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March 30, 2006

A Debate Over Apple Computer

Over and StreetInsight.com, where I write daily commentary, there has been a series of posts debating the value of Apple Computer (AAPL) shares. A StreetInsight colleague got the ball rolling with a cautious post. Another colleague and I took up his challenge and responded. What follows is the exchange as it is currently archived on the website:

We had an exchange on our site (March 29 and March 30) regarding methods for valuating Apple Computer's stock. Tom Au got the ball rolling when he posed the following open question to AAPL bulls: "Does anyone think that Apple's return on equity could go as high as 30% in the next year or so, based on a book value today of about $11 a share?" To which Apple bull Jeff Bagley replied that "any valuation method that depends primarily on ROE is mostly meaningless when it comes to Apple Computer." Jeff admits that it has been a painful few months for AAPL bulls, but he puts his valuation in the company's positive free cash flow yield of more than 4.0%. The following day, Steve Birenberg also weighed in by agreeing with Jeff. Steve pointed out that an ROE-based valuation doesn't mean all that much because AAPL is a momentum stock.

Click "Continue Reading" below to see what Tom, Jeff had to say....

Tom Au
Open Question for Apple Bulls
3/29/2006 10:04 AM EST
This article was originally published in Market Insight on March 29, 2006.

On March 10, I placed a "pan" (don't buy) comment on Apple Computer (AAPL) (in the mid-60s), a weaker rating than an outright sell. This elicited comments from others that I have read with interest as to why the stock should stop going down. In particular, Steve Birenberg, a tough and worthy opponent on the Comcast (CMCSK/A) debate (where we're basically tied), published on Apple today. Since early March, the stock drifted downward to below $60.

The question: Does anyone think that Apple's return on equity (ROE) could go as high as 30% in the next year or so, based on a book value today of about $11 a share? It's now in the low 20s, a very good, but not stellar figure. This correlates closely with the 22% growth rate used in, for example, Bloomberg's dividend discount model (DDM). (If a company pays no dividends, as is true of Apple, the ROE is sometimes a fair proxy for the company's medium-term growth rate.)

Based on 22% growth, Bloomberg's DDM indicates a fair value of about $45. The break-even growth rate would be about 25%, based on price of $60. With a 30% growth rate, the implied price would be $87.

Using my modified investment value metric, my buy price would be (30/15)-squared * book value or 4 * 11 = 44. This would represent a situation in which investors observed a 30% ROE, but doubted that it (or its corresponding 30% growth rate) would be sustainable. It's noteworthy that Apple pays no dividends, and hence, the modeled stock price does not benefit from a 10 times dividends term.

My target selling price would be 30 times the resulting earnings of $3.30 a share, or $99 a share. This is an application of the PEG rule, P/E ratio  ROE, in which ROE is substituted for the growth rate. In fact, the ROE is more often a cap rather than a proxy for a sustainable growth rate. (Companies like Apple can temporarily grow faster than their ROE as this metric ramps up from a lower to higher level. For instance, a rise in the ROE from 2%, where Apple started several years ago, to as little as 4%, would represent 100% growth off a depressed base.)

The range of 44 to 99 is a bit wider than usual, occasioned by the highly hypothesized ROE, but value investors often look to buy at 50 cents on the dollar and sell at 100. From a price of $60, the downside risk would be about $15, and the upside about $39, a risk-reward ratio of better than 2.5 to 1.

Even with an ROE target that I find aggressive (30%), I could see my way to losing money with the current entry price, below $60, (although the potential reward would more than balance it). Can Apple's ROE in fact get that high? I'm a bit skeptical, but certainly willing to listen to arguments from the other side.
No positions, pending some answers

Jeff Bagley
Apple: I See Incredible Value at These Levels
3/29/2006 11:37 AM EST
This article was originally published in Market Insight on March 29, 2006.

I'll be the first to admit that being an Apple Computer (AAPL) bull has been painful this quarter, and with the benefit of hindsight, I was a pig in the stock. But our clients enjoyed a great run with this stock last year, and I'm fairly confident that the company continues to represent a great long-term holding. Note that many insiders effectively increased their stake in the company yesterday, so I guess I'm not alone in my bullishness.

Return on Equity Is a Mostly Meaningless Metric for Apple

To answer Tom Au's question, I point out that any valuation method that depends primarily on ROE is mostly meaningless when it comes to Apple Computer. Before I'm called crazy, let me point out that the company has too much cash on its balance sheet and no debt.

If it so chooses, Apple can lever up using debt, buy back shares and/or pay a special dividend. The immediate result would be a huge increase in return on equity. A huge increase! Accordingly, I view your model, in this case, as a good illustration of garbage in, garbage out.

Management Silence, in Words and in Action, Doesn't Help

But will the company lever up, buy back shares or pay a special dividend? No, and that's part of the problem. The company has refused to defend its stock at all, and that's surely contributed to the sickening decline.

Management's silence in the face of all the negativity --Intel (INTC) transition, iPod seasonality, France, etc. -- along with insider selling by Jobs, makes investors fear the worst. The stock trades like death. Who can blame anyone for selling? The "playbook" says that this thing has negative preannouncement -- or something similar -- written all over it.

Company Policy Is Company Policy

The company does not comment on fundamentals during the quarter, except for milestone announcements (e.g., the billionth iTune downloaded) along the way. And the board of directors is dogmatically against share repurchases. That leaves the Apple shorts with plenty of ammunition -- Carte Blanche, if you will -- and the Apple longs wondering why the heck they're still long this canine-like stock that with few exceptions, goes down every single day.

Insiders Exercised Options, Increasing Their Stake

Although much of the insider trading activity has focused on Steve Jobs, I point out that last Friday, eight executives exercised options underlying 1.9 million shares. They surrendered 864,264 to the company to cover the cost of exercise, effectively increasing their stake in the company by more than a million shares, representing more than $61 million.

Now I realize that they didn't put up cash to purchase the shares. But they could have sold the stock. It looks to me as if they see a bargain, and this is at the end of a very tumultuous quarter.

Valuation Especially Compelling

I know you've heard it all before, but I view Apple shares as especially compelling using my favorite metric: free cash flow. On a trailing 12-month basis, which I believe is a conservative way to approach it, the company generated approximately $1.759 billion in free cash flow. Adjusting for the $8.7 billion (about $10 per share) in cash and short-term investments on the company's books, this yields a free cash flow yield of more than 4.0%.

That's very attractive given the current level of interest rates and the company's torrid growth. The company's excellent market position in the evolving digital revolution, as well as the incredible resurgence of its computer business, will likely enable Apple stock to once again regain its high-flying status.

Note, also, that the company bounced nicely off its 200-day moving average this morning. The technically oriented crowd has been all over this stock, so we'll see if the 200-day moving average represents real support. I sure hope so.

Steve Birenberg
My View on Apple Valuation
3/30/2006 8:44 AM EST
This article was originally published in Market Insight on March 30, 2006.

Current Consensus

The current consensus estimates for Apple Computer (AAPL) in 2006 and 2007 are $2.14 and $2.62. The high estimates are $2.41 and $3.05, respectively. AAPL has been easily beating consensus estimates for much of the last two years, although I believe part of the reason for the sharp pullback in the shares is a fear that that this trend is over. In fact, estimates have been coming down some recently as analysts have adjusted their own numbers to be more in line with management guidance due to the Intel (INTC) transition for Macs and the seasonality of iPod sales.

Apple Won't Quite Make a 30% Return on Equity

Tom Au asked if the company could earn a 30% return on equity in the "next year or so." When I look at stocks and try to determine upside/downside targets, I typically look at next year's earnings on the upside and current year earnings on the downside. On that basis, at the consensus estimate, the answer to Tom's 30% ROE question is not quite, even if the high estimate were earned. Of course, if the high estimate is earned, this debate is irrelevant as the stock would soar to Tom's bullish target of $99 on the renewed confidence in earnings momentum.

As Jeff Bagley pointed out, the ROE debate on AAPL is complicated by the fact that the company has $8.7 billion in cash and no debt. Both those things serve to reduce ROE, although neither is a financial or fundamental weakness.

Cash Could Contribute 28 Cents of 2006 Estimate

Let's stipulate that AAPL can earn 4.25% on that cash. Taxed at the recently reported quarterly rate, cash could contribute 28 cents of the 2006 estimate and a larger amount of the 2007 estimate as free cash flow builds the cash balance.

Hypothetical Buyback Results

As noted by Jeff, the company could easily bump its ROE by levering up to buy back stock. Even though, for whatever reason, stock repurchase is off the table at AAPL, let's look at what would happen if AAPL spent all its cash to buy back shares. The current cash balance would buy 150 million shares if the company paid $65, bringing shares outstanding down to 730 million. Subtracting lost after-tax interest income leaves $1.65 billion in net income in 2006 and about $2 billion in 2007. Using the lower base for shares outstanding, EPS would be $2.26 and $2.80, making the share buyback accretive by 12 cents and 18 cents, respectively.

If the current book value were adjusted to the share buyback and 2006 and 2007 net income, book value would drop to about $3.4 billion or $4.65 per share. ROE would now be 60% in 2007 and the answers to Tom's question would be a resounding yes.

AAPL Is a Momentum Stock

What does this prove? Absolutely nothing. For a stock like Apple, Jeff is right that ROE-based valuation doesn't mean all that much. Apple is a momentum stock. Most value-based approaches won't work in guiding the stock price. Rather, investor sentiment and earnings momentum work interchangeably to determine the price of the stock.

Right now, sentiment is poor, and earnings momentum could be slowing. My argument in many posts has been that there is plenty of revenue and earnings growth ahead driven by new iPods, rising sales of Macs, and an increasing contribution from high margin iPod accessories. Also, the revenue upside from an Apple phone is enormous relative to current APPL sales. Where I have been wrong is expecting the stock to pay for this growth now when sentiment is poor and earnings momentum is slowing. Where I will be right is when the earnings come though and sentiment improves. I believe that time is not far away.

Posted by Steve Birenberg at March 30, 2006 10:22 AM in AAPL