Brian White has become somewhat notorious over the past year as Apple's (NASDAQ:AAPL) most bullish analyst. Back in April, White took the audacious step of setting a $1,111 price target on the shares. Apple shares have traded in a rough range of $525-$705 since that time, so the $1,111 price target assumes that the stock will (approximately) double in the next year. As I will discuss below, by viewing Apple as a growth company and assigning a valuation accordingly, it is not difficult to justify an $1,111 price target (which would give Apple an approximately $1 trillion market capitalization). However, it is one thing to state that Apple is worth $1 trillion, and another to claim that the market will soon come to this conclusion. Over the past few months, an increasing number of hedge fund managers and other prominent investors have made highly public bearish calls on Apple. While sell-side analysts overwhelmingly have "buy" ratings on Apple, the investment community as a whole is not about to accord Apple a 20X earnings multiple. As a result, the stock price is likely to appreciate in proportion to earnings growth.
Apple's Intrinsic Value
At the trough of Apple's September-November selloff (during the course of which the stock dropped by more than 25% from its all-time high of $705), White declared the drop "insanely insane". As he noted, the stock traded at a forward P/E below 10X, even though Apple has posted a 92% CAGR in EPS since 2003. Obviously, it is unrealistic to expect Apple to maintain a growth rate anything like it has achieved in the past. That said, the company posted an impressive 59.5% growth rate for FY12, with EPS of $44.15 vs. $27.68 in FY11. Apple has demonstrated by example that it is possible for a mega-cap to continue growing sales and earnings at a rapid pace. The current Wall Street consensus (which has historically been too conservative for Apple) calls for EPS growth to slow to 12% in FY13 before accelerating back to nearly 20% in FY14.
I expect FY13 and FY14 earnings to be materially higher than Wall Street's current expectations. Working backwards from the average FY13 analyst estimate of $193 billion in revenue and EPS of $49.32, analysts are expecting FY13 gross margins of 40%-41%, well below FY12's record level of 43.9%. However, gross margin declines are likely to be more modest. While Apple did project Q1FY13 gross margin of 36%, this clearly reflects management's typical conservatism. Initial margins for the iPhone 5 (and iPad mini) were lower than for previous models largely because of low yields for the new in-cell display technology that Apple is using. More recent research suggests that Apple has overcome this problem, with yields of 70%-80% for the iPhone 5 display. As a result, margins should remain roughly flat quarter-over-quarter at 39%-40%. Margins will improve through the rest of the year as Apple's slew of new products mature. The continuing mix shift away from the low gross margin Mac and iPod lines towards the somewhat higher margin iPad and much higher margin iPhone will also help.
Revising FY13 gross margins higher to 42% provides $2-3 of EPS upside. Additionally, Apple has significant revenue upside relative to analyst estimates for the second half of FY13, as there is a good chance that Apple will launch China Mobile (NYSE:CHL), the world's largest wireless provider, as a carrier partner in that timeframe. Furthermore, if Apple's rapidly increasing R&D investment is any indication, new product lines are in the works. The long-rumored "iTV" is the most likely candidate for introduction in the next year. If this (or another) new product launches in late FY13, there is additional revenue upside. I estimate the EPS upside from a 2H China Mobile launch and the potential introduction of new products to be $3-$6. All told, Apple is likely to produce EPS around $55 for FY13, well above the current consensus.
Moreover, Apple has significant room for growth beyond FY13, although the growth rate is likely to fall to ~10% by FY15. As Horace Dediu recently pointed out, only 50% of global wireless subscribers currently have access to the iPhone. China Mobile is the biggest single opportunity, but there are still plenty of other carriers that Apple will look to add over the next few years. The introduction of the cheaper iPad mini last month will also help expand Apple's potential customer base in the developing world (although the mini is still expensive relative to disposable income in those markets). IDC expects the global tablet market to more than double in the next four years, which provides Apple with an ongoing growth opportunity. NPD's tablet growth projections are even higher.
Given my expectation for an EPS CAGR of 20%-25% over the next two years, followed by ~10% growth for several years thereafter, $1,111 seems like a reasonable 2013 price target for Apple, as Brian White suggests. This represents a 15X multiple on Apple's likely FY14 EPS of $65, plus Apple's cash and investments. The 15X multiple is slightly higher than the S&P 500's multiple, but this seems justified by the higher growth rate.
Apple's Market Valuation
While the case for an $1,111 price target is fairly straightforward, this does not mean that investors should expect the market to accord Apple such a lofty valuation in the near future. Apple's key problem is that the more it grows, the more skeptical investors become about future growth. Citi's (NYSE:C) recent analysis of Apple is fairly typical. The analysts list "size" as the biggest risk for Apple investors to consider. The Citi analysts are still bullish on Apple, but their $675 target price is very modest, being $30 below Apple's September high. Their suggested P/E multiple of 13.74X is virtually identical to Apple's current valuation, implying that the market is already pricing Apple near fair value.
Looking at the sell-side community more broadly, analysts are expecting only 12% growth in FY13 after the company recorded 60% EPS growth in FY12. The same skeptical view of Apple's growth prospects can be seen in the company's recent multiple contraction; the TTM (trailing twelve months) P/E ratio has dropped from around 20 in late 2009 and early 2010 to a range of roughly 12-15 since mid-2011. This is true even though Apple has added nearly $100 billion in cash and investments to its balance sheet over the past three years.
(Courtesy of YCharts)
As a result, since that time, Apple's stock price has grown more or less in line with earnings. Over the past year, the stock has appreciated by 60%, in line with FY12 earnings growth. It is unreasonable to expect Apple's TTM earnings multiple to return to the 20X level of early 2010, as White seems to expect. Instead, investors should look for Apple's multiple to remain range-bound, so that the stock's gains will primarily be driven by earnings increases. This implies a lower 2013 price target, but a continuing opportunity for capital appreciation beyond 2013 as earnings growth continues. My mid-2013 price target of $800 implies a multiple of approximately 14.5X my expectation for FY13 EPS of $55. In a "best-case" scenario, EPS could reach $80 by FY15 (this assumes a 3 year CAGR of 22%), putting $1,111 within range at that time.