The proper way to value APC (and any other investment) is via a discounted cash flow analysis, but in the interest of keeping you awake, let me run through two shortcuts.
1) Estimated growth and terminal P/E ratio
APC's stock price in the future (let's pick five years for the purposes of this discussion) will, like today, be a function of its earnings per share and the P/E multiple that the market assigns to those earnings. So, let's just guess how fast EPS will grow and what we think the P/E will be and we're done, right? Not so fast. These two measures don't determine future value, they are a result of it. If APC's market continues to grow at a healthy rate and the company maintains or expands its market share and margins, then its EPS growth and P/E multiple will remain high. Therefore, we should focus on the drivers of APC's EPS growth and P/E rather than randomly guessing what we think they will be.
Let's start with the growth of APC's market, which I believe, with the explosive growth of the Internet and the rise of computing in international markets, will expand at an average rate of approximately 20-25% per year for the next five years. I think that APC's competitive position is defensible for quite a while, as it's the market leader and has successfully fought off many challenges from much larger companies such as Hewlett-Packard. Thus, I believe that APC can maintain its market share and margins, and might reduce its sharecount as well. Therefore, I think that the consensus analysts' estimate for APC's five-year EPS growth rate of 21.8% is reasonable.
It's harder to predict APC's P/E in five years, since it will be influenced by many external factors such as interest rates, in addition to many company-specific factors. As G. Bennett Stewart wrote in The Quest for Value, "P/E multiples change all the time -- in the wake of acquisitions and divestitures, changes in financial structure and accounting policies, and new investment opportunities. P/E multiples, in short, adjust to changes in the quality of a company's earnings." Given the very high quality of APC's business and my belief that it will remain so, I think it's possible that APC's P/E ratio will not contract.
Only now is it reasonable to generate the table below, which shows the compound annual growth rate for the stock over five years, based on different assumptions about its EPS growth rate and terminal P/E ratio. My conservative assumption is 18% EPS growth and a slight decline to 28x in the P/E ratio, which would yield a 15% annual return.
EPS Growth
12% 15% 18% 22% 25%
15 | -3% -1% 2% 5% 8%
Terminal 25 | 7% 10% 13% 16% 19%
P/E Ratio 28 | 9% 12% 15% 19% 22%
32 | 12% 15% 18% 22% 25%
35 | 14% 17% 21% 25% 28%
2) APC compared to the S&P 500
While I'm wary of relative valuations, I don't think it's unreasonable to think about whether APC's stock is undervalued by comparing the company's most important financial metrics with those of companies in the S&P 500 (though APC is not in the index, its market capitalization -- $6.5 billion as of last Friday -- is only a bit lower than the $7.5 billion median for the index):
S&P 500 APC Rank/
Measure* APC Median Percentile
Revenue growth 18.8% 6.3% 83/83%
EPS growth 31.3% 10.8% 72/86%
Projected 5-yr. EPS growth 21.8% 13.0% 67/87%
Net income margin 15.4% 8.1% 44/91%
Gross margin 46.0% 38.4% 159/68%
Return on equity 26.0% 16.0% 82/84%
Return on total capital 25.8% 11.2% 39/92%
Net cash as % of market cap 7.0% -20.8% 28/94%
Debt (in millions) $0.1 $1,625 23/95%
10-year stock performance 53.7% 13.2% 9/98%
Insider ownership 19.0% 2.0% 43/91%
P/E ratio 31.5 16.3** 126/75%***
* All figures are based on trailing 12-month data
unless otherwise noted.
** The S&P 500's average P/E ratio is nearly 30,
but this figure is due to a handful of companies
with extremely high P/Es. Thus, the median --
the P/E ratio of company #250 -- is much lower.
*** Assumes that the 31 companies without a P/E ratio
are ranked above APC.
Source of S&P 500 data: Value Line, 2/3/00
With the exception of gross margin, APC is dramatically higher than the median for the S&P 500 (on average, APC scores in the 88th percentile). Of course, APC trades at a higher price as well, but I think this premium is warranted.
Conclusion
These two shortcuts, as well as a full discounted cash flow analysis, show that APC -- using fairly conservative assumptions -- is likely to be a market-beating investment over the next five years. It would not be unreasonable to expect 15% annual returns, and perhaps more.
--Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected]. To read his previous guest columns in the Boring Port and other writings, click here.
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