Goldman: Apple Is a Top Stock for 2011

BOSTON ( TheStreet) -- Apple ( AAPL) saturation is occurring at the investor level. When everyone loves something, it's destined to fall out of favor, right?

Not according to Wall Street, which remains downright giddy about Apple's 2011 prospects. Of analysts covering Apple, 91% advise purchasing its shares, making it the fifth highest-rated S&P 500 stock.

Both JPMorgan and Goldman Sachs name Apple a Focus Stock and Conviction Buy, respectively, for 2011. Apple also made the Barclays 2011 Top Picks, ranking 21st, based on perceived upside.

Although Apple is tirelessly touted, it remains a compelling investment. First, let's take a look at how Apple has fared over the past few years. Here is a snapshot of its business fundamentals.

12-Month Sales Growth: 52%
12-Month Net Income Growth: 70%
12-Month Stock Performance: 55%
3-Year Annualized Sales Growth: 40%
3-Year Annualized Net Income Growth: 59%
3-Year Annualized Stock Performance: 23%

Needless to say, Apple's growth record and stock performance are impressive, especially when considering that the company's products are targeted at consumers. Consumer spending has been a drag on the broader U.S. economy since 2008, when recession struck, and remains at below-trend levels due to 9.8% unemployment. Also, Apple currently carries $51 billion of cash and investments, and no debt, so its balance sheet is best-in-class. That cash coffer provides tremendous opportunity for acquisitions, share buybacks or sizable dividends.

Analysts are optimistic about Apple's trajectory in 2011. Analysts' median 12-month price target, at $384.16, suggests an impending gain of 15%. Goldman is among Apple's biggest bulls, offering the second-highest price target, at $430, implying a rise of 29% in the next year. Piper Jaffray offers the loftiest target, at $438, consistent with a 31% gain.

Goldman's latest missive on Apple, at 59 pages, touches upon all near-term catalysts for the Cupertino, Calif.-based company and explains why Wall Street, in Goldman's view, is underestimating a fundamental improvement in 2011. According to Goldman, the primary concerns weighing on investors are recent gross margin erosion and less-than-bullish guidance from management. But the bank believes that the spread deterioration is not only normal, but that "margins have already bottomed." It has an aggressive forecast for sales of the iPad, Apple's tablet computer, predicting 37 million units will be shipped in 2011.

Goldman's price target, at $430, is equivalent to 20 times its 2011 earnings per share forecast. By contrast, the stock has commanded a multiple of more than 23 times its forward earnings, on average, over a five-year span. So, there is upside possible, beyond $430.

The three so-called key points of Goldman's investment thesis are Apple's integrated platform model, its potential for gross margin expansion and the possibility of faster-than-expected iPad adoption. However, the bank expects other themes to produce incremental earnings growth in 2011.

Apple utilizes its hardware and software platforms, like iTunes or iPhone Apps, to leverage profit by allowing third-party developers and content providers to engage in its software ecosystem. This means that, with minimal research and development investment, Apple can rapidly expand its earnings.

Proof of this point is its operating expense-to-margin relationship since 2002. According to Goldman, Apple has grown operating expenses by 369% since 2002 while expanding operating profit by 1,036%. The operating profit margin jumped from 0.2% to nearly 27% over that span. Despite near-term headwinds, Goldman expects this trend to persist and predicts a 30% operating margin by 2013. Goldman's 2013 earnings estimate, which it believes is conservative, is $28.29. Apple's stock costs 12 times that figure.

As product adoption increases in 2011, Apple will be able to generate significant sales growth through its so-called iOS products, or products that run on its OS system. In particular, Goldman feels that investors aren't considering the sales and profit opportunities afforded by gaming and handheld computing.

While other researchers view Apple as a device-story, meaning its design and first-mover status has attracted customers over the years, Goldman views it as a platform story that began with the iPod. Ease of use and integration continue to impress customers. And interoperability of products makes it increasingly likely that Apple will fortify its position as the tech hegemon.

This dominance is what reassures Goldman about margin expansion. Major product launches consistently coincide with margin deterioration as Apple "seeds new markets." Goldman cites the 2003 higher-capacity iPod, 2005 iPod Nano, 2007 iPhone and 2010 iPad and iPhone 4 launches to confirm this pattern. Following each of these product releases, the gross margin immediately dropped, then recovered and, in some cases, even surpassed, pre-launch levels within three quarters. Critical to Goldman's thesis is the cannibalistic potential of iPad.

There are indications that the iPad is diverting sales from PCs. Apple's combined PC market share popped to 4.4% for the September-ended quarter, reflecting both the Mac and iPad categories. That figure is at a high not reached since 1996. Goldman speculates that Apple's combined PC market share could nearly triple and reach 12% by the end of 2011.

This would dramatically alter the PC landscape, which is currently dominated by Hewlett-Packard ( HPQ), with 17% share. Also, the profit-per-device potential of iPads far exceeds that of Apple's lower-end laptops because the iPad has reduced input costs, less processing power and is a smaller size.

Goldman identifies three risks of primary importance: a double-dip recession, legal and regulatory hurdles and uncertain succession. Another downturn has been largely dismissed by economists, but even if it were to occur, Apple would be best positioned to grow, albeit at slower rates, in the consumer technology space. Its stock, however, would sell-off sharply.

A more likely downside catalyst is regulatory backlash. Apple's integrated platform and market saturation make it a prime target for anti-trust suits. However, the company's generally fair pricing, user-friendly platform and avid fan base mitigate this regulatory risk.

The issue of Steve Jobs' successor is another story, entirely. The visionary's health remains a concern for investors. However, Tim Cook is an equally capable executive with significant internal experience. He too, however, is considered irreplaceable, presenting risk.

These three caveats should be weighed against growth prospects and reasonable valuation. Consider that Apple's trailing P/E of roughly 18 represents a 31% discount to its five-year average multiple. Here is a snapshot of Apple's current market pricing relative to computer and peripherals industry averages.

Forward Earnings Multiple: 22 (3% Industry Premium)
Book Value Multiple: 6.4 (30% Industry Premium)
Sales Multiple: 4.7 (40% Industry Premium)
Cash Flow Multiple: 16 (19% Industry Premium)
PEG Ratio: 0.8 (20% Growth Discount)

The likelihood of a major acquisition remains remote, despite an elevated $27.58 of cash per share. Goldman forecasts $4 billion of 2011 capital expenditure, with $600 million going towards expanding the retail store base by 40 to 50 locations. The bank also expects additional investment to retool products and expand Apple's manufacturing facilities.

Apple has a massive market capitalization of $306 billion, in part because it finances exclusively with equity. That valuation dwarfs the market value of Wal-Mart ( WMT), the world's largest company based on sales, at $194 billion. Traditionally, the larger a company gets, the slower its growth becomes. Many investors are avoiding Apple specifically for this reason. However, in an increasingly global environment, where growth is driven by emerging markets, the environment for U.S. multi-nationals has, arguably, never been more favorable.

Goldman's projection of Apple's terminal growth rate, the pace it expects the company to expand at in perpetuity, is 3%. If one assumes fertile global conditions and continuation of a telecom and tech boom in emerging and frontier markets, that rate could justifiably be 4% or 5%. Boosting terminal growth renders Apple's stock cheaper and justifies higher targets.

JPMorgan, which has a 12-month target of $420 for Apple, has incorporated a Verizon ( VZ) iPhone into its 2011 modeling and believes that Apple may have as much as $1.25 per share of incremental earnings from the move. Although it pains value investors to bandwagon a stock that has risen 56% in 12 months, the path of least resistance for Apple shares is still up.

-- Written by Jake Lynch in Boston.


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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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