US Federal Reserve Chair Janet Yellen raised eyebrows earlier in the month following comments that certain sectors of the stock market are trading at inflated valuations. Yellen noted in particular that biotechnology and social media stocks presently accompany lofty forward price-to-earnings multiples. Though attracting far less attention than Alan Greenspan’s “irrational exuberance” remarks some 17 years earlier, the Fed Chairwoman’s assessment is certainly warranted and can even be expanded to more clearly define two emerging types of technology sectors.
New Technology ought to be differentiated from Old Technology. New Technology comprises growth stocks, including Facebook, Amazon, and Netflix, which trade at 41x, 160x, and 80x forward earnings, respectively. To put this into perspective, the overall S&P 500 trades at 16x its forward earnings. This market multiple is consistent with its historical average, though nevertheless inexpensive given today’s low interest rate environment. Old Technology, which includes companies that are the beneficiaries of annuity revenue streams, trade at far lower and less expensive multiples. Apple, Oracle, and Microsoft, for example, trade at 11x, 10.8x, and 12.9x forward earnings, respectively.
On Tuesday, Apple reported its quarterly earnings results. Since 2011, pundits have expended every effort to exert the opinion that Apple requires many more new and innovative products to maintain its earnings growth. Without doing so, the pundits claim the stock is overvalued and destined for a material decline in price.
These criticisms should be generally directed towards New Technology companies. After all, growth investors are paying for future earnings many years out, thus explaining the triple-digit P/E ratios. Apple, however, is not a New Technology company. At 10.8x forward earnings after removing the $22.05 per share in cash, Apple investors are buying a value stock that returns capital to shareholders and produces an annuity stream of revenue.
Rather than introduce new innovative gadgets, better product penetration that will enhance this annuity stream of revenue is enough to drive Apple’s earnings higher. Consider the three following examples.
On July 16, Apple announced a partnership with IBM to develop 100 new applications. The relationship will target the corporate segment. Because the traditional Apple customer is the “consumer”, this marks a change in the company’s strategic direction. Currently, Apple can only boast a 20% penetration rate of the corporate market. Notebooks are 60% penetrated. Apple CEO Tim Cook mused on the company’s conference call that “we win if we can drive that penetration number I spoke about from 20% to 60%. That would be incredibly exciting here. The walls would shake. That’s what I hope for.”
In addition to growing the company’s corporate share, the iPad unit sales continue to amaze. Since the product was brought to the market in 2010, Apple has sold 225 million iPads. Four years later, for every 10 iPads sold today, 5 of those buyers are purchasing an iPad for the first time in their lives.
Finally, with China’s rollout of 4G technology earlier this year, Apple formed a much-anticipated arrangement with China Mobile. The deal provides Apple with access to 700 million subscribers. Last quarter, iPhone sales grew a remarkable 48% in Greater China (which includes Hong Kong and Taiwan), surpassing Apple’s own internal estimates. “The unit grow was really off the charts,” said Cook.
These three remarkable trends demonstrate that Apple doesn’t require new, innovative products each year to drive earnings higher. Continuing to penetrate the market with its existing products will grow its earnings and should drive the stock price higher to a market multiple of 16x earnings.
*Clients of Baskin Financial own Apple, Microsoft, and Oracle. This author does not own shares in any companies listed in the commentary above.