September 9, 2016

Electric Cars May Be Cool, But Amazon’s Valuations Are More Warranted Than Tesla’s


Summary:

  • Apple valuations are currently pricing in a very pessimistic view of the company, while accounting distortions that are removed imply that the worst may already be priced in.
  • Market expectations for Tesla are for it to have best-in-peer returns going forward, raising questions about valuation downside.
  • Amazon’s multiples may be sky high, but operating performance signals that the market’s expectations are actually reasonable.
  • Starbucks’ ability to consistently improve ROA’ indicates that their stock may be fairly valued at worst.
  • Pfizer has started a successful transition into a higher ROA’ business, but the market already appears to know that.

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Apple Inc. (AAPL)

aapl

AAPL is trading at a 9.7x Adjusted P/E, near historical lows.

We use an Adjusted P/E and P/B metrics because we always want to know what is “priced in” to the stock price. We evaluate the Adjusted Enterprise Value of firms relative to their expected Adjusted Earnings for the next year (in the case of our Adjusted P/E) or their Adjusted Assets. Adjusted Earnings are earnings resulting from the company’s core business operations, regardless of how it is financed, and adjusted to its current dollar value. Adjusted Assets are the core operating assets of the firm, necessarily adjusted for problematic accounting standards for reporting of the balance sheet. These are adjusted to eliminate accounting distortions and shenanigans, and to enhance comparability across different companies, industries and geographies, to determine potential mispricings.

Anyway, at a 9.7x Adjusted P/E, the market is pricing in expectations for a declining Adjusted ROA, from 114% in 2015 to 22% in 2020, accompanied by 23% Adjusted Asset growth. What we mean by this is that the stock is currently priced as if the Adjusted ROA levels of the company are going to fall to 22%.

The Adjusted ROA metric we use is a measurement that is calculated after the balance sheet, income statement, and statement of cash flows of a company have been thoroughly adjusted to create an apples-to-apples set of financial information. An advanced ROA computation is then applied which corrects for many formulaic biases and flaws in traditional Return on Asset and Return on Capital Employed computations.

Historically, AAPL has seen incredibly strong Adjusted ROA levels, rising from -9% in 2001 to a peak of 153% in 2011. While their Adjusted ROA had recently begun to decline to 98% in 2014, it recovered to 114% in 2015. Meanwhile, their Adjusted Asset growth has seen similar strength, rising from a low of -3% in 2000 to a peak of 67% in 2012, before declining to still robust 17% levels in 2015.

Sell-side analysts have less bearish expectations than the market, projecting their Adjusted ROA to decline to only 68% levels in 2017, accompanied by 9% Adjusted Asset growth.

Apple’s traditional profitability metrics materially understate the company’s profitability, with an ROA of 17% versus an Adjusted ROA of 114%. The biggest drivers of this are how traditional metrics treat the company’s cash, not identifying how much is actually unrelated to the operations of the business, and how traditional metrics treat R&D investment. The company’s immense excess cash inflates their Asset base and the incorrect expensing of their R&D investment lowers their earnings. This is why as-reported ROA levels are much lower than Adjusted ROA levels.

Considering market expectations for a collapse in Apple’s Adjusted ROA levels, markets already appear to be pricing in any competitive and operational headwinds for the business, limiting incremental potential equity downside.

Tesla Motors, Inc. (TSLA)

tsla

TSLA is trading at a 6.2x Adjusted P/B, near historical averages. However, Adjusted P/E is still at robust 82x levels. At these levels, the market is pricing in expectations for Adjusted ROA levels to see a positive inflection, from -5% in 2015 to 8% in 2020, accompanied by continued 50%+ Adjusted Asset growth.

As a start-up company, TSLA has struggled to drive Adjusted ROA levels into positive territory. Their Adjusted ROA ranged from -33% to -22% from 2009-2012, before finally inflecting in 2013, with Adjusted ROA reaching 6%. While the Adjusted ROA rose to 7% in 2014, it subsequently dropped back to negative territory at 5% in 2015. Meanwhile, as one would expect from an early life-cycle company, Adjusted Asset growth has been incredibly aggressive, ranging from 34%-109% as the company has been investing to build scale.

Analysts have bullish expectations relative to the market and relative to the company’s performance to date, projecting Adjusted ROA to increase to 9% by 2017, accompanied by 57% Adjusted Asset growth.

Traditional Net Income Margin for TSLA grossly overstated how much money the company lost in 2015, with a -22% Net Income Margin versus an Adjusted Earnings Margin of -5%. The biggest drivers of this issue are problems with how traditional analysis treats R&D investments, expensing them rather than considering them as investments, distorting real economic profitability analysis.

Adjusted ROAs in the car industry tend to range between 6%-9% levels. However, growth rates for most car companies are well below 50%+ a year. Market expectations for TSLA to be able to reach the high end of those profitability ranges with sustained strong growth imply that they are already pricing in it being a best-in-class car company. This may limit further potential for equity upside.

Amazon.com, Inc. (AMZN)

amzn

AMZN is trading at a 73.5x Adjusted P/E, near historical highs. At these levels, the market is pricing in expectations for an improving ROA, from 10% in 2015 to 21% in 2020, accompanied by 36% Adjusted Asset growth.

Historically, AMZN had seen very strong profitability, with Adjusted ROA rising from -6% in 2002 to 60% in 2009. However, this dropped to 25% in 2011 before fading to 7% in 2014, as the company aggressively ramped up investment in the business, growing Adjusted Assets by at least 40% a year in most years. Although, the company has appeared to see an inflection in Adjusted ROA levels in 2015, with their Adjusted ROA recovering to 10%, accompanied by Adjusted Asset growth returning to historical averages around 25%.

Analysts’ expectations are in line with the market, projecting Adjusted ROA levels to expand to 21% by 2017, accompanied by 6% Adjusted Asset growth this year, before a reacceleration of growth.

Amazon does an excellent job of managing their working capital, which traditional ROA does not pick up, with an ROA of 2% versus an Adjusted ROA of 10%. Traditional ROA only looks at the asset base of the company, as opposed to Net Working Capital, which includes Accounts Payable and other operating liabilities. As such, traditional analysis does not identify how much of Amazon’s operating balance sheet they are able to finance through their suppliers, which reduces the company’s required asset base to operate the business, improving their real ROA.

While valuations initially appear high for AMZN, the company is already starting to show the Adjusted ROA recovery and Adjusted Asset growth that markets are expecting going forward, implying that current high expectations may be warranted. Moreover, if the company can sustain this improvement, there may even be further potential for equity upside.

Starbucks Corporation (SBUX)

sbux

SBUX is trading at a 33.6x Adjusted P/E, near historical averages. At these levels, the market is pricing in expectations for an increasing Adjusted ROA, from 18% in 2015 to 29% in 2020, accompanied by 7% Adjusted Asset growth.

Historically, SBUX has seen steadily improving profitability, with Adjusted ROA rising from 7% in 2000 to 18% in 2015. The firm grew Adjusted Assets aggressively in their early years, with Adjusted Asset growth ranging from 15%-27% from 2000-2007. However, the firm has significantly moderated since then, with Adjusted Asset growth ranging from -2% to 12% since 2008, excluding the 23% growth in 2014.

Analysts’ expectations are less bullish than the market, projecting Adjusted ROA to remain at current 18% levels through 2017, accompanied by 9% Adjusted Asset growth.

Traditional metrics understate the company’s assets, causing the firm to appear to be trading at a more expensive valuation than it actually is, with a 14.7x P/B relative to our 6.0x Adjusted P/B. The biggest driver of this is the focus of traditional P/B metrics on book equity as opposed to the company’s total asset base. Because of SBUX’s aggressive share buyback program in recent years, book equity levels look artificially low, distorting this metric.

While market expectations appear fairly aggressive relative to the firm’s historical profitability level, SBUX has shown an ability to consistently improve Adjusted ROA levels. Additionally, considering valuation levels that are well below historical peaks, SBUX appears fairly valued at worst.

Pfizer, Inc. (PFE)

pfe

PFE is trading at a 15.3x Adjusted P/E, near historical averages. At these levels, the market is pricing in expectations for modest increases in Adjusted ROA, from 15% in 2015 to 20% in 2020, accompanied by 5% Adjusted Asset shrinkage.

PFE saw robust Adjusted ROA levels prior to 2007, ranging from 16%-21%, before declining to 11% in 2008, driven by drug patent cliffs, starting with Xanax and Zoloft in 2006 and followed by Zyrtec and others in 2007-2008. Adjusted ROA ranged from 10%-12% from 2008-2014. However, PFE started to attempt to rationalize the business starting in 2010, shrinking their balance sheet and re-aligning their investment strategy with new profitability levels. Following this strategy, PFE was able to drive Adjusted ROA to 15% in 2015.

Analysts’ expectations are in line with the market, projecting Adjusted ROA to increase to 17% in 2017, accompanied by 4% Adjusted Asset growth in 2016 that will then moderate.

Pfizer’s traditional ROA materially understates the company’s profitability with a 5% ROA versus a 15% Adjusted ROA. The biggest driver of this issue are problems with how traditional analysis treats R&D investment, which distorts real economic profitability analysis.

Considering that PFE already appears to have begun their plateau shift with Adjusted ROA improving from 10% levels to 14%, expectations for modest incremental improvement and stabilization going forward appear reasonable, implying that PFE may currently be fairly valued.

These five companies are just a few of the 3,000+ companies that can be seen with updated weekly data on the Valens Research web application you can see here. Also, to read more of our articles on Seeking Alpha about corporate equity and credit valuations, and the importance of cleaning up financial statements when analyzing companies, click here.