sure that the companies that make Apple products make them to Apple standards (Yes, Apple could do a much, much better job making sure that its suppliers take care of their workers and I hope the company has been shamed into a serious effort to fix this problem) and get them to where they need to go on Apple schedules. In fiscal 2011 Apple’s capital budget came to $4.4 billion. Of that about $612 million went into the continued build out of Apple’s stores. The rest went into a category called manufacturing and engineering—and of that $3.8 billion went into international investment, most of that in the company’s suppliers.

I think there are two great manufacturing stories in the technology industry today. The first is Intel (INTC), which builds its own factories and relentlessly uses manufacturing technology to drive its competitors into irrelevance. The other is Apple. The two models are entirely different but they both work.

Apple’s is so good that last year’s delay in introducing the new iPhone from the summer to the fall stood out as a major Apple lapse. In a technology industry that is filled with vaporware and product delays the hoopla over the “miss” is an testament to the quality of Apple’s globally distributed manufacturing operation. (If you think this is easy, go ask Boeing (BA).)

The big question for investors is how long Apple can keep this up. I think that’s a legitimate worry. Where will Apple’s next 80% in earnings growth come from?

We can see part way down the road. It looks like March will bring the iPad 3 with a higher resolution display. And on last year’s schedule for the iPhone 4S, in September or October Apple will introduce the iPhone 5 with a bigger 4-inch screen (likely) and with Qualcomm’s quad mode chip to enable the phone on 3G and LTE networks.

The iPad 3 will enable Apple to drive the still immature tablet market. BIP (that is before iPad) sales of tablet devices ran at about 200,000 units a year. In fiscal 2010, the first year of availability, Apple sold 7 million iPads. In fiscal 2011 sales came to 32 million iPads. And this is essentially without a significant penetration of any developing economy.

Over time I’d expect that Apple will lose market share in tablets, but over time Apple is picking up share in the smartphone market. Credit Suisse estimates that Apple will grow its share of the smartphone market to a 24% in 2012/2013. That would be a huge increase since Apple had just 12.4% of global smartphone subscribers at the end of 2011, according to comScore. Still it’s not totally outlandish since Apple picked up two percentage points of share from the end of September to the end of December. And the LTE enabled iPhone 5 would, again industry rumor has it, be compatible with the network operated by China Mobile (CHL), the world’s largest wireless carrier. That should be good for a few points of global market share.

Credit Suisse estimates that there will be a total of 244 million potential customers in developing economies by 2015 with income profiles that would make them potential buyers of iPhones and iPads. These customers represent potential incremental sales of $84 billion for Apple by 2015.

And finally for worried investors I’d list one final way that Apple is different from those dotcom companies that crashed in 2000. Apple finished 2011 with $100 billion in cash and the company is clearly pondering some way to pay some of it to shareholders. (At yesterday’s shareholder meeting CEO Tim Cook repeatedly said Apple is looking at the best use of its cash.)

The most likely method, the market consensus now holds, would be through a dividend. If you subtract Apple’s trapped offshore cash and a reasonable reserve for capital investments, Apple still has enough to pay out a dividend yield equal to the 2.1% yield on the S&P 500.

A payout like that would certainly provide major support for the stock not only because a 2.1% yield is itself attractive these days, but also because paying a dividend would add potential new buyers for Apple’s stock as institutional investors who are prohibited from buying stocks without dividends suddenly found themselves able to add Apple to their portfolios.

None of this makes Apple a buy and forget stock. If Apple TV is Apple’s next big product, will it be any good? Can the iPhone keep picking up share once Nokia (NOK) stops bleeding smartphone sales?

And there’s an important barrier at $650 or so. Credit Suisse calculates that at that price Apple would make up 5% of the S&P 500 index. Very few companies have ever become 5% of the index. ExxonMobil (XOM) and Microsoft (MSFT), yes, but not General Electric (GE) or Wal-Mart (WMT) or Cisco Systems (CSCO). IBM (IBM) managed to reach 6% of the index in the 1980s.

At $650 a share investors would have to be convinced again that this time it’s different. And maybe at $650 it won’t be. But $650 is almost 27% from there. Let's talk again then.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Apple, Boeing and Nokia as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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