Apple Stock: All Good Things Come To Those Who Wait March 8th, 1999 Look, I know by now if you’re an Apple investor you’re getting increasingly impatient with AAPL’s price performance. It’s pretty much a mysterious case of market psychology why Apple, in spite of 15 months perfect execution, can’t post a valuation higher than 13 times earnings. Last week just about everyone but Apple pre-announced bad earnings to soften the blow when the real numbers come in. Apple has no reason to pre-announce poor numbers because it looks like Apple will again show year over year growth in revenue, market share and even gross margins. None of this seems to matter to the herds of sheep on Wall Street as they trampled Apple down indiscriminately with the whole PC industry. The computer manufacturing industry is now in its fourth year of declining growth. PC makers are looking at only a 2 percent revenue increase in 1999 and about a 10 percent increase in unit sales down from a high of 25 percent in 1995. Although Apple makes computers, none of the declining numbers for the PC industry as a whole look remotely like the performance we can hope for from Apple in 1999. Most of that decline is due to the saturation of business end-users. If your company isn’t computerized by now then it probably won’t ever need computers. Apple was never big in the business sector anyway. Another reason we can expect Apple to do better than the PC industry as a whole in 1999 is that Apple’s major markets, publishing and education, are both due for upgrades. Unlike business office usage where it’s hard to justify upgrades beyond 200 MHz, publishing and graphics can never get enough speed and are currently moving from the 604e PowerPCs to the new G3s to stay competitive. At Seybold in Boston last week the G3’s are getting rave reviews such as this strong endorsement by Pfeiffer Consulting. "Apple's Power Macintosh G3 systems, coupled with Apple's software technologies and third party Macintosh publishing software, allow publishers to achieve over 30 percent greater productivity than those using Windows." Cool. Pfeiffer Consulting goes on to say that, "Macintosh requires significantly less intervention by technical support staff, reducing maintenance costs and system downtime." Also from Seybold, TrendWatch, a market research firm based in Harrisville, Rhode Island, noted Apple still has 91 percent of the installed base in graphic design shops and corporate design departments. That’s 91 percent in spite of a multi-pronged concerted effort by the Wintel consortium over the last few years to forge inroads into the graphics community. The education market has yet to get the classroom up to speed with the information age creating an unusually fertile growth opportunity for Apple. Signs are that in the next few years wiring classrooms will become a major initiative of school boards everywhere. In fact, in the state of Texas there are visionaries high up in the education bureaucracy who entertain fantasies of eliminating textbooks in favor of a portable device. Imagine paperless schools in which textbooks were mere applications stored on a student’s hard drive and each classroom had a wireless LAN controlled from the teacher’s desktop. The implications for advancing the productivity of education are only overshadowed by the possible windfall such a shift would be for Apple. That is if Apple can step up to the plate with the P1. With 3 million plus students in the Texas K-12 education system and tens of millions more in gloomy industrial era classrooms across the nation, Apple cannot afford to miss this boat. Because of the opportunities that exist in the education market the potential for the new consumer portable should be considered as great as the iMac. At this point, however, most investors and analysts are very myopic when it comes to the future prospect for the P1. Few see it as rivaling the iMac in success. It would be easy for the AppleTrader to whine and moan about the horribly unfair treatment that the street is piling upon our favorite company. But instead I’ll just list off a number of reasons that make Apple an incredible value play in today’s ridiculously overpriced market. In no particular order: The iMac is the best selling computer in Japan. Hello, New York, anyone awake up there? Apple has belatedly opened an online Apple Store in Japan. Sales in Japan stymied by the usual channel complications that make Japan the world’s most trying market can now be completely sidestepped. Am I the only one who realizes the historical significance of an American company being a stellar success at selling a consumer electronic product to the Japanese? The iMac is making history in Japan. Not only is it a best seller but it’s also the first computer in history to sell slightly better to women than to men. Then there is Canada where the iMac sales have surprised the computer stores who didn’t stock enough and are now taking back orders. Being out of stock in the old days meant possibly missing a sale. Today it means that sale is being deferred to the online Apple Store. Australia, Hong Kong, Singapore and even Europe all report a strong surge in sales. The iMac (still without a PC challenger after 8 months) relentlessly continues the Mac expansion into the relatively unexploited territory of the casual home user. The growth rate among new users with the Internet acting as the killer app will continue to be stronger than the overall figures for the PC industry. Looks like the candy coated iMacs were certainly a marketing coup d’état for Apple. Suprisingly there are still doubting Thomas Wall Street analysts who can’t imagine the iMac phenomena extending much beyond this quarter. Apple’s stock performance in 1998 was the second best in the entire S&P 500, second only to Dell. In spite of this stellar performance which might have lead to over valuation, as I would contend that it has in Dell’s case, Apple is still the most undervalued of all the computer manufacturers. The price to book ratio of Dell is 15 times that of Apple. The price to book ratio of IBM, Compaq and Gateway all hover at about 3 times that of Apple’s. The price to earnings ratio is likewise out of whack with the PC box makers running on average at 2.5 times the ratio of Apple. The price to sales ratio is also on average 2.5 times that of Apple among the PC manufacturers. According to McChat, the source for the calculations above, "If Apple had a price to earning ratio of 34.90, the average of the five stocks (HWP, IBM, GTW, DELL, CPQ) Apple would be valued at $96.69." Surely, it’s too much for us to expect Apple to be treated like one of the PC gang. Still the numbers point out a killer value exists in Apple for anyone who cares to do his homework. In late February, Hambrecht & Quist initiated coverage of Apple with a HOLD rating which seems a bit over-cautious but their report accurately sums up Wall Street’s evaluation of the Apple situation. Everyone is sitting on the sidelines with a wait and see attitude. A memorable paragraph from the Hambrecht & Quist analysis, "The company may be further along than the other leading indirect PC vendors in its re-engineering program in transitioning to the new "earns times turns" business model necessary to be competitive in the market today. Apple has reduced internal inventory to only about two days and has increased inventory turns to 182 (the best in the industry), while bringing the cash conversion cycle down to about 3 days. This has contributed to some of the highest product margins in the industry and significant positive cash flow from operations; the latter giving the company the ability to repurchase shares." That paragraph is music to the ears of an investor. The boys and girls at Apple deserve a big hand for some really excellent work and we investors deserve a better stock price than we currently have. So why a hold rating and not a buy? Well, Hambrecht & Quist note that the easy gains have already been made. Much of the gains thus far they contend were made by cost cutting and margin improvements, not by increased sales which are still below Apple’s peak in 1995. Like everyone else they’re wondering just how long this iMac fad can last. Also the analysis is not forward-looking in that they don’t consider the future profits Apple might realize from the FireWire, the consumer portable, OSX, WebObjects, QT4, or Havi. What, you haven’t heard of Havi? (Home Audio/Video Interoperability) According to Forbes it’s an effort by a consortium of giant consumer electronic manufacturers (Sony, Matsushita, Phillips, Toshiba, Sun, Apple, etc.) to "shape the future of your living room" by setting a universal standard for all your consumer electronic devices to communicate with each other. The lynchpin is the FireWire (IEEE 1394). The motivation is to beat Microsoft to the punch. The Havi standard will not be PC dependent, instead the aim is to converge the controls for every appliance in your house into a hand held device running on a Java or Jini base. My advice, sit tight and accumulate more in the mid-30’s now while you still have the chance. By the end of 1999 Apple is very likely to have a chart similar to 1998’s, sporting a 100 percent gain. 0001001100001000010000000110001000010001000001100011110000 Dell and IBM announced their little 15 billion dollar decade long deal and that caused a further dip in AAPL. Nevermind that the deal won’t even begin to effect the marketplace for a year. Or, that Dell, while being the industry leader at spitting beige boxes out the factory door is not a technological innovator with no R&D and has to get that hardware from somewhere. IBM is a logical choice since they are already a major supplier to Dell. It’s kind of an awkward deal since the two companies will be competing in some areas while trying to cooperate in others. The Wall St. Journal noted that the irony of the situation is "somewhat akin to General Motors becoming Ford’s main supplier." This alliance hardly spells curtains for Apple, yet, at first blush, skittish investors shaved a point or so off Apple’s value as if Apple wasn’t already the most undervalued of the computer manufacturers. CompUSA bombed this week dropping to new record lows on reports that they are losing money like a sieve and see no profit for as far out as one might want to look. The iMac was their best selling computer last quarter so Apple, as usual, is suffering for their unholy alliance with CompUSA. The age of the computer superstores with Soviet-era conceptions of service is long gone. CompUSA is an old dinosaur on its way to the glue factory. Your comments are welcomed.