This article is the first in a series of two. My reasoning throughout the article is that despite taking into account very conservative (sometimes draconian) scenarios, Apple still remains grossly undervalued at its current price. This first half details my views on the future growth of Apple (NASDAQ:AAPL) in emerging markets and the second half talks about a DCF analysis. The second article will incorporate three other methods that I used to value Apple.
As mentioned before, I have been pretty pessimistic throughout the article. My intention is to come up with a valuation on the lower side at which I will feel considerably safe buying the stock.
Reasons for pessimism
I am not a tech guy and can't claim to have a conversation on technical details without sounding dumb. However, the reason I see the glass as half empty is that Steve Jobs is not there and with that is missing his vision, creative genius, obsession with perfection, and eccentricity. Isn't that what gave birth to a Mac, an iPod, an iPhone and an iPad? So while Apple has a lot of smart people, so does Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT), and Amazon (NASDAQ:AMZN). While Apple will improvise, I just don't see it bringing a revolutionary product. With Steve Jobs onboard, Apple was an M3 firing on all eight cylinders zipping past its competitors caught unaware in their nice little family sedans. However, it is clear they would do anything to grab lost territory.
Future in emerging markets
A lot of articles mention that future growth for Apple has to come from emerging markets (China, India, Brazil etc.) since the US markets are approaching saturation and this is precisely what makes me nervous. There can be many ways to look at it and determine Apple's potential in, say, Greater China. One can do a McKinsey type study and analyze customers and markets in detail or look at the projected smartphone/tablet market, etc. However, with limited time and resources at my disposal, I looked at a cruder way to justify my pessimism. I looked at the price of Apple's product to average wages in China. I looked at the prospects of individual products.
In the U.S, a survey by Chitika mentions that a significant chunk of those lining up and buying iPads on the first weekend reside in coastal areas where the median income is higher by about roughly 10% (click here). Though the article is a couple of months old and may not be a true representative, it cannot be ignored. The average nominal GDP/Capita in the US in 2011 was $48,328 (source). Since it has to be a number greater than zero, an average, unlike median, is biased. However, since we are looking at the broader picture, this should still be a decent number to start with as the market seems to be dominated with users earning higher wages. To ensure a margin for safety I discounted the number by 30%. With an average selling price of an iPad of $550, the price of an iPad is about 1.62% of an average user's annual income, which is not all that high.
Let's move to China where the GDP/Capita is roughly $5417. Repeating the above calculations shows us that the same ratio comes to about 14.50%. However, two things distort this number. First, there is a greater disparity between the salaries with super high incomes for one segment compensating for extremely depressed wages (approx. 150 million live below poverty line) of others which translates into a fewer percent of the population (albeit a tremendous number owing to the huge population) being Apple's potential customer. Second is the high emphasis on savings. Unlike the U.S., people in emerging markets do not have access to reliable social security or healthcare. As a result, savings are high and one just needs to look at the enormous Domestic Savings to GDP ratio for the country. This essentially means that plenty of those who can afford an iPad might not end up owning one. Third is the competition. Unlike the U.S. the rules aren't stringent which means the market can be flooded with fake devices at deeply discounted prices. As long as it looks like a beemer and everyone who looks thinks its a beemer who cares if it's got a Nissan motor under the hood, right?
A similar logic applies to iPhones. The subsidy in the U.S. decreases the above mentioned ratio to about 0.59%. However, whether Apple will get a similar subsidy in China is prone to debate and if it doesn't, the corresponding ratio would be 13.18% (assuming an average selling price of $500). Moreover, high end phone users comprise a smaller percent of total phone users. For instance, only 4% of China Mobile's (NYSE:CHL) users (here) fit into this segment. While 4% translating into 27.3 smartphone users is definitely a huge number, I am unsure as to how many will line up to spend another $500 to upgrade their models when a new device with minor improvements (say improvements in iPhone 4s over iPhone 4) launch in a year or two. Long story short, Apple seems to be on the expensive side. Even with its impeccable specifications - Siri that speaks Mandarin, social media integration etc., it is just not a bang for the buck for a majority of the potential customers. I just cannot envision a typical iPhone buyer in Greater China or other developing nations owning a Mac and an iPad at the same time, especially when they have bigger issues in mind such as a slowing economy, higher inflation and a potential property bubble. Without two of three devices, Apple's ecosystem, a big advantage that retains its customers, is not utilized optimally, further increasing the chances of existing users making a switch to a competitor. The results are slowly becoming apparent. An article by Financial Times mentions that "revenue in Greater China slid 28 per cent to $5.7bn in the three months to June 30 compared with the preceding quarter" (here) with retailers mentioning that the prices had to be significantly reduced to boost consumption. There are tons of other articles mentioning the slowing growth for high end product consumption in China.
I am not an Apple bear but having come from a developing nation, I am a bit skeptical about its potential in such nations.
I wanted to follow up with a DCF analysis of the stock and following were my inputs.
1. Revenue Growth:
- Average growth over last three years: 54.19%
- Compounded growth over last three years: 53.94%
- Analyst forecasts over next three years: 22.03%
- Used Rate: 7% for next five years that will eventually slow down to a stable growth rate of 1.6% by year 10 (Current 10 year Treasury bond yield)
Note: I don't think a 7% growth is justified because a) Apple has momentum on its side, and b) professional analysts and other SA contributors, who breathe Apple, know a zillion more things about the company than I do and their projected rates are significantly higher. However, let's stick with it to get a valuation on the lower side.
2. Operating Margin:
- Average operating margin over the last three years: 31.57%
- Average operating margin predicted by leading analysts for next three years: 31.35%
- Assumed operating margin: Last year's margin will drop to 25% by the 10th year.
Note: The decline will be because Apple will come under greater pressure to introduce newer devices with different form factors and will have to reduce prices due to increased competition.
3. Sales to capital ratio:
I have incorporated working capital, capital expenditures and acquisition costs instead of projecting them separately.
- Average sales to capital ratio over last three years: 5.59%
- Maximum sales to capital ratio over last three years: 17.87%
- Assumed sales to capital ratio of 40% until year 10, following which it will be adjusted to ensure a ROIC of 12%.
Note: I have used a higher sales to capital ratio to capture the fact that growth will come at a higher price for Apple as it will need to make greater investments and more expensive acquisitions going forward. Also, its current ROIC is impressive at 6293%. However, I reduced it to about 12% for terminal year.
Apple doesn't have debt so I converted its operating lease commitments to debt.
5. Cost of Capital:
Risk Free Rate: 1.61% (current 10 year treasury yield)
Implied risk premium as per S&P 500 is above 6% however, I have used historical premium of 6% in my calculations.
Beta as per Yahoo Finance 0.91. However, I have used a beta of 1.2 to capture its growing risk for the next 10 years, following which it will come down to 1.
6. Options outstanding were valued using a Black-Scholes calculator
Following is the DCF. What is noteworthy is that even after such reduced assumptions, the value per share is still dramatically higher than the current stock price.
Even after taking a 25% margin of error the stock price should not drop to less than $561.
Apple to me seems grossly undervalued. While I know that momentum traders getting margin calls and recent bad news are some of the reasons for the depressed price, I still do not understand how an efficient market can depress the price of a stock so much. If I had the means, I would definitely buy tons of it.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.