Saturday, November 20, 2010

Rule #1 Analysis Blitz #3: Apple (AAPL)


First off, I apologize for almost missing my weekly commitment of 1 Rule #1 analysis a week.  I had a somewhat good excuse: I caught a bad case of the flu, and had to stay home from work on Thursday.  I'm getting better now, but still constantly coughing through the night!  Anyway...

On my Facebook account, I've set up my Facebook Notes to pull the posts I write from this blog.  My last post on RIM generated manycomments from my friends.  Since RIM was once the largest Canadian company by market capitalization on the Toronto Stock Exchange, naturally, my fellow Canadians have an interest in the company.  In those comments, competition from Apple seemed to be a recurring theme and there was much interest in Apple as well.  So, I have decided to use Apple for my 3rd Rule #1 analysis.  I'm sure a lot of you would like to see this too, as the iPods, iPhones, and iPads have become so omnipresent in our homes these days.

Moat
As usual, you can download the completed spreadsheet here.

Apple has a perfect Big 5s sheet.  The only red is in the 9-year average EPS growth.  It's red because in Year 1, Apple had a negative EPS, losing $0.05/share.  Since then, the EPS has grown impressively at more than 50% per year!  The company is debt free and in fact, has about $40 billion in cash.  By numbers alone, Apple is a top-notch company.  I don't think there are many companies its size ($281 billion market capitalization) that can match its impressive growth!

From a qualitative standpoint, Apple has a wide, wide moat.  Just check out the price of an iPod relative to a similarly spec'd out MP3 player, and you will find out that Apple charges a premium for the iPod.  Yet, the iPod has a large majority of the market share.  Or you hear about Apple/Steve Jobs' (CEO) "distortion field", which is the notion that people being affected by the "distortion field" loves Apple products regardless of what happens.  Take the iPhone 4 antenna issue...Steve Jobs says that "only" 1.7% of iPhone 4s are affected by the bad antenna design.  If you are an engineer, you know that means the iPhone 4 is not even up to 3-sigma quality standard...which is quite terrible.  However, the iPhone 4 had great sales despite this fact.  Another example is the iPad.  Despite what many people think, Apple did not come out with the first tablet.  Archos, for example, a French company, came out with a number of tablets in 2009.  However, when the iPad came out, it changed the world.  Since then, everyone has wanted a tablet, and to be precise, everyone has wanted an iPad.  This is Apple's moat!

The only thing that has come remotely close to challenging Apple's is Google's Android.  For a long time, Apple had been fairly lonely in the smartphone space and no one came close to offering a similar look and feel of the iPhone, until the Motorola Droid came out.  Using Apple's own words, "it changed everything."  In my opinion, the Android platform is not as slick as Apple's iOS, but it does have advantages that are not insignificant.  For example, its latest version of the OS is able to support Flash on its browser.  You can easily use tethering on it.  It is also available on phones from many manufacturers.  People like choice and this may be Apple's only disadvantage, that it can only come out with a few products because it is still just one company.  This is the only place where I see weakness in Apple's moat.  Keep your eyes on this one because it's going to be interesting!

Applet gets a score of 9 on Moat.

Moat Score: 9 / 10

Figure 1: Rule #1 Analysis of Apple (AAPL)

Margin of Safety
From Figure 1, you can see the sticker price of $463.74 from the Rule #1 spreadsheet.  This was using the assumptions of 20% EPS growth for the next few years and a PE ratio of 20.  Analysts estimated the EPS growth to be 16%, but I thought that was a little low, so I had used 20 instead.  The PE ratio of 20 is currently what Apple has and I thought it was a good number to use.

So, Apple at $306 is still underpriced, but not enough for us to start buying with a 50% margin of safety.  If you think the EPS growth will be higher than 20%, say 23.5%, the entry price would be just above $306. If you feel comfortable making that assumption, you're good to go!

The payback time, using the analysts' estimated growth rate, comes out to be 9.0 years.  Again, that's a low estimate.  If we use 20%, the payback time becomes 8.1 years.  I would say it's not too bad of a number to start accumulating the stock if that was your plan.

Apple's stock is probably fairly priced or a little underpriced, but not with a huge safety margin.  I'll give the MOS score a 6 out of 10.

Margin of Safety Score: 6 / 10

Management
Steve Jobs, the CEO of Apple, is the heart and soul of Apple.  He was one of the co-founders of the company, but was ousted in the early 80s. The company, after a few CEOs and losing the personal computer OS war with Microsoft, finally brought Jobs back as their CEO in the late 90s.  With Jobs back at the helm, he introduced the iPod and iTunes, and brought the company back to profitability.  The rest, as they say, is history.  Apple would not be where it is (the second largest company in the US by market capitalization) without Jobs.

From what I read and hear about Steve Jobs, he is arrogant and somewhat of a control freak and perfectionist.  Regardless, I don't think anyone can doubt that he is a brilliant man.  It is by all of these traits that he's been able to steer Apple in its recent trajectory.  However, a few years ago, Jobs was diagnosed with pancreatic cancer.  He underwent surgery and returned to health.  Several years later, he took a leave of absence and had a liver transplant.  As of late, his health seemed to have returned again, but he is still very thin.  His health is definitely a risk for shareholders, particularly because he has been so influential to the company itself.

If Jobs were healthy, I would definitely give Apple a score of 9 or 10, but because of his health concerns, I rate it a score of 8.

Management Score: 8 / 10

Meaning
Apple has received some criticism for its business practices.  One of the higher profile cases was the string of Foxconn employee suicides.  Foxconn is a contract manufacturer for Apple and is alleged to operate with sweatshop conditions in its plants.  It started with one single employee who committed suicide after losing an iPhone prototype.  The media questioned whether this was a result of the Apple secrecy policy that led to violence against this employee and his eventual suicide.  Later in 2010, more than 10 employees at Foxconn committed suicide and Foxconn's business practices were questioned again.  Although Apple was not directly linked with these incidences, it does not totally exonerate it from them, however.

The Human Right's Campaign, a pro-homosexual group, rates Apple very highly in its "Corporate Equality Index".  It basically means that Apple recognizes homosexual unions as equivalent as heterosexual marriages and provides benefits.  This is one issue that I have struggled with myself.  Although our Catholic faith tells us that homosexual acts are sinful, we are called to be compassionate and accepting to homosexuals.  I have absolutely no problem with this.  However, when a company claims to be tolerant by recognizing homosexual unions, is that a compassionate action or is it actually endorsing in homosexuality?  I don't want to discriminate against homosexuals, but is speaking out against homosexual unions a kind of discrimination?  For now, I don't believe it is discrimination.  First, I do not believe that marriage should be redefined.  It has for millennia been defined as a union between a man and a woman.  To illustrate my point, I will use an analogy.  It is similar to a chair being defined as something you sit on that has legs, and usually not higher than waist height.  Now, a group of NBA players who are taller than 7' have come together and started using tables as chairs.  Because of their height and size, tables are more suitable furniture to be used for sitting.  So, they ask that we change the definition of chair to include tables as well.  Therefore, when benefits are not given to homosexual unions, it is not because they are being discriminated against, but rather, it is just not accepting the re-definition of marriage.  For now, I will maintain this stance.  So, Apple gets some points docked for endorsing in this re-definition of marriage.

Lastly, let's return to "Antenna-gate", the iPhone 4 antenna issue.  Clearly, there has been a design flaw with iPhone's antenna.  If there weren't, Apple would not have given away free bumper cases to consumers who bought the phone.  However, I felt that Apple dropped the ball handling this incident.  Instead of just saying, yes, we made a mistake, period, Apple started releasing videos of how other phones would lose reception if gripped in a certain way.  They had missed the point, which was this: many people were complaining about iPhone 4's reception (including Consumer Reports), much more than any other manufacturer.  Instead of admitting the fact, they tried to create an illusion that the issue really wasn't that bad, "just" 1.7% of the phone were affected.  By the way, HTC claims that only 0.016% of owners complained about the Droid Eris' reception (about 100 times less than iPhone 4).

These ethical issues, although I may have made them to sound fairly bad, are actually quite minor.  When you compare these issues to the issues surrounding Johnson and Johnson, you will quickly notice that Apple is probably not that bad.  In any case, Apple's business itself is good for our society.  It has brought incredible innovation and has made life more enjoyable.  Can you imagine a world without touch screens that let you swipe to go to the next photo? or using 2 fingers to zoom in and out of a page?  or iTunes? or iPads?

Meaning Score: 6 / 10

Summary
Moat Score: 9 / 10
Margin of Safety Score: 6 / 10
Management Score: 8 / 10
Meaning Score: 6 / 10
OVERALL (not an average): 7 / 10

The only 2 problems I see with investing in Apple right now is its Margin of Safety and Meaning.  If you buy Apple now and sales for whatever reason comes under analysts' estimates, the stock has a ways to fall.  You also need to understand the ethical issues surrounding the company.  Although they are fairly insignificant, you should still be watchful.