We recently published an article On October 7, 2013 titled: "Apple at $800: flight delay or cancellation?", where we pointed out that Apple, Inc. shares (AAPL) boast an attractive adjusted forward price/earning (P/E) ratio of 7.48 for the year ending September 2014 and 8.18 for the year ending September 2013.Adjusted forward P/E ratio was calculated by excluding $146.6 billion in cash and long term investments from its market capitalization of $438.8 billion, hence yielding an adjusted market capitalization of $292.2 billion.
Some may argue that excluding cash and long term investments should also exclude returns associated with such assets. During its latest quarterly earnings release, Apple recorded other income/expense (which usually includes earnings associated with cash holdings and investments as well as hedges) of $234 million for the
quarter and $1,043 million for the nine month period ending June 29 2013. Even if we are to extrapolate that Apple's cash and long term investments on an annual basis are generating as much as $1.3 billion at the moment, and such income is excluded from its earnings, Apple's adjusted price/earnings ratio would be 8.48 for the year ending September 2013 and 7.74 for the year ending September 2014.
Apple deserves a higher price/earnings ratio than current levels. Its price/earnings ratio is facing headwinds due to the fact that Apple's market capitalization is quite large, hence it is increasingly difficult for its share price to move higher due to sheer size, as it is already almost a half trillion dollar company. At the same time, Apple is facing headwinds as there is skepticism about the longevity of its main revenue generating product, the iPhone, and some of its other products (iPad and iPod), hence only securing a price/earning ratio comparable to an electronic equipment consumer goods company, whereby average price/earning ratio for such sector is about 11.6, haunted by memories of Palm, Blackberry, Nokia, etc....
Even by such measure, when taking Apple's cash and long term investments into consideration, Apple's price/earning ratio is underperforming. Yet, Apple is not a typical technology consumer electronics company, as it has been in business for over three decades, has an established track record for consistently introducing blockbuster products, and it is involved in multiple sectors including retail, personal computers, software, services & media (radio, music and video).
Could Apple unlock higher total shareholder value by slicing/spinning-off itself into multiple companies? Apple Corporate Services Inc. would provide legal/regulatory, accounting, human resources, executive, administrative and marketing services to other Apple companies. Apple iPhone Inc. would specialize in mobile phones, Apple Computers Inc. would specialize in Macs, iPads and other computer devices, Apple iTune Inc. would specialize in music, video, radio and other media, Apple Service and Accessories Inc. would specialize in accessories, peripherals, etc... Apple Retail Inc. would specialize in retail outlets. Apple New Business Initiatives would develop new products, hold intellectual
property rights, and conduct research, while generating revenues by charging royalties to other Apple companies, either existing or launched, to incubate, launch and sell the new product lines (similar to ARM Holdings plc (ARMH) which develops intellectual property and generates profits from generated royalties charged to microprocessor chip manufacturing companies). Apple Software would develop all software. Finally, Apple Consulting, which would be primarily mandated to preserve and expand the Apple ecosystem, by working horizontally across different Apple companies, drawing synergies, ensuring teamwork and leveraging the scale of the Apple group of companies.
Assuming that under such system Apple is able to preserve its ecosystem and family scale, then there is no question in our mind that the total value of all the market capitalization of the created Apple companies would substantially exceed today's market capitalization of Apple Inc.
According to a simulation we ran, utilizing our own estimates for margins for each Apple product, in conjunction with Apple's data sheet, we estimated that Apple generates about 65.3% of its profitability from the iPhone, 22.4% from the iPad and Mac, 1.5% from the iPod, 7.6% from iTunes and 3.2% from accessories and other.
ratio of 17.5 for the personal computer industry, 27.6% for application software, 15.2 for business software and technology, 11.6 for electronic equipment consumer goods, 21.86 for technology, and introducing our own filters to further dampen such numbers, we estimated that the market capitalization weighted average price/earning ratio for most of the above hypothetical companies would be no less 13.6. When we take into account newly created value from Apple New Business Initiatives (which we estimate would add no less than about $10 billion in market capitalization), we reach a weighted average price/earning ratio of about 14.
Compared to Apple's current adjusted price earning ratio of 7.74 for the year ending September, 2014, it does seem that Apple certainly tastes a lot better by the slice. However, whether Apple is offered by the slice or as a whole, it does seem there is a lot more value in its ingredients than current market valuations.
So should Apple be sliced? We don't think so; the risk to the ecosystem and integration would be too high. As a matter of a fact, if Apple had existed in its past as a series of slices, and if the weighted average price/earning ratio of its slices was indeed 14, then analysts and bankers would have made the case why a super-merger among all such Apple slices/companies should take place, placing a premium of no less than 20% on the sum of the parts....
The bottom line is that we feel Apple is extremely attractive at current price levels and valuations. For those who are skeptical, maybe they need to think of Apple slice by slice and then sum them up... Investors who share our perspective can either buy Apple shares at current levels, where they closed at $489.64 on October 10, 2013, or possibly buy calls expiring in April 2014 for a premium of about $23.