By many accounts Apple (AAPL) and Google (GOOG) are the two most well recognized brands in the world. Recently, the two companies have remained tangled in litigation as Google has a third party interest in Apple’s injunction against its competitor Samsung—which operates on Google’s Android operating system.
Outside the courtroom Google is winning.
The two Silicon Valley tech giants have traveled down very different paths over the past year as Google’s stock has appreciated nearly 45% while Apple has floundered, losing 19.76%. The graph below illustrates the disparity of Apple and Google’s stock price over the previous year.
While the graph may be a sad sight for Apple investors, an interesting question might bring these weary shareholders back to life: Will Apple’s stock price rally to catch Google?
Apple has a chance at catching Google for three reasons—superior cash flows, a dominant global App share, and incredible customer satisfaction ratings. Furthermore, Apple is significantly undervalued compared to Google and the market should correct itself to offer a better illustration of the two companies’ ability to generate value for their shareholders.
In this article I will compare Apple vs. Google in terms of value and overall ability to maximize shareholder value.
Cash is King
Apple is still the cash king. For the trailing twelve months, Apple has generated more than 3.5 times the free cash flow of Google. Why is free cash flow so important? Free cash flow makes it possible for a company to fund growth opportunities, pay dividends, and buy back shares—which is exactly what Apple plans to do. Apple is sitting on $145 billion in cash—with approximately $102 billion sitting overseas—and recently issued its first debt issue to unlock that cash and begin buying back shares. Under current U.S tax law, bringing the cash back to the United States would cause Apple to incur major tax burdens. Issuing the debt provides Apple with cheap capital, a reduction in the company’s capital cost, and effective leverage of its strong balance sheet. Below is an illustration of Apple’s cash flows compared to Google’s.
Apple unveiled its aggressive capital return program in which it plans on paying $45 billion to shareholders through dividends and share repurchases by 2015. On Apple’s most recent earnings call, CEO Tim Cook announced that Apple had already returned $10 billion of the $45 billion. What’s more, on that same earnings call, Apple announced that it plans on doubling the size of the return program—to an impressive $100 billion. Moreover, the company is also increasing its dividend 15%. The number one objective of a company should be maximizing shareholder value and Apple is doing just that. The share repurchase program should boost the stock price in the short run as investors look to take advantage of the dividend increases. Furthermore, Apple’s huge cash stash will still leave the company with plenty of cash to invest in acquisitions, research and development, and further capital return programs. Score one for Apple.
Value Creation: The One Dollar Promise
Warren Buffett is a huge proponent of management’s ability to generate value for its shareholders. The One Dollar Promise is a measure used by Warren Buffett to measure how effectively management is investing its retained earnings to create value. In other words, a company should be generating at least a dollar of market value for every dollar reinvested into the company after paying dividends. Let’s compare Apple and Google.
The graphs both illustrate Apple and Google’s tremendous ability to create value for their shareholders. Google currently has slight edge as it is creating approximately $5.64 of market value for every dollar retained compared to Apple’s $3.65. Score one for Google.
Return on Invested Capital is a ratio used to measure how efficiently a company is investing its retained earnings. Below is a graph comparing Apple and Google’s ROIC.
As the chart illustrates, Apple is currently generating higher returns with its invested capital. Apple is buying back its shares at the perfect time because the stock is significantly undervalued and as long as management stays committed to creating value for its shareholders (as evidenced in the One Dollar Promise graph), the returns should stay in the 30-40% range for the near future. I believe Google’s returns will increase in the near future because the market for Internet search advertising is rapidly growing. Google dominant market coupled with the company’s superior market share should result in continued sustainable value creation for Google shareholders in the years to come.
Apple’s App Market Share and Customer Satisfaction Ratings
Apple’s dominant market share and customer satisfaction ratings are unprecedented— with a 96% satisfaction rate among iPad customers, according to a recent study by ChangeWave. Moreover, Apple continues to overpower its competition for App sales. Canalys estimates the sales from Apple’s App Store accounted for 74% of all global app sales worldwide in the March quarter. According to CFO Peter Oppenheimer, “a recent study by Kantar measured a 95% loyalty rate among iPhone owners, substantially higher than the competition, and iPhone remains top in customer experience.” Apple’s dominant market share along with its superior customer satisfaction rates should not only continue to boost its App revenues but should also attract unsatisfied Google App consumers. Furthermore, Apple should see increases in gross margins as new customers become willing to pay premium prices for Apple products.
Apple overwhelms Google on a valuation comparison. Apple is trading at 12.06 times earnings while Google is trading at 21.6 times earnings. Apple’s has a PEG ratio of 0.84, price to free cash flow of 9.74, price to sales of 3.06, and pays a 2.43% dividend. Google currently trades at a 1.25 PEG ratio, 25.03 times free cash flow, 4.55 times sales, and does not pay a dividend. Below is a comparison of Apple and Google based on what I consider to be one of the most important valuation metrics—price to free cash flow.
Apple investors are getting a piece of the cash generating machine at a bargain when compared to Google. Score one for Apple.
Being the value aficionado that I am, I was impressed when I stumbled on Jae Jun’s old school value investing website. To say I was by the ease and the depth of these spreadsheets would be a huge understatement. (I used his spreadsheets to run this valuation analysis) Given a conservative 15% free cash flow growth estimate, a 12% discount rate, and 2% terminal growth rate, I have Apple valued at $844.50—a 46% discount to the current price of $454.74. Assuming an 18.1% growth rate, a 12% discount rate, and a 2% terminal growth rate Google’s fair value is $1018.78. Given the current market price of $877.53, Google is trading at a 14% margin of safety—which is not a large enough margin of safety to warrant a safe investment at this time.
Apple is an undervalued cash cow that I believe will appreciate substantially in the next 2-5 years. Expect Google to continue lagging Apple in its cash generating ability until it solidifies its market share in non-search segments and the profitability of its heavy investment in emerging markets are known. That being said, Google has a larger upside for growth and if the company effectively allocates its heavy investment in emerging, growing markets and product development, Google could catapult past Apple in the next 8-10 years.
Risks facing both Apple and Google are intense competition, currency fluctuations, and weakening consumer demand. Apple is facing intense competition in the tablet and smartphone market, especially from Samsung. Furthermore, Apple may lose market share and be unable to charge premium prices for its iPhones and iPads if users begin switching to alternatives such as Samsung’s Galaxy S4 or Amazon’s (AMZN) Kindle Fire. Finally, no article about Apple would be complete without mentioning visionary Steve Jobs—whose superb leadership and innovative intellect will be sorely missed at Apple. That being said, Apple still has some of the highest brand loyalty rates in the world and has huge untapped market expansion opportunities in emerging markets such as China. Google faces competition in its online advertising division from companies like Facebook (FB) and Microsoft (MSFT). However, both Google and Apple are committed to creating the world’s best, most innovative products that change people’s lives and make the world a better place.
Will Apple catch Google?
Only time will tell.