The Sky is Not Falling – At Least Not for Apple

Batten down the hatches. After a long sustained bull market, we are in the midst of an overdue market correction.

But now is a particularly strong buying opportunity for Apple shares.  WHY?

There are two problems with the recent 27% selloff in Apple shares since February 2015:

1. AAPL is now ridiculously cheap – at $97/share it is selling for 10.5 times earnings vs 19.8 for the S&P 500. Adjusting for AAPL’s $142 B in cash (net of debt), the PE ratio is only 7.8x. This compares to 33.9x for Microsoft (27.9x after net cash) and 29.3x for Google-Alphabet (25.3x after net cash).
2. Panic over reports of a 30% drop in iPhone orders is unfounded:

• The media is in a frenzy all based on reports by Japanese business publication Nikkei that iPhone production orders have been cut by 30%. In January 2013 this same publication issued a similar “sky is falling prediction” claiming that production had been slashed by 50%, noting disappointing sales and weakening demand; Apple iPhone sales for every quarter of 2013 (including Q1 calendar year) beat iPhone sales of the comparable quarter in the previous year.
• CEO Tim Cook has repeatedly warned against trying to predict sales by observing isolated supply chain checks.
• For the last nine quarters, Apple has exceeded their iPhone guidance every quarter. Their guidance for Q4 2015 (calendar year) was that Apple would be on track to beat last year’s 74.5 M iPhones.
• Many of these irresponsible attention-grabbing headlines are comparing calendar year Q1 2016 to Q4 2015; that is ridiculous, because sales ALWAYS drop on a sequential quarter basis after the holiday sales surge. The only meaningful comparison for Q1 2016 is versus Q1 2015, which was 61 million iPhones.
• Concern over China sales are at the root of the clamor, yet Stifel analyst Aaron Rakers just reported that sales in China of non-Android phones (which are mostly iPhones) grew 33% (year to year) last quarter to an all-time high of 24.3 million phones.

Is Apple approaching a point where it can no longer report strong unit growth in iPhones? Most likely, yes. Is there any sign that iPhone sales will actually decline any time soon? Absolutely not.

How does this growth picture compare to Microsoft, for instance? Since MSFT’s cash-adjusted PE is 3.6 times Apple’s, Microsoft should have much more expected growth than Apple. However, that is not borne out by recent results. In the last fiscal year, MSFT revenue declined 12% and Apple grew revenue 22%. MSFT grew EPS 5.5% and Apple grew 38%. Looking at the underlying business is even more concerning -- MSFT’s two biggest businesses are under siege by strong cash-rich “free” competitors, and Microsoft has failed miserably in Mobile (which is the future):

• Windows is slipping
• PC shipments declined 11% last quarter – the largest drop ever
• Windows share of OS continues to decline in 45 of the last 46 quarters
• Microsoft’s two OS competitors (Apple and Google) are both offering their OS and upgrades free of charge
• MS Office is losing share
• Apple offers Pages/Numbers/Keynote free of charge, and Google offers Google Doc’s also free of charge
• Mobile has left Microsoft behind
• Microsoft’s OS share is only a dismal 2.9% despite major investments including a disastrous acquisition of Nokia and the failed Zune

How does Apple’s growth compare to Google? Since GOOG’s cash-adjusted PE is 3.3 times Apple, Google-Alphabet should have much more expected growth than Apple. However, that is not justified by recent results. In the last fiscal year, Google grew revenue 13% and Apple grew revenue 22%. Google grew EPS slightly more (44% vs. Apple’s 38%). But that does not warrant a PE ratio 3.3 times higher. And while Google continues to dabble in many businesses, they remain more dependent on their search advertising business than Apple is on iPhone; and with Google’s extreme dominance of search, they are limited to market growth in that business (which should cool as global economic growth slows.)

Concern over Apple having flat-lined in growth has been expressed for several years. Yet in the last fiscal year, Apple’s revenue grew 22% and EPS grew 38%.  That’s faster earnings growth than any of the top 20 market cap stocks.

Here is a comparison of the key stats:

	AAPL	GOOG	MSFT
Market Cap ($B)	$538.5	$477.6	$407.3
Market Cap less Cash ($B)	$396.9	$412.1	$334.7
Net income ($B ttm)	$53.4	$15.4	$12.3
Free cash flow ($B ttm)	$55.9	$12.3	$19.0
PE (TTM)	10.5	29.3	33.9
PE (Forward)	9.3	20.3	16.3
PEG	0.8	1.5	2.0
Quarterly EPS growth (yoy)	38%	44%	6%
Dividend Yield	2.1%	0.0%	2.8%

Even if AAPL’s revenues flatten, EPS growth will continue from Apple's aggressive stock buyback program using all that cash. Apple’s annual free cash flow is $55.9 B, compared to $12.3 B for Google and $19.0 B for Microsoft. So Apple has much greater potential for continued EPS growth fueled by stock buybacks.

So for all the Cassandra’s out there preaching the impending Fall of Apple – Apple is not Troy.

Disclosure: I have owned Apple shares since 1985. I bought Microsoft shares in 1986, but have sold most of those between 176 and 466 times my investment. I bought Google in 2010 and still hold those shares.