Apple No Bargain as Crunch Time Nears

Think of Apple (AAPL) as the Latrell Sprewell of personal computer companies. A mere six months after it produced one of the worst implosions in the recent history of its industry, it has come charging back, gaining a reputation as one of the market's most reliable growth stocks.

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But Apple is probably far more volatile than many investors would like to think. The company's consumer focus puts it squarely in the middle of the worst part of the generally bad market for personal computers. And this time, revamping the business won't be as simple as introducing a new color scheme. If Apple is to come back strong, it must accomplish the Herculean task of reversing a deeply entrenched trend in the education market toward computers running the Windows operating system.

Meanwhile, contrary to conventional wisdom, the stock has gotten rather expensive.

Apple has gained about 55% in 2001 amid a steady stream of generally positive news. Apple introduced its lightweight Titanium G4 Powerbook in January, and the product quickly met with a positive reception, helping Apple's notebook sales grow more than 30% in February, the month the Titanium started shipping. In March, the company finally released OS X, its next-generation and long-delayed operating system, to overall favorable reviews. Last week, Apple unveiled its new, lighter, thinner iBooks, and just this week it formally set plans to open its first retail store, confirming months of speculation.

"At this point, they're trading as much on news events as on financials," says David Bailey, an analyst at Gerard Klauer Mattison. (GKM hasn't done recent underwriting for Apple.)

What, then, of the financials?

Cash and Cash Equivalents on the Barrelhead

The most common defense of Apple's value is its considerable cash reserves. As of March 31, the company had $4.1 billion in cash and short-term investments. That works out to $12.21 a share in cash, a solid floor for the company's stock. And bulls point out that if you discount all that cash, Apple looks very cheap. The stock closed Thursday at $23. If $12 of that is cash, the market is valuing the enterprise itself at just $11 a share.

The question is largely academic. No one at Apple is about to break up the cash from the rest of the company. Indeed, it will need to start spending when it starts building its retail stores. Still, carrying the argument through to its conclusion produces surprising results. Apple earns a considerable sum of interest on its cash, so valuing the enterprise apart from that cash would necessarily involve omitting that income. GKM's Bailey, for one, expects Apple to earn 60 cents a share in fiscal 2002. But when he excludes interest and other income, his estimate drops to a mere 21 cents a share. On that basis, Apple is currently trading at an incredible 52 times its 2002 earnings.

It's true that Bailey is less optimistic than many other analysts. But even more mainstream views make the same point. Subtracting interest and other income from Multex.com's consensus estimate of 77 cents a share leaves Apple's estimated 2002 earnings per share at 38 cents. Using that figure, the market is valuing Apple's enterprise at 29 times its 2002 earnings. As it stands right now, forgoing the clumsy exercise of valuing the company apart from its cash, Apple is trading at just under 30 times 2002 earnings estimates.

In other words, separating the cash from the enterprise does nothing to make Apple look any cheaper.

Extra Bases

Apple isn't exactly inexpensive on a price-to-sales basis, either. It trades at nearly 1.3 times its estimated sales for fiscal 2001, which ends in September. Never mind that that ratio is more than double that of Gateway (GTW), a Windows-based competitor in Apple's core consumer and education markets. Apple is still expensive in terms of its own history. It's certainly nowhere near as cheap as it was for much of the 1990s, when Wall Street, wary of management's missteps and skeptical about the company's ability to grow its business in a world dominated by Windows, consistently valued Apple at a fraction of its annual sales.

The Floating Opera Apple's annual sales vs. market capitalization

*Estimates Source: Multex.com and The Company

If it weren't for the huge run-up in Apple's stock in the last two years of the decade, you could say that the market's longstanding skepticism has proved prescient. Analysts now estimate that Apple's sales will reach $6.7 billion by 2002. That's pretty much where they were in 1991. Remember that sales aren't this flat because of any spinoffs or large business lines that Apple has exited. It's all lost market share.

Earnings, meanwhile, have looked even worse, showing no discernible growth pattern, when they've existed at all. Wary observers would like to see whether Apple can stabilize its earnings stream before they start trying to predict how it will grow it.

"I'd like to see some stabilization of share or a great new growth story," says UBS Warburg analyst Don Young. "I've been struggling to figure out what the plan is. If you go out and rebound just to lose it all again, don't even talk to us. This is worse than the worst auto company in terms of cyclicality." (UBS Warburg hasn't done recent underwriting for Apple.)

Ride the Snake A decade's worth of earnings per share at Apple

*Estimates Source: Multex.com and The Company

K-12: The Final Frontier

The key to the next turnaround lies in the education market. Apple's dominant presence among educational institutions helped create a generation of faithful users and set the stage for its initial strong forays into the consumer market. But today, far fewer students graduate from high school or university with the filial connection to the Apple operating system that might condition their future computer purchases. That problem is compounded by the near-total dominance of the Windows platform in the workplace.

Apple has been steadily giving away its share of the education market to PC vendors for years, finally losing the top spot to Dell (DELL) last year.

This trend is disturbing, especially in light of the unavoidable fact that the growth of personal computer sales is slowing in the long term. Of course, CEO Steve Jobs has pledged a reversal. The company is pricing its entry-level iBook laptops $100 below the $1299 list price in the education market, and claims to be winning new contracts for that product. But the buying season has just begun, and Apple's success will have as much to do with its ability to re-establish relationships with schools as its ability to deliver cheap notebook computers.

"To get the consistency of earnings, they need to have a strong presence in education," Bailey says. "So to value it right now, with the uncertainty in education, is difficult."

That's not to say valuing Apple is impossible. But it's certainly hard enough to make claims to its relative safety seem greatly exaggerated.

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