Apple: Near-Term Gains, Long-Term Caution

Nov.21.12 | About: Apple Inc. (AAPL)

In two months, Apple's stock (NASDAQ:AAPL) price has fallen by almost 21%. The company is currently trading at a P/E of 11.9x and at a future P/E (FY13) of 9.8x. With a 5-year growth rate of 15%, a 2% terminal growth rate and a 12% discount rate, the stock currently trades at a margin of safety of 23%. The average target on the street is $760, which is 36% higher than the current price. Not to forget, the company has USD 121bn in cash, equivalents and marketable securities ($128 per share) and has not splurged on erroneous acquisitions, which gives it a lot of room for inorganic growth.

A lot of hedge funds are sitting on significant profits on Apple. Since there is a probability of an increase in the capital gains tax next year, unwinding the most profitable trades just before 2013 makes sense. This selling pressure is probably one of the most notable reasons behind the stock price's sharp decline. However, this reason is totally unrelated to the company's fundamentals.

In this article I have laid out only short-term catalysts, as I am long Apple with a short-term horizon of less than a year. A lot of this information is out there, but it only makes sense when the dots are connected. I am not completely convinced of the Apple dominance theory in the long run.

I have used numbers when necessary but my thought process on this topic is comprehensive and utilizes more than just figures.

Catalysts:

i) The US smartphone market is still growing. The number of American smartphone subscribers, 57% of wireless customers, is expected to reach 70% in 2013 according to an analyst at Macquarie Securities. That's growth of 23% in the US market alone.

ii) Growth and usage of tablets is increasing exponentially. As per IDC, growth in tablet sales has been more than 50% and is expected to grow by 41% in 2013. Personal incomes have been increasing consistently in 2012 and September's monthly increase was the highest year-to-date on a y-o-y basis. This could result in high demand for the iPad and iPad Mini this holiday season.

iii) In October Apple released new iMac products with improved design, performance and displays. Additionally, Apple introduced a thinner and lighter version of its most popular Mac, the 13-inch MacBook Pro, featuring a Retina display with over 4 million pixels and all flash storage. These new products could boost sales during the holiday season.

iv) On 28 September iPhone 5 was released in 22 countries. The profits from sales of this phone will be shown in the next quarter (quarter ending December 2012).

v) Apple is low-balling estimates. The company has revised down its estimate for the quarter ending December 2012 significantly. It is expecting only a 12% y-o-y increase in revenues for the December quarter. As per company estimates, the expected EPS for the quarter ending December 2012 is $11.75, a reduction of 16% from the same period last year. Analysts are also expecting Apple's EPS to decline on a yearly basis as quite a few new product introductions will have elevated costs, and hence margins will be lower. Two points need to be considered here. First, even if this is the case, cost will fall over time (hardware cost always reduces with time), which will increase margins in the future. Basically, this is a short-term issue. Second, Apple missed its September 2012 earnings and therefore, is likely low-balling estimates. It doesn't want to fail to meet expectations for two consecutive quarters as that could hamper the stock price notably. I think Apple is likely to exceed analyst estimates by a big margin. It's just playing a smart strategy of giving low estimates and then beating them by a margin.

vi) Shaw Wu of Sterne Agee checked Apple's supply chain and found that Apple has significantly improved its iPhone 5 production capacity. He mentioned this in his note to investors on 8th November 2012. He believes Apple will sell 46.5 million iPhone units in the December quarter, a whopping 42% increase sequentially and 26% on a y-o-y basis.

vii) Apple will release iPhone 5 in more than 100 countries at the end of December 2012. This will be their fastest international rollout ever and will significantly enhance sales in 2013.

viii) Apple will be potentially adding Apple TV and Apple Radio to its ecosystem. It has been reported that Apple TV is in tests with cable operators. This could potentially be an additional revenue stream and a catalyst for the stock price.

ix) China, the world's fastest growing smartphone market, will surpass the US smartphone market by the end of 2012. From December 2012 onwards, China Unicom, the second largest carrier in China (21% market share), will start selling subsidized iPhone 5s on its network. Soon after that, China Telecom, the third largest carrier in China (14% market share), will also start selling subsidized iPhone 5s on its network. This could significantly increase iPhone 5 sales in 2013, which is Apple's highest margin product.

x) China Mobile, the largest carrier in China (65% market share), doesn't sell the iPhone. iPhone 4 and 4S are incompatible with China Mobile's proprietary 3G network (TD-SCDMA). However, as per a virtual teardown of iPhone5 by UBM Techinsights, the cost of the baseband modem in the iPhone 5 has risen by nearly 80% to $25. That's 15% of the phone's total cost, up from 10.5% on the iPhone 4S. This is mainly due to MDM9615, also known as "world mode mobile data modem," which, according to Qualcomm, supports China Mobile's proprietary TD-SCDMA network. Apple did this for a reason. China Mobile is crucial to Apple because currently Apple is losing the Chinese market to Android. Android has 77% of the market share in China as compared to iOS's less than 10%. Apple is very much aware of this and needs access to China Mobile's distribution networks of 699 million subscribers in order to penetrate this fast-growing market. China is an extremely important region for Apple, which gets 21% of its net sales from Asia and a 60%-plus growth rate from that region. Both parties (Apple and China Mobile) are in talks and the iPhone 5 has the needed hardware to support China Mobile's proprietary 3G network. It is expected that by mid-2013 or before, a deal could be brokered by which iPhone 5 would be carried on China Mobile's network. A meager 2% of China Mobile's subscribers switching to the iPhone in the first year would increase iPhone sales by more than 50% in China. This is not counting iPhone 5 sales on China Unicom and China Telecom, which will start in December 2012. And don't forget: iPhone is the highest margin product for Apple.

These are strong catalysts capable of increasing the stock price significantly in 6 to 12 months. Recent selling pressure due to potential increases in 2013 tax rates is totally uncorrelated to the company's fundamentals. It is time to take advantage of Mr. Market's mood swings. A 25%-30% upside in the next 6 to 12 months is very likely.

Disclosure: I am long AAPL. 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.