Monday, February 15, 2016

Race to the top: The Duel between Alphabet and Apple!

Apple and Alphabet, the two companies jockeying for the  prize of “largest market cap company in the world” are both incredibly successful businesses, with unparalleled cash machines (the iPhone and Google Search) at their core. That said, the last month has been eventful for both companies, just as it has for the rest of the market, as their latest earnings reports seem to suggest that these firms are on divergent paths. Having valued Apple multiple times on this blog over the last five years, and bought and sold the stock based on those valuations, the most recent earnings report is an opportune time for me to revisit Apple’s value. Having never valued Alphabet on this blog, though I have valued it in my classes multiple times, its earnings report is a good time to initiate the process with a valuation.

The Apple Rollercoaster
Apple’s most recent earnings report came out on January 26, 2016, and it contained mixed news. On the good news front, Apple announced the largest quarterly earnings in corporate history and higher earnings per share than expected by analysts. The bad news was that these earnings were generated on revenues that were close to flat for the year, that iPhone sales were lower than expected and that the management expected revenues to stay weak through next quarter (in its guidance). The market’s reaction was negative, with Apple’s stock declining by 6.57%, a drop in market capitalization of more than $30 billion, right after the announcement. In the picture below, I capture the pricing reaction to Apple, with its earnings history as background information:

In summary, it looks like the market is weighing the iPhone and guidance bad news far more than the earnings good news in making its assessment, with Apple's history of beating earnings every quarter for the last eight weighing against it.

To evaluate whether the earnings report merited the negative market reaction, I went back to the intrinsic value drawing board and updated my valuation of Apple, the last of which I posted in August 2015 and subsequently updated in November 2015, after its annual report (with a September 2015 year end) came out. My assessment of Apple’s value in November of 2015 was $134/share, but more importantly, the narrative that I had for Apple was that of a slow-growth , cash rich company (revenue growth rate of 3% in the next five years and a cash balance of $200 billion), with operating margins under pressure (declining from the 32.03% it earned as a pre-tax operating margin in the 2015 fiscal year to 25% over the next decade) and a very low probability of a difference-making disruption. Looking at the earnings report, it is true that revenue growth came in below expectations (but not by much, given my low expectations) and operating margins dropped, again in line with expectations.

The net effect is that  my narrative changed little, and using a slightly lower revenue growth rate (2.2% instead of 3%) leads me to an updated assessment of value per share of $126 in February 2016 and almost all of the difference is coming from a repricing of risk (higher equity risk premiums and default spreads in the market). In keeping with my view that estimated value is a distribution, not a single number, I ran a simulation on Apple's value in February 2016:

At the price of $94 at close of trading on February 12, 2016, Apple looks under valued by about 25% and at least based on my distribution, there is a more than 90% chance that it is under valued.

Alphabet Soup
Alphabet surprised markets on February 1, 2016, with on earnings report where the company reported higher revenue growth than anticipated, coupled with higher profit margins. Since it was also the first report that the company was releasing as holding company, where it was breaking itself down  by business, there was also excitement about what you would learn about the company from this report. As with Apple, I start by looking at the pricing effect of the earnings report, comparing, actual numbers to expectations and tallying the stock price reaction to the report:

Markets were impressed by both the revenue and earnings numbers and the stock price increased by 8% in the immediate aftermath, briefly leading Alphabet to the front of the market cap race.

As a counter to the market's excitement, I decided to compare the narrative (and value) that I had for Alphabet in November 2015 (after their last earnings report) to the narrative (and value) after this one (in February 2016).  In November 2015, my narrative for Google was that it would continue to be a dominant and profitable player in a growing online advertising market, growing 12% a year in the near term, maintaining its operating margins (left at 30% in pre-tax terms, in perpetuity).

It is true that in their most recent earnings report, Alphabet reported double-digit growth in revenues (impressive given their size and the state of the global economy) and higher operating margins than they did in the previous quarter. I left my original narrative largely intact, with revenue growth remaining at 12% and pushed up the target pre-tax operating margin to 32%, and arrived at a value per share of $631/share. Presenting Google's value as a distribution, here is what I get:

At $682.40, the price at which the class C shares were trading at on February 12, 2016, the stock is trading at about 8% above the median price, with a 35% chance of being under valued. Since these shares have no voting rights, attaching a value to voting rights, will make the shares a little more over priced.

I know that one reason for Google's restructuring/renaming exercise last year was an ostensible desire to improve transparency, but I think that there may be less here than promised, at least at the moment. There were a few things that became transparent in Google's last earnings release, as captured in this picture of a key part of the earnings release from the company:
  1. It became transparently obvious that Google is almost entirely an online advertising company. All of Google's other businesses generate collective revenues of $448 million, while reporting operating losses of $3,567 million. To even call them businesses is perhaps stretching the definition of the word "business", since all they do well, right now, is spend money. While it is reasonable to cut them some slack because they are young, start-ups, there is nothing in this report that would lead you to think about them any differently than you always have, if you were a Google-watcher.
  2. It is transparently clear that in spite of its technological sophistication, this company uses financial terms loosely.  Note that what the company reports in its earnings release as operating income of $23,245 million in the 2015 fiscal year is really EBITDA, and perhaps the only thanks that we can give is that it is not an adjusted EBITDA. If you are going to be transparent, it is best if you not follow the dictum of Humpty Dumpty in Alice in Wonderland, and claim that a "word is what you choose it to mean".
Transparency is good for investors, but with Alphabet, I will reserve my cheers until I see real evidence of it (and perhaps I will, in the full 10Q).

Apple vs Alphabet
If this were a boxing match, Apple and Alphabet would be the super heavyweights, fighting it out for the world championship. To judge which is the better company, though, you would have to specify on what dimension you are making the comparison, i.e., as a business, an investment or as a trade.

I. As Businesses
Apple and Alphabet share a few common features. First, each of them derives their value from one cash cow, the iPhone for Apple and the search engine for Google, that individually have values so large that they would exceed the GDPs of many small countries. Second, both companies are known for their attention to detail and customer focus, at least on their core products, perhaps explaining why they have been so successful over time. Third, both companies have work forces filled with brilliant people who seem to like working for them. In short, these companies are perfect illustrations of how customer focus, employee satisfaction and shareholder value maximization often go hand in hand.

Each company, though, has areas where it has advantages. The Alphabet advantage is that its core product, its search engine, enriched with YouTube and the Google ecosystem, requires less care and maintenance to keep cash flows going, with Facebook perhaps being the only threat in the short or the medium term to profits. In contrast, Apple's iPhone franchise requires the company to constantly reinvent the product and make its own prior models obsolete, creating a two-year cycle that is both expensive and gut wrenching to watch. The Apple advantage, though, comes from its history of having survived a near-death experience (in the late 1990s) and reinvented itself. Consequently, the company is much more aware of how tenuous its hold on value is and it does try harder to find new game changers. There is one final difference that, at least at the moment, is working for Alphabet and against Apple, which is that Apple has made China its biggest foreign bet and Google has little exposure to the Chinese economy, thanks to the Chinese government's fear that all that stands between it and chaos is a good search engine.

If I were to pick a better business at the moment, it has to be Google. The company's core is strong and will get stronger and the biggest threat it faces, i.e., that the way we look for things may change from search engines to social media sites, is more distant that the the one faced by Apple.

II. As an Investment
The quality of an investment does not always correlate with its quality as a business, with the price driving the divergence. Buying a great business at too high a price is a bad investment, just as buying a bad business at a low enough price can be a good investment. Both Apple and Alphabet are good businesses, but as an investor, my money is on Apple, rather than Alphabet, at the prevailing price:
  1. The break even points for the two companies to be fairly priced are wildly divergent. Apple does not need any revenue growth and can see its operating margins slashed by a third and it would still be a fairly valued investment at its current price. Google will have to deliver 12% revenue growth with its current already high pre-tax operating margin to break even. 
  2. This may just reflect my personal predilections, but I need a bonus to invest in a company that wants my money but is not interested in my input (my vote on key decisions). I have had my disagreements with Tim Cook, but Apple is a much stronger corporate democracy than Alphabet, which remains a dictatorship, albeit a benevolent one (at the moment). 
I would hasten to add that I have never owned Google, as an investor, and that may reflect the fact that I continually under estimate the profit-making power of its online advertising engine. So, feel free to download my valuation, change the inputs you don't like and make it your own.

III. As a Trade
If momentum is the biggest driver in the pricing game, it is Alphabet that has the advantage right now, notwithstanding the decline in its price in the days since its last earnings report. Whether fair or not, markets have found the good news in almost every Alphabet story and find the storm clouds even on Apple's sunniest days. As long as the momentum game continues, you will make money far more easily and quickly with Alphabet than with Apple, but just a note of warning, from Apple's own recent past. Momentum will change, almost always without any advance warning and for no good fundamental reason, and when it does, I hope that you are able to get ahead of it.


Raw Data
  1. Apple Last 10K (September 2015) and Current 10Q (December 2015)
  2. Google Last 10K, Last 10Q and Earnings Release (no current 10Q at the time of post)
  1. Valuation of Apple in November 2015 and February 2016
  2. Valuation of Alphabet (Google) in November 2015 and February 2016
Blog posts in this series
  1. A Violent Earnings Season: The Pricing and Value Games
  2. Race to the top: The Duel between Alphabet and Apple!
  3. The Disruptive Duo: Amazon and Netflix 
  4. Management Matters: Facebook and Twitter
  5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
  6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
  7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
  8. Taming the Market? Rules, Regulations and Restrictions (Later this year)


Nickv said...

Some food for thought :
Let's assume that today search is all about Google, followed by Bing (Microsoft).
Let's then assume that in the not too distant future, advances in machine learning allow search to move to voice through the likes of Siri (Apple), Cortana (Microsoft), Google Now (Google), M (Facebook) and that search is no longer visual or at least significantly less visual.
Let's assume that Google makes the majority of its revenue of Google sites (ex YouTube as this stays in tact)
Based on the assumptions above, the Bets need to be paying off and rather quickly as a user interface change will challenge Google's dominance and it will be mega caps doing the challenging.
My own assumption is that this future is +- 2-5 years away

KK said...

Professor, thank you for the breakdown here.

How would you model Alphabet's upward bound? As you identified it is primary an advertising company. I think advertising has been a very consistent 1.5% of GDP for a very long time, and while there has been a huge turnover from TV to online, I don't think that overall number is growing. Granted online the only real competitor is Facebook but they are fierce and very focused. Or do we ignore that and just look at their ability to grow revenue at 12%?

Anonymous said...

very good post, one of your most readable and concise!

Anonymous said...

What Monte Carlo software do you use?

Tim said...

Dear Prof. Damodaran.

Thank you very much for your hardwork and commitment in bringing out this valuation experience and knowledge of yours to the world. I have a question regarding the simulations you run and refer to in your valuations. I know some part of it maybe proprietary but if you could just share your general approach to your simulations it would be helpful enough. As far as I understand, you "stress-test" some/all of your assumptions to come up with those various scenarios?

Kiyoshi Fujioka said...

Dear Professor,

I recently found this web site and am enjyoing your posts a lot!
There are somehtings I find difficult to understand in your valuation calculation. I hope you can clarify.

(1) You are calculating free cash flows as EBIT x (1 minus tax rate) minus CAPEX.
But don't you need to add depreciation like below?

EBIT x (1 minus tax rate) PLUS depreciation minus CAPEX

(2) Interest payments are ommitted in your free cash flows calculation. However, your WACC appears to be based on a levered capital structure. Don't you need to either a) deduct interest payments from free cash flows; or adjust WACC for unlevered capital structure?



Michael J said...

Great post,

My questions is on the divergent policies of Apple and Alphabet on issuing guidance.

Something that I often think about is the effect of earnings guidance on investor expectations and consequently on share prices.

I understand the inherent logic in issuing guidance; improving communication with markets, transparency concerns and potentially lower share price volatility though I cannot help but wonder if such a practice can instead act to a company's detriment. Some folks have thought about this a lot longer and harder than I and come to the conclusion that the only thing that it materially improves is trading volumes.

Is earnings guidance' as a concept to improve shareholder returns redundant? Or is the ability to ignore issuing earnings guidance a luxury reserved for the mega-caps or for companies in which investors place a large amount of confidence? Would a discontinuing of guidance by Apple help in stabilising its share price by reducing volatility or would this be overshadowed by the uncertainty it would create around important variables such as expected revenue or units sold?


Michael J

Aswath Damodaran said...

1. Nicky and KK: The upper bound on value will increase if Google is able to break out of its "online ad" narrative with other products. The problem is that is has no track record so far of doing so.
2. Kiyoshi: I am not subtracting out cap ex, but reinvestment = cap ex - depreciation + chg in WC
3. I use Crystal Ball, an Oracle product, and develop the distributions based on the company's history and the cross sectional differences in the sector.

Tim said...

Dear Prof. Damodaran,

One thing I cannot really understand from the Apple valuation spreadsheet, is the calculation of the actual growth rate in revenue in the most recent year. As far as I get it, it is annualised (power of (1/0.25)). Yet, since we are using annual revenue figures (even if one of them is trailing), why is annualisation necessary here?

Thank you in advance!

Anonymous said...

Just curious, has any one done an analysis of Apple's cash position over the next 5 years with some basic assumptions (low revenue/earnings growth at 2-3%, same R&D spend, modest dividend increases, and varying stock repurchase (none, modest, expanding).

Given that Apple is a cash machine, it would seem that its growing cash hoard would have a significant impact on the company's value. For example, if free cash flow continued at $70B per year this would grow it's cash balance substantially in 5 years. Wall Street does not seem to place much value on this fact.

Anonymous said...

Why aren't more people moving borrowed money from us banks or any Bank that's offering negative interest rates 2 Chinese and Russian Banks does that offer positive savings rate? Does the exchange rate makeup for the interest rate arbitrage opportunity. Or are there enough restrictions legally? Is it possible for the u.s. government to just print up money exchange it and put it in foreign Banks at a higher savings rate? Are we this become a problem when you go back to try to convert it to US dollars.