The 4 Horsemen of The Apocalypse Part 1
Early in the Summer of 2007, just before the run on Bear Stearns, Jim Cramer, came out with his new 4 horsemen of tech, which included Apple (AAPL), Amazon.com (AMZN), Google (GOOG), and Research In Motion (RIMM). Mentioning that people were using old thinking to value these companies, he felt “we are now starting to pay up for growth,” something I hate doing. Somehow I remember hearing this during the heydays of the tech bubble, and reading about this in the excellent book Supermoney by Adam Smith about the concept stocks of the late 60’s/early 70’s etc.. The disregard for logical thinking went something like this this time around:
“If Google grows at 33%, we can’t give it a 25 multiple forever… we can’t give it a multiple that is too low versus Proctor, versus Pepsi, versus Coke, when those companies are single digit growers and Google is a 33% grower… Research In Motion is a big grower, Apple is a big grower, these are all double digit growers… Amazon, just suddenly out of nowhere is a 15% grower… I was talking with my friend Erin Burnette this morning and she was saying ‘Jim, aren’t you being unrealistic that Amazon can go back to its old price’… I don’t think 35 points is unrealistic… These are stocks that are bet against as is often the case hedge funds hate the idea of valuation, they always used to key in on valuation in the 90’s, and that’s where they always got it wrong… valuation is not a good reason to short… it actually had worked for a while but its not working now… I like all these companies because unlike Cisco, Dell, Intel, Microsoft which had been the 4 horsemen, those all became cyclical… these new 4 horsemen all have product cycles or something secular going for them.” (Source: TheStreet.com Interview with Jim Cramer 6/8/2007)
I politely disagree with the idea that valuation could no longer matter, because it matters a great deal. I come from the belief that at the right valuation, any investment could potentially be a compelling one, both on the long and short side. A great company does not necessarily make a great investment no matter how compelling the secular growth story is, nor does growth necessarily add value if it comes at too high a price. While equities were more of a sideshow to the main event in the credit markets over the past business cycle, equities are arguably more in the public psyche for better or worse. Of course, credit market excesses were reflected in the share prices of the financials and homebuilders. It is interesting to note that the original 4 horsemen and the new 4 horsemen both signaled a top in global markets that occurred within months. So with this said, it may be an interesting time to look at where the new 4 horsemen are now.
Horseman #1: Amazon.com (AMZN)
Amazon.com (AMZN) has shares that are down 45% over the past 52 weeks, although multiples still seem rich. AMZN trades at 35x FY2009 EPS, 9x Book (mrq), and 19x EBITDA (ttm). Net cash on Amazon’s balance sheet amounts to about $1.89B. My free cash flow estimates for 2008 amount to about $450M-$500M, based on estimates of operating cash flow of about $700M and capex of $200M-$250M. Putting a conservative multiple of about 12x on Amazon.com’s free cash flow and adding net cash gives a valuation of about $7.6B for a share price of around $18.00. Assuming operating cash flow can double over the next business cycle and capex spending slows as AMZN matures, would give a share price of about $36.00-$40.00. So as much as I like Amazon.com as a consumer, it doesn’t seem to offer much of a margin of safety at a price of $52 a share.
AMZN may also find growth in profits difficult to come by for a while, just like other retailers, even as it picks up more customers through retail industry consolidation. AMZN recently reported the best year ever in terms of sales, which they have been doing almost every year since they became a public company and this is reflected in the company’s low P/S multiple. That would make AMZN a great buy if sales always translated into profits, but this isn’t always the case. Sales have been growing as more people discover the value that Amazon.com provides relative to traditional retailers, but selling products by lowering margins hurts profitability, especially when those margins are razor thin to begin with. An estimated 8,000 retailers have gone out of business in 2008, and with 12,000 more expected to go out of business in 2009, the opportunities for AMZN to grab market share on the cheap are there. So AMZN may be worth another look down the road at a better valuation and at current valuations could even make for an interesting short sale candidate.
Horseman #2: Apple (AAPL)
Apple (AAPL) is the next horseman, a great American technology company, which has products consumers love and has a stock that money managers and traders loved to buy on the way up. Known as a company that gives low guidance to easily beat estimates, this could have been part of the reasons for the momentum in the stock price. AAPL has had a sort of rebirth of sorts as Steve Jobs returned about a decade or so ago. Based on personal channel checks of going to the mall over the past few years, Apple stores are always busy (not necessarily a sign of demand, however if no one is buying, something which I haven’t ever counted, although I have read that Apple has the highest revenue/square foot in the world), and the company has a lock in the MP3 player market with its iPod, partly due to iTunes, which is a sort of network that locks users in, and largely due to great design and marketing. The iPhone has been a huge success too, and is a product that has not yet been matched by competitor’s offerings. Because Apple is so well known as a company and as a stock, this has made me want to stay away from the shares. I like unpopular stocks over popular stocks on average I suppose (vice versa for short ideas). Better profit opportunities can be found where others aren’t looking.
The big announcement at Mac World 2008 was the air book. This year, the big news is that Steve Jobs won’t bother showing up for the event. There have been rumors about Jobs’ poor health during 2008, all of which were false. The irrational selling that occurred because of this underscores how important the consensus believes Jobs is to Apple’s success. I don’t necessarily think this is completely true as Apple’s COO Tim Cook seems fairly capable of running the place and Jonathan Ive is good at coming up with products like the iPod, iPhone etc.. But I think this brings up another important risk factor bulls overlooked, which is reinvention, or product cycle, risk. For Apple to continue to be successful, it has to constantly come up with new, innovative products or it will go the way of the Walkman. So far so good, but I want this to be discounted into the share price before I consider buying AAPL stock. Another headwind facing Apple is declining Mac Book sales. AAPL sells superior goods so this shouldn’t come as a surprise in a down economy, but could hurt valuations because a lot of Apple’s future growth is tied into increased Mac sales.
Now that Apple stock is down 57% over the past 52-weeks, I’ve become interested enough to see if some of the bad news has been priced into the shares. Multiples look much more reasonable for AAPL, with a forward P/E of 17x FY2009 EPS and 14x FY2010 EPS and an EBITDA multiple (ttm) of 8x. The first thing I noticed when taking a quick look at the financials was that AAPL has about $25B in cash on its balance sheet and no debt. Let’s assume AAPL can do about $5B in net income, add back depreciation of about $500M and add back changes in working capital of about $1B gives a conservative estimate of operating cash flow of $6.5B. Subtract capex of about $1B and free cash flow comes to $5.5B. Putting a 12x multiple on my estimated free cash flow gives AAPL’s operations a value of around $78B. Adding $25B in cash would give AAPL a market cap of $103B. Assuming 888M diluted shares outstanding gives us a share price of around $116. After doing this back of the envelope valuation, Apple shares could warrant further research.