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Apple vs. Amazon: A Tale of Two Tech Stocks

U.S. stocks have displayed substantial volatility thus far in 2014, but gained little ground overall following 2013’s spectacular returns. When stocks churn up and down but fail to establish a definite direction, analysts will sometimes say prices are “consolidating,” or “stuck in a trading range.”

But that does not mean that the prices of individual stocks all follow the same directionless pattern. The chart below shows the percentage change in the prices of two popular technology stocks, Apple and Amazon, from early January to late April 2014.

AAPL-AMZN-01

While both stocks started the year with losses, declining by 10% (Apple) and 13% (Amazon) by late January, Apple went on to earn a positive return (+4%), while Amazon’s stock has continued to slide, accumulating losses of almost 24% over the same period. The two companies’ very different reactions to their recent earnings announcements in late April can be seen in the chart — Apple’s stock gained almost 8% in one day, while Amazon’s declined by almost the same amount. What caused these two tech giants to have such different returns thus far in 2014?

The answer has to do with the ability to grow profits and earn a sufficient return on the capital invested in each company, usually referred to as a company’s “fundamentals.” The next graph compares each stock’s gross profit margin, which measures the percentage of sales revenue left over after covering basic costs. The companies look competitive, with Amazon gradually expanding its gross margin.

AAPL-AMZN-02

But when we progress a little further down the income statement and compare each stock’s operating profit margin, which takes a more complete range of expenses into account, a different picture emerges:

AAPL-AMZN-03

Apple posts a consistently positive operating margin that fluctuates between 25-35%, while Amazon’s starts out low (below 5%) and deteriorates further, all the way down to 1% for fiscal year 2013. Worse still, Amazon has pre-warned the market that it is likely to lose money in the 2nd and 3rd quarters of 2014, with the possibility of even further deterioration in its operating margin. The market clearly disapproves of this trend, and has reacted by punishing Amazon’s stock price.

The next graph compares Apple and Amazon based on their return on invested capital (ROIC), which measures the change in value of each dollar invested in the companies over a full fiscal year. In order for a company to grow its value, its ROIC must be greater than its cost of capital, or the minimum return demanded by investors each year. While the cost of capital can vary widely, from as low as 5% (for the safest companies) to as high as 12% (for the riskiest companies), the return on capital must always be above the cost of capital, or the company is decreasing the value of investors’ capital.

AAPL-AMZN-04

When it comes to return on invested capital, Apple is amazing — it has been increasing the value of investors’ capital for years. While Amazon earned a healthy ROIC in 2009 and 2010, their ROIC has evaporated in recent years, even turning negative in 2012. And, based on Amazon’s recent announcements, investors can expect continued substandard performance from the company for at least several more years.

Therefore, although the brand names “Apple” and “Amazon” evoke similar admiration among consumers, when we “open up the hood” and view the companies from the perspective of an investor, we quickly see that we are dealing with two completely different cases. Apple is not only an exemplary brand, but a strong and profitable company. Amazon, on the other hand, is suffering through some major growing pains as it tries to wean consumers away from the deep-discount/free shipping mentality that is the root cause of the company’s lack of profitability. Based on the dramatic declines in its stock price so far this year, the market apparently remains unconvinced that Amazon will be immediately successful at restoring its profitability to acceptable levels.

[Data supplied by S&P’s Capital IQ. The author holds no positions in AAPL or AMZN at the current time.]

Categories: Market Commentary

Get Real: 2013 was Another Sluggish Year for GDP Growth

The last 4 years have been characterized by a consistent phenomenon among economic forecasters: each year began with forecasts of strong consensus growth ranging from 3.0-4.0%. As each year 2010-2013 unfolded, however, these forecasts were gradually ratcheted down until the final, disappointingly-low revised number was quietly revealed. Despite all the go-go forecasts, 2013’s final growth rate settled down to a lackluster 1.9% — the average since 2000. The chart below shows the annualized growth rate of real GDP (trailing 4 quarters) since 1948.

Real-GDP-Annual-Growth

The 30-year trend of slowing growth is evident in the graph. Average growth has fallen every decade since 1981. Since 2000, Real GDP growth has averaged only 1.9% per year. Despite reduced tax rates, staggering budget deficits, artificially low interest rates and multi-trillion dollar stimulus programs, this is all the growth the US economy has been able to muster.

Until economists set aside their “magical thinking” and start discussing the economy in which we’re operating, rather than the economy they wish we had, we’ll continue overdosing on the wrong medicine. To read more on how our collective thinking can become so highly focused on the wrong issues, refer to my 2009 article The Dogma Days of Summer.

Categories: Market Commentary

Sector Returns Q1 2014: Utilities and Health Care Led the Way

One of my favorite ways to gauge market sentiment is to study which sectors led the way over the past quarter (I use the returns to the SPDR sector ETFs — data obtained from S&P’s Capital IQ). For the all-important first quarter of the year, comparing sector returns can also signal what type of a year it will be for stocks. The first chart shows that two distinctly risk-off sectors, Utilities and Health Care, had the best returns for Q1, with 10.9% and 6.1% total returns, respectively.

01-Health-Care-Utilities

The middle of the pack sectors were Telecom (3.8%), Materials (3.1%), Financials (2.7%) and Technology (2.7%). These sectors delivered respectable returns, but suggest a more cautious outlook for 2014. If investors were more bullish, we would expect sectors such as these to outperform the safer Utilities and Health Care sectors.

02-Telecom-Materials-Financials-Tech

Bringing up the rear we have Energy (2.1%), Consumer Staples (1.6%), Industrials (1.6%) and Consumer Discretionary (-2.7%). The weak performance of the risk-on sectors (Energy, Industrials and Consumer Discretionary) reinforces the impression that investors waded into stocks cautiously in Q1 2014.

03-Energy-Staples-Industrials-Discretionary

A sluggish first quarter for stocks is not that concerning, given the 30% returns we saw in 2013. A quarter of consolidation is certainly warranted. If the risk-on sectors don’t play a bit of catch-up in April-May, however, especially Consumer Discretionary, Industrials and Energy, we may be in for yet another “sell in May and go away” range-bound summer. Stay tuned.

Categories: Market Commentary

S&P 500 Forms Ominous Technical Pattern

[02.16.14] I look forward to fund manager John Hussman’s blog posts each week (hussmanfunds.com). John is an experienced market researcher, but in some of his articles last year he reflected on his overvaluation concerns, which were similar to those expressed by Jeremy Grantham’s team (read GMO’s November 2013 newsletter here regarding asset overvaluation in 2013).

Hussman’s February 17 post contains some dramatic updates to his long-term market thesis that I will review below, and then comment on further. I recommend reading John’s full article: Topping Patterns and the Genuine Cause for Optimism. (First 6 exhibits that follow are from Hussman’s Feb. 17 article.)

First, John reproduces a graph he’s been updating frequently, using a methodology from Didier Sornette’s Why Stock Markets Crash:

Log-Periodic-BubbleThe graph shows the S&P 500 converging on what Sornette terms a “log-periodic bubble,” which is essentially caused by investors “buying the dips” reflexively every time the stock market declines in value. “Buy the dips” results in corrections that are shorter and shallower each time. This pattern has prevailed immediately before each of the most serious historical stock market bubbles burst (1929, 1973 and 2000) — the fact that it’s repeating again in early 2014 is mildly nerve-wracking.

Next Hussman explains a technical pattern known as “3 peaks and a domed house,” attributed to George Lindsay’s Art of Technical Analysis, which was edited and updated by George Carlson in 2011. The pattern is shown below — Hussman asserts that we are most likely at point 27 in the pattern — the one just before a market crashes:

3-Peaks-Domed-HouseThe similarities with 1929’s point 27 (S&P 500):

3-Peaks-19291973’s point 27 (S&P 500):

3-Peaks-19732000’s point 27 (Dow Jones Industrial Average):

3-Peaks-2000and 2014’s point 27 (S&P 500) are impossible to miss:

3-Peaks-2014Considered along with the Sornette log-periodic bubble analysis, I would say this additional perspective takes us into moderately nerve-wracking territory — especially after a 5-year bull market run that’s raised equity values 135% above the March 2009 lows.

The Shiller P/E10 (or “CAPE,” for cyclically-adjusted P/E ratio), is one of the most popular metrics analysts cite as signaling overvaluation. Some analysts have questioned if the P/E10 is as relevant as it once was, however. (This article by Chris Turner via Advisor Perspectives explains how analysts use the P/E10 to estimate the fair value of the S&P 500.)

I have written several articles on how the P/E10 forecasts long-term stock returns (including The Journal of Portfolio Management, June 2007). Below I’ve updated the exhibits from a 2012 article I published in Problems and Perspectives in Management, entitled Could US Stocks be Fairly-Valued Under the “New Normal” Paradigm? The graph shows that, as of year-end 2013, US stocks were overvalued based on historical values of the P/E10, but only by as much as 8.6% if investors are benchmarking “normal” to the post-1982 period (the start of the last secular bull market):

SP500-Fair-Value-PE10On the other hand, if the market’s memory is shorter, and investors benchmark fair value to a P/E multiple based on only a 3-year moving average, and use an exponential moving average of past earnings that places more weight on recent observations (which I call the P/EXP3):

SP500-Fair-Value-PEXP3US stocks could have been undervalued as of year-end 2013 by as much as 6.8%, if, once again, investors are benchmarking “normal” to the post-1982 period.

Conclusion: Both a Sornette log-period bubble and a Lindsay “3 peaks and a domed house” formation are evident in US equity values in late 2013 through early 2014. These patterns have preceded the bursting of stock market bubbles in 1929, 1973 and 2000. Additionally, US stocks are “overvalued” based on a traditional P/E10 CAPE, but are within the high range of normal valuation if the market no longer benchmarks to a 10-year moving average of earnings and/or a 130-year history of relative valuation.

Consistent with a large body of research (Shiller’s Irrational Exuberance included), it’s extremely difficult — and perhaps impossible — to see a bubble through the windshield. Only after the bubble bursts, and we can study it in the rear-view mirror, can we rationally deconstruct how we got there and why we couldn’t back away from the precipice with sufficient caution not to burst the bubble. I see current circumstances as another of these instances. Investor enthusiasm for “buying the dips” makes it difficult to forecast the imminent bursting of a bubble, unless there are further negative developments in the unfolding global credit market downturn. I would recommend assuming a strongly defensive position only if global volatility increases significantly. This week’s news flow bears close watching.

Categories: Market Commentary

Is Amazon a “Buy” After Its Recent Price Correction?

In this post I will analyze Amazon, Inc. (AMZN) from a fundamental perspective, and estimate how close the stock price is to fair value after its steep correction, which was triggered by slightly disappointing sales growth (see story on Bloomberg.com). All the tools I use to write this article are featured in my recently-published book, Applied Equity Analysis and Portfolio Management, which also contains a more detailed case study on Amazon’s valuation, and an interactive spreadsheet that allows users to study and model the company’s metrics in even greater depth. As you read the following analysis, bear in mind that the process featured in the book focuses on whether or not a stock is suitable for a fundamentals-based buy-and-hold portfolio.

Amazon makes an interesting valuation case study because it continues to perplex professional analysts, as it has done for years. In a report dated Jan. 31, 2014, Michael Souers of S&P’s Capital IQ downgraded Amazon all the way to “sell,” with a 12-month target price of $350, while a team of 4 analysts at Credit Suisse left Amazon at an “outperform” rating in a report with the same date, estimating the fair value of the stock to be closer to $450. Even after its recent revenue miss and price decline, it is clear that analysts’ opinions remain divided.

For both the past year and last 3 trading months (shown below), Amazon’s stock delivered returns similar to another NASDAQ favorite, Google (GOOG), but Amazon’s Jan. 30-31 price decline stands out:

01-AMZN-GOOG-NDXIn terms of dot.com-friendly valuation ratios, such as price/sales, Amazon even looks like a bargain compared with a stock like Google:

10-PS-AMZN-GOOGAnd, with all that fast revenue growth, Amazon is also competitive in terms of revenue/share:

03-Rev-Share-AMZN-GOOGBut that’s where the similarities end. From a fundamental perspective, investor concerns regarding Amazon’s valuation can be seen by comparing 3-year growth rates (CAGRs) in key value-creation metrics:

02-AMZN-CAGRsAmazon’s 3-year revenue growth is exemplary, but from Dec. 2010-Dec. 2013, earnings before interest and tax (EBIT), net operating profit after tax (NOPAT), EPS and free cash flow (FCF) all contracted dramatically. A multi-year record of selling more and earning less will make it hard for a stock like this to qualify for inclusion in a fundamentals-based portfolio.

Amazon’s valuation problems can be traced to declining operating margins, which means fewer sales dollars get pushed into EBIT, and thus NOPAT and FCF, which hurts its per-share valuation. Amazon’s operating margin compared to Google is vapor-thin:

05-OPM-AMZN-GOOGand does not compare favorably even with a traditional discount retailer like Wal-Mart:

05B-OPM-AMZN-WMTWith such a low operating margin, and thus EBIT and NOPAT, Amazon’s return on invested capital (ROIC) is lower than its weighted average cost of capital (WACC), and thus too low for it to create intrinsic value:

06-ROIC-AMZN-GOOGThus, while Amazon has market value-added (MVA) per share that’s comparable to Google:

07-MVA-Share-AMZN-GOOGand far superior to Wal-Mart:

07B-MVA-Share-AMZN-WMTAmazon does not measure up in terms of value-creation metrics such as economic value-added (EVA) per share:

08-EVA-Share-AMZN-GOOGor free cash flow per share:

09-FCF-Share-AMZN-GOOGA multi-year trend of soaring MVA and declining EVA is symptomatic of the type of overvalued stock we want to avoid including in a portfolio that’s focused on fundamentals:

11-EVA-MVA-TrendCredit Suisse’s Jan. 31 report provides their analysts’ per share estimate of Amazon’s fair price using discounted cash flow (DCF) analysis. Their fair-value price of $449 is based on a WACC of 10.5% and perpetual growth of 3.0%. Next we will use the spreadsheet tools that accompany my book to forecast Amazon’s future trajectory and run our own DCF analysis.

Several of Amazon’s income statement items need adjusting in the forecasts; these are shown in the table below:

12-IS-AssumptionsRevenue growth for the past 5 years averaged 31.2% per year; this is tapered from 24.0% in 2014 (per S&P’s Capital IQ) down to 4.0% in 2018 and beyond, 1.0% more optimistic than Credit Suisse. Although operating margin averaged 2.6% historically, it’s been in a downtrend, so we smooth operating margin back to 6.0% by 2018, which is 1.2% higher than the company has achieved in the past 5 years. Net margin is also smoothed upward proportionately, and we fix share growth at 0.0%, which will also help AMZN’s DCF valuation. The only balance sheet assumption that I changed was property, plant and equipment (PPE) to sales — Amazon has been investing heavily in recent years, and it’s reasonable to assume that these investments will begin paying off, so their PPE/Sales ratio was tapered from 14.7% in 2013 all the way down to 8.0% in 2018 (lower capital intensity will increase pro forma ROIC and FCF, and thus per share valuation).

Amazon has a beta vs. the S&P 500 over the past 5 years of 0.90, but over the past 2 years their beta has been 1.47. To model an optimistic scenario, I leave their beta at 0.90 and estimate a WACC of 8.1%, considerably lower than Credit Suisse’s 10.5%. This will also help Amazon’s per share valuation.

As shown below, the optimistic forecast scenario restores Amazon’s operating margins to 6.0%:

13-Pro-Forma-Op-MarginReturn on equity (ROE) and ROIC expand robustly:

14-Pro-Forma-ROE-ROICas do NOPAT and FCF:

15-Pro-Forma-NOPAT-FCFDespite all the optimistic assumptions, Amazon still models up as overvalued using DCF analysis, however:

17-Intrinsic-Value

My per-share fair value estimate of $309.63 is closer to Mr. Souer’s. Despite modeling an optimistic future trajectory for the company, Amazon’s share price has risen faster than the company’s ability to generate fundamentals such as EBIT, NOPAT, free cash flow and economic value-added.

Conclusion: Amazon’s recent price correction is appropriate for its extended valuation, but the stock still has another 14% to go on the downside before it would represent fair value to a fundamentals-focused investor. The stock has an amazing investor base, however, so this is in no way a prediction of a negative price path for Amazon — many investors appear unfazed by its current P/E ratio of 600+, and the stock has rallied a bit off of its recent bottom. While it may be appropriate for some investor’s portfolios, Amazon does not meet the value profile for inclusion in a fundamentals-based portfolio at this time.

Disclosure: The author holds no shares of Amazon at the current time, and has no plans to initiate a new position.

Categories: Market Commentary

The Steadily-Improving Economic Outlook For 2014

It’s that time of the year — I can’t let the pundits pontificate without throwing my opinion into the ring. This post will take you on a tour of the individual components of The Conference Board’s leading and coincident indicators as described in Chapter 2 of my new book Applied Equity Analysis and Portfolio Management. The chapter describes how to analyze the level and trend of each indicator, synthesize your analyses into discrete scores of -1, 0, or +1, enter these values into the chapter spreadsheet (included with the book), and let the spreadsheet average your scores into a diffusion index for each set of Conference Board indicators. We’ll start with the leading indicators, which are depicted in the table below, along with the weights assigned by The Conference Board.

Leading-Unscored

We’ll start with the Leading Indicators. The most heavily-weighted component is the Average Length of the Manufacturing Workweek (weight = 0.2781), shown below with total employment in the manufacturing sector. The length of the workweek has regained its pre-recession level, which is typically interpreted as a positive signal. Unfortunately, as also shown in the graph, this longer workweek is being enjoyed by 5 million fewer employees in the U.S. since the start of the 2008 recession. Although the length of the workweek is up, the dramatic contraction in manufacturing employment leads me to score this indicator zero, rather than a more optimistic +1.

01A-Man-Work-Tot-Emp

The second leading indicator is the ISM’s New Manufacturing Orders Index (weight = 0.1651). The index has recently reversed its post-recession downtrend, bouncing strongly off its recent low of 50 (suggesting contraction). Notice how previous recessions have been preceded by similar downtrends. I will rate this indicator +1.

02-ISM-Manufacturing

The University of Michigan’s Consumer Sentiment Index (weight = 0.1551) has also been in a slow, steady uptrend, which merits a score of +1. Notice how the indicator collapsed in late summer of 2011 before Bernanke went to Jackson Hole and vowed to leave the QE spigot on full blast for “as long as it takes.”

03-Cons-Sent

Interest Rate Spread Between the 10-year T-Note and the Fed Funds Rate (weight = 0.1069). This indicator is really a proxy for the slope of the yield curve. A steeply sloped yield curve indicates economic expansion, while a flat or inverted yield curve indicates slowdown or contraction. The curve has recently steepened, as longer-term rates have rebounded with the expectation of further tapering of the Fed’s QE program. This indicator also merits a score of +1.

04-Int-Rate-Spread

Manufacturers’ New Orders for Consumer Goods (weight = 0.0811). Nominal and real Durable Goods Orders (deflated by the Personal Consumption Expenditure Index, or  PCE) are shown below. The indicator rebounds sharply following the last recession, with Durable Goods Orders displaying slow, steady growth back to their levels preceding each of the last 2 recessions. The positive signal conveyed by this indicator merits a score of +1.

05-Durable-Goods

The Conference Board’s proprietary Leading Credit Index is replaced by The Chicago Fed’s National Financial Conditions Index (weight = 0.0794). Lower levels indicate “looser” borrowing conditions. Access to credit remains easy, especially for this stage of an economic expansion, so I’ll rate this indicator +1.

06-Chi-Fed-Credit-Cond-Index

Level of the S&P 500 (weight = 0.0381). The S&P 500 is on the verge of breaking out of its secular bear phase. As stock prices are supposed to lead economic conditions by 3-9 months, I will rate this indicator a cautious +1.

07-SP500

The reason for my caution over the level of US (and global) stocks is conveyed by the graphic below, which shows that Central Bank “activity” has fueled stock prices to a considerable degree. I remain concerned over what happens when more significant tapering occurs.

Central-Bank-Equity-Rallies

Manufacturers’ New Orders for Capital Goods (weight = 0.0356). Unlike the pattern observed in Durable Goods, the Capital Goods Orders index has yet to match its level from prior expansions. The trend is up, however, so I’ll rate this indicator zero.

08-Capital-Goods

Initial Unemployment Claims (weight = 0.0334). Unemployment claims continue trending lower. This indicator therefore rates a score of +1.

09-Initial-Unemployment-Claims

Building Permits for New Private Housing Units (weight = 0.0272). This indicator continues advancing, but only to levels associated with the depths of the 1982 and 1991 recessions. I will therefore rate the indicator zero.

10-Housing-Permits

The individual scores for each leading indicator and their weighted and unweighted averages (with possible lows and highs of -100% and +100%, respectively), are shown in the table below. The weighted diffusion index value of +70% is by far the strongest score since the most recent economic expansion began, indicating further acceleration of economic growth through the first half of 2014, and possibly longer.

Leading-Scored

The prospect of faster future growth was confirmed by a Q3 GDP growth rate of +4.0% (see below). The above analysis of the leading indicators corroborates that this may not be an outlier, but representative of our first year of growth exceeding +3.0% in almost a decade.

01-GDP-Growth

Next we’ll consider the Conference Board’s 4 Coincident Economic Indicators. This set of indicators measures the strength of current economic activity. Retail and Food Service Sales (substituting for The Conference Board’s Manufacturing and Trade Sales indicator (weight = 0.5318, shown below)), have risen steadily since the last recession, earning this indicator a score of +1.

01-Total-Sales

Total Nonfarm Payrolls (weight = 0.2597). The US economy is producing jobs, with total employment finally achieving its level from the mid-2000s.

02-Total-Nonfarm-Payrolls

Taking a shorter-term look at payrolls and hiring confirms that the pace of new job creation remains sluggish. I will therefore rate the Total Nonfarm Payrolls indicator zero — the uptrend is positive, but the level of employment is not sufficient for a +1 score.

08-Payrolls-and-Hires

Personal Income Less Transfer Payments (weight = 0.1357). Personal income in the US is at an all-time high, which is definitely a positive. Examining the next graph below, however . . .

03-Pers-Inc-Less-Transfers

. . . I also compare Personal Income to Transfer Payments and Personal Consumption Expenditures. Notice how the upward trend in income and spending is strongly supported by an above-trend sruge in Transfer Payments (Social Security, Medicare, Welfare, etc.). Although I have strong concerns about future reductions in Transfer Payments and the effect on spending, I’ll rate this indicator a cautious +1.

03A-Transfers-PCE-Pers-Inc

Industrial Production (weight = 0.0728). Until last year, Industrial Production was the most heavily-weighted coincident indicator. The nominal series looks encouraging, but the inflation-adjusted series displays some convoluted behavior. Although the trend in the nominal series is upward, the lackluster behavior of the real series leads to a ranking of zero.

04-Industrial-Production

Merging the above -1, 0, or +1 ratings into a diffusion index provides a score of +50% if all indicators are equally-weighted, and +67% if we use the Conference Board weights. The implication is that growth and economic activity have accelerated in the current period.

Coincident-Scored

A few more charts to wrap up. Unless “this time it’s different,” historically bullish sentiment is usually a negative sign for equities — the latest reading of bulls over bears makes me a little nervous:

Bull-Bear-Spread

We also live in a society that abhors discussion of long-term structural problems, like the tens of trillions in underfunded Social Security and Medicare liabilities — we’ll never be able to pay half the “promises” baby boomers are counting on:

Medicare-Social-SecurityIt might not be the disparity between rich vs. poor that incites the revolution:

US-Household-Income-Since-1960Perhaps it will be the one-time wealth tax that keeps being discussed — the exhibit below is from a recent IMF report. Just because it worked in Cyprus, I wouldn’t count on it working in the US . . .

One-off-Tax-Private-Wealth

Of course, much of our short-term prosperity is fueled by the US sinking deeper into debt every day:

05-Debt-and-Debt-to-GDP

Corporate profits as a percent of GDP are at an all-time high, while wages and salaries as a percent of GDP are at an all-time low:

Wages-Salaries-Profits-to-GDP

And much of those profits are increasingly concentrated in the financial sector — even with significant household deleveraging (ah, the power of those hidden fees . . . ).

Fin-Profits-and-Household-Debt-to-GDP

Overall, there has been a significant pickup in economic activity in the second half of 2013. If the Fed treads lightly with its QE tapering, a real GDP growth rate of +3.0% in 2014 is definitely possible. Longer term, however, income disparity, federal deficits and debt loads, hopelessly underfunded entitlement programs and an increasingly “financialized” US economy present significant concerns — concerns that US and global stocks seem content to ignore — until they can’t. For the short term, however, US stocks are likely to rally at the slightest provocation, and the outlook for growth and job creation in 2014 looks more promising than it has in any calendar year since the financial crisis.

Categories: Market Commentary

Is Apple a Buy at $390? The Fundamentals Are Compelling, But the Technical Outlook is Weakening

The market continues its fascination with Apple’s downfall. The stock has now shed approximately 50% of its once record-setting market cap, which exceeded $700 billion in September 2012. Writing for Wall St. Cheat Sheet on April 20, Nathanael Arnold asked “Is Apple Down for the Count?”, although his article concludes that “All Apple needs to do to reverse its fortunes is unveil another must-have product and it could very well once again become the darling of Wall Street.” In this article I will take a detailed look at Apple’s fundamentals vs. key competitor Google, with an occasional comparison to Amazon as well.

Let’s start out with a quick tour of Apple’s profile (all data are from S&P’s Capital IQ, unless otherwise specified). With a market cap of $365 billion, the stock is still a major presence in the NASDAQ-100. Their ROIC of 232% is off the charts, and despite a Friday (04.19.13) closing price of $390.53, the analysts’ consensus target price 12 months from now is $190 higher, at $580. Although the stock is not much to look at from a dividend yield perspective (1.4%), their P/E of 8.8 is lower than technology down-and-outers like Intel (9.4) and Cisco (11.4). Does Apple really merit a P/E multiple usually reserved for deeply troubled companies? We’ll seek to answer that question with a thorough look at the company from a fundamental perspective.

01-Dashboard

The chart below shows the 3-year compound average growth rate (CAGR) for Apple’s key metrics. The company looks great from a rear-view mirror perspective. Average annual revenue growth = 54%, with EPS growing an average of 69% per year. The company has grown free cash flows an average of 34% per year, and economic value-added (EVA) has grown at an average annual rate of 74%. Hard to think of another company that could compete with these results. Of course, the market is a forward-looking discounting mechanism, and after we complete the historical tour, we’ll model Apple’s future a little later in the article.

02-CAGRs

Apple’s historical profit margins and yields look anything like those of a challenged company. Not only are operating and free cash flow margins large — in the 20% to 30% range — but the trend is up for both metrics. As a new dividend-payer Apple’s dividend yield is unexciting, but at $390/share the stock has an earnings yield of 11.4%. Not a lot of double-digit earnings yields to be found these days.

03-Margins-Yields

Apple’s stock performance chart looks like a horror movie. Despite a rough 12 months for technology stocks in general, Amazon and Google managed to post returns of 20-35% over the period. Apple is down 30% year-over-year, and 50% since its all-time high in September 2012. Without question, that is one ugly stock chart.

04-Stock-Returns

The fundamental process I follow first compares the level and trend of per-share fundamentals with a key competitor. We’ll match Apple against Google in the following charts. In terms of revenue per share (the primary source of all fundamentals), Apple is the clear winner. They’ve grown revenue/share from $40 to $170, while Google’s revenue/share has “only” expanded from $70 to $150 over the same period.

05-Rev-Per-Share

The tendency for Apple to beat on per share fundamentals continues for the next several charts. They’ve overtaken Google in terms of EBITDA/share:

06-EBITDA-Per-Share

Earnings per share:

07-EPS

Net operating profit after tax (NOPAT) per share:

08-NOPAT-Per-Share

and Apple’s per-share profits are well supported by free cash flow per share:

09-FCF-Per-Share

Apple’s operating margin has expanded from 22% to 35% over the past 5 years, while Google’s has compressed from 30% to 26%. Operating margin is a key driver of discounted cash flow (DCF) analysis, as it directly affects EBIT, NOPAT and free cash flow. Large and expanding operating margin is therefore a strong positive in any DCF analysis.

10-Operating-Margin

In terms of relative valuation, Apple’s free cash flow yield has been expanding, climbing to 7.0% in 2011 and topping 9.0% in 2012, while Google’s has never exceeded 4.5%.

11-FCF-Yield

Both stocks’ price to sales ratios have been declining since 2009, with Apple’s stock consistently providing better value based on this metric.

12-Price-to-Sales

Next we’ll look at the classic profitability ratios. Apple’s ROA has expanded every year for the past 5 years, most recently topping 24%. Google’s ROA shows a 4-year downtrend, compressing all the way down to 11% in 2012.

13-ROA

Return on equity shows a similar pattern. Apple’s ROE of 35% is more than double Google’s ROE of 15%.

14-ROE

Apple is an absolute killer in terms of ROIC, another key driver of value creation. Google’s ROIC has never exceeded 50%, while Apple’s ROIC has been well above 200% in both 2011 and 2012.

15-ROIC

Economic value-added, or EVA, is one of the purest measures of value creation. While both companies generate large and growing EVA/share, Apple has also overtaken Google based on this metric.

16-EVA-Per-Share

Next we’ll examine trends in Apple’s key income statement drivers as we set up for our discounted cash flow analysis. Apple’s 5-year revenue growth CAGR is 44.8%. Gross margins have expanded from 35% to 44%, with operating margin expanding from 22% to 35%. Net margin shows a similar trend. Common shares expand as stock options are exercised, but the average yearly rate of 1.6% does not dilute Apple’s valuation severely.

17-IS-Avg

Now that we’ve considered the trend in the income statement drivers, we’ll forecast Apple’s future income statement. Years 2013-2016 are explicitly forecasted, with 2017 representing our horizon forecast — the values we model in perpetuity. I’m going to really stress Apple in the forecast to build in a solid margin of safety, as the general consensus is that the company’s operating performance will begin to suffer from competitors like Google and Samsung. As the table below shows, I’ve tapered future revenue growth from 12.0% in 2013 down to 6.0% in 2016, and only 2.0% in perpetuity thereafter — these are very conservative assumptions, and probably appropriate given the intense competition in mobile phones and tablets. I’ve gradually squeezed gross margins from 40% to 36%, operating margins from 31% to 27%, and net margins from 22% to 18%. This reverses half of the gains in margins Apple has earned in recent years. As a new dividend payer, Apple will probably devote a fair amount of energy to growing dividends. I taper dividend growth from 16% to 6%, and use a perpetual dividend growth rate of 4.0%, slower than slow-growing, large-cap dividend plays like J&J. Once again, all the forecasting assumptions are deliberately conservative.

18-IS-Forecast-Assumptions

To calculate Apple’s weighted average cost of capital (WACC), I bumped their historical beta up from 1.03 to 1.20, which raises their WACC to 10.1% (very high in this low-yield market). The higher WACC will suppress Apple’s per share intrinsic value in the DCF model.

18-WACC-Assumptions

The table below shows Apple’s estimated per share intrinsic value each year from 2012 to 2017. Even with the conservative modeling assumptions, Apple has a DCF intrinsic value of $539/share, $149 higher than Friday’s closing price of $390. Granted, the squeezing of the margins in the forecasts puts the stock on a very slow-growth trajectory, but a per-share increase of $200 over the next 5 years (with dividends also likely to grow) is not something too many investors would complain about. The stock models up as extremely undervalued at $390/share.

19-DCF-Intrinsic-Value

Let’s turn our attention to some metrics typically associated with competitive positioning. In the exhibits that follow I use 3 stocks — Apple, Google and Amazon — and treat them as a 3-stock market. The graph shows that, based on the total sales revenue of the 3 companies, Apple is gaining market share while both Google and Amazon lose some share. This is just a fancy way of showing how much faster Apple has been growing, even against star stocks in the same sector.

20-Market-Share

Apple has certain cost advantages over Google and Amazon as well. Apple spends far less on research and development per dollar of sales, which is truly amazing when you consider that the company is still viewed as the greatest innovator of all time:

21-RD-to-Sales

Apple has consistently spent less on CAPEX/sales than Google, and spent less than both companies in 2012.

22-Capex-to-Sales

Apple also dominates in terms of selling, general and administrative expense per dollar of sales.

23-SGA-to-Sales

The exhibit below takes a different look at Apple, using tools provided by EVA Dimensions, LLC. Their PRVit (“prove it”) scorecard ranks Apple as a buy, based on a combination of intrinsic value (ranked in the 94th percentile of the Russell 3000), and actual valuation (ranked in the 48th percentile). EVA Dimension’s PRVit system shows that Apple is fundamentally more attractive than 84% of the stocks in the Russell 3000.

24-PRVit

Of course, Apple’s technical chart looks like something out of a Freddy Krueger movie. The stock price has totally broken down, plunging ever-further below its 200-day moving average for the past 3 weeks. The MACD is increasingly negative, indicating that the negative price momentum is accelerating. The only small bright spot in the chart is the relative strength index (RSI), suggesting the stock is temporarily oversold.

25-AAPL-Technicals

Summing up, Apple’s profound stock price decline of approximately 50% over the past 7 months has left it in desirable fundamental territory. It outperforms Google based on virtually every fundamental measure, and a discounted cash flow model using very conservative assumptions suggests the stock could be undervalued by as much as $190/share. Technically, the stock looks terrible, of course, so it’s hard to pull the trigger and issue a full-fledged buy recommendation right now. The stock bears close watching, however. If technical sentiment turns, or Apple announces a significant reinvigoration of its product line, or a competitive resurgence in the iPhone/iPad space, or even Apple TV, the stock could easily regain $100 a share or more and still be fundamentally undervalued. Apple belongs on every investor’s watch list.

Disclosure: The author owns no shares of Apple at the current time.

Categories: Market Commentary

Commodities’ Prices Signal Downturn as US Stocks are “Last Asset Class Standing”

The chart says it all. In addition to “Dr. Copper” (the metal with a Ph.D., as veteran analyst Barry Ritholtz once quipped), Gold, Aluminum and Coffee have all joined the downturn in commodities prices.

Copper-Alum-Coffee-SP500

Every time we see this sort of divergence, stocks eventually follow. It’s likely to happen even in a Quantitative Easing-fueled, “buy the dips” environment. US stocks have shrugged off an exceptional amount of disappointing macro data in recent months, including plunging Purchasing Managers’ Indexes, a huge miss on the nonfarm payrolls number, and shockingly low GDP growth. Let’s see how long equities can stay aloft before the QE helium starts leaking out of the balloon.

Categories: Market Commentary

CAT, ORCL and FDX: 3 Market Bellwethers Send a Negative Signal

This week 3 market bellwethers — Caterpillar, Oracle and FedEx — all missed their earnings targets. Predictably, the overall market shrugged off this news, preferring to instead focus on Bernanke’s promise to continue repurchasing illiquid debt from banks’ balance sheets at a rate of $85 billion per month. This excess liquidity has been driving up the prices of stocks, real estate and commodities for the past several years, so the market’s habit for shrugging off bad news is familiar in this bull market cycle. But can stocks continue ignoring bad news forever? The chart below shows the returns for CAT, ORCL and FDX for the past quarter:

Market-Belleweathers

In a bull market, we expect leadership from risk-on sectors like Industrials (CAT and FDX) and Technology (ORCL). The graph shows that CAT’s price action has been sounding an alarm since mid-February, when it decoupled from the bull market and turned negative. CAT’s reaction to their earnings miss was therefore less severe than that of ORCL and FDX, which had been participating in the rally until announcing their earnings misses this week. The market reaction was swift, as these misses were largely unexpected.

In the old days, pundits like Louis Rukeyser and Marty Zweig (both watching the big tape in the sky now), would have called strike three on this troubling trifecta of news. If CAT’s not selling as many bulldozers as they thought, doesn’t it mean the global construction boom is slowing? If FDX isn’t growing its shipping business, doesn’t it mean global commerce is slowing? If a technology sector leader like ORCL is surprised at how slowly its profits are growing, doesn’t it mean they’ve overestimated businesses’ ability and need to buy and use their database and business knowledge products? Well, that’s what these signals used to mean — before euphemisms like “Quantitative Easing” were introduced into the vocabulary.

From a technical perspective, all three stocks have broken below their 50-day moving averages, with CAT and ORCL sitting right on their 200-day moving average. FDX still has a few dollars of leeway before it touches its 200-day MA. Nervous territory for investors in these stocks, to be sure.

CAT-03.23.13 FDX-03.23.13 ORCL-03.23.13

For the more intrepid out there, however, the S&P 500 continues chugging along, well above its 50- and 200-day MA:

SP500-03.23.13

These fundamental and technical developments add to my worry list, which began with my March 14 post S&P 500 Decouples from China and Brazil. Renowned technical analyst John Murphy lists such decoupling as a warning signal in his recent post on Wiley’s Capital Exchange Blog, John Murphy’s 5 Laws of Intermarket Trading.

It might be time to take off the tin foil hats, turn down the sound on CNBC, and do a little thinking for ourselves about the market’s prospects for spring and summer. Sell in May and go away worked well in 2011 and 2012 (although the market revived appreciably in late 2012). But, as Larry Kudlow is so fond of saying, no one ever went broke taking profits.

Categories: Market Commentary

Seasonally-Adjusted Housing Permits 515,000 Larger Than Non-Adjusted Permits Over Past 4 Months

As the graph below shows, in the 4 months spanning November 2012 through February 2013, seasonally-adjusted housing permits have been 515,000 units larger than the non-adjusted permits number. Considering that the US had 838,000 housing permits pulled in the past 12 months, these miraculous adjusted numbers seem to fit the Fed’s “QE can fix the economy” narrative a little too suspiciously for my tastes.

SA-Housing-Permits-Minus-NSA-Permits

Categories: Market Commentary