As we head into Christmas, Apple (AAPL) shares have continued to slide and now trade at "just" $500 per share. I believe now is a good entry point on AAPL both for long-term investment and a short-term bump from January tax loss selling.
First let's discuss Apple as a long-term investment. To do so we must look at whether Apple's huge sales and earnings can be sustained into the future. Lying at the heart of this issue is Apple's competitive position; Apple's cash flow stream going forward is only as strong as its competitive position.
Can Apple's Prodigious Cash Flow Be Sustained?
Apple's competitive advantage lies in a combination of product innovation and marketing.
I don't think many will disagree that Apple has a fantastic track record of innovation under Steve Job's reign. Being the first mover and innovator Apple has been able to lead almost every market it entered; namely smartphones (iPhone), tablets (iPad) and MP3 players (iPod). The rise of Apple has been something of a public spectacle over the past five years.
Apple products are widely perceived to be of very high quality, in terms of physical build quality and user friendliness. While there is wide debate over whether or not this perception is warranted, I believe this debate is largely irrelevant for investors. The perception of quality can be a stronger competitive advantage than real quality leadership because it is easier for competitors to produce a higher quality product than to change entrenched consumer beliefs and buying habits.
Through first mover advantage and efficient marketing, Apple has very successfully created the perception of a quality premium. This of course allows Apple to charge a premium price resulting in very high profit margins. Apple has a 44% gross margin; on the other hand competitor Huawei has a 37% gross margin, HP HPQ has a 23% gross margin and RIM RIMM has a 29% gross margin.
However Apple's sales are almost entirely from "one-time" purchases i.e. consumer durables. This means the revenue stream is not quite rock solid. Take for example the revenue stream of Procter & Gamble (PG), by selling recurring purchase products like toilet paper and dish soap P&G has built an iron-clad revenue stream based on habitual purchases. Apple's revenue stream by contrast is based on one-off purchases with a product life of 18 to 24 months.
However Apple has made up for this by continuously re-engineering their products. Each successive generation of iPod, iPhone and iPad is an impetus for customers to upgrade. The latest generation of iPod is barely an upgrade from the last, but this makes no difference, Apple has given willing customers a reason to upgrade.
How Strong Is Apple's Competitive Advantage?
Apple's competitive advantage is not insurmountable. It is a demand based competitive advantage resting entirely on customers' perception and Apple's continued innovation.
The problem for Apple is that this demand side advantage is not matched with any cost side advantage.
Let me explain what that means: Coca-Cola (KO) also has a demand side advantage, their marketing is among the best in the world and has turned Coca-Cola into a very, very strong habitual purchase. However, what's possibly more important is that Coca-Cola has cemented this demand side advantage with economies of scale in distribution and marketing, i.e. a cost side advantage. By maintaining a huge worldwide distribution network Coca-Cola is able to cut prices below what any competitor can possibly sustain (between 1980 and 1982 Coca-Cola and Pepsi (PEP) waged a vicious price war).
Furthermore by selling in such huge volume, Coca-Cola can spend more than competitors on marketing since the cost is spread over so many bottles of Coke. These economies of scale give Coca-Cola very big profit margins, but it also gives them "nuclear" weapons to bring to bear against any competitors.
To compete with Coca-Cola new entrants must pull off the near miracle in breaking a habit built over a lifetime, while running huge losses in maintaining a large distribution network and huge marketing budget. At any point Coca-Cola can twist the knife by dipping into their own profit margins to cut prices or raise marketing spend or a combination of both. Anyone remember Virgin Cola?
But the biggest risk to Apple's competitive position is technological change. In this industry things change fast. It wasn't so long ago Nokia (NOK) and Microsoft (MSFT) held rock solid positions in their respective markets, Apple has dealt a blow to both.
No matter how good Apple's reputation is, if they fall behind in product innovation that reputation will crumble fast. Electronics are not habitual purchases; although Apple currently has a strong following I believe this is because they've continuously released best of class products.
Recently Apple's product line has come under attack. The iPhone which represents almost 50% of Apple's revenues has come under attack from Android and notably Samsung's S3 handset. The iPad (representing 20% of sales) has come under attack from worthy rivals in the Kindle and Google's (GOOG) Nexus devices.
More worryingly for Apple there is evidence they're losing pricing power in tablets. The iPad mini is the first time Apple has competed on price, a step Jobs refused to take. If competing on price becomes a trend for Apple it would of course put pressure on Apple's huge profit margins.
In business one can only expect large profit margins and returns on equity to be sustained if there is some sort of insurmountable competitive advantage. Apple has a good, but not great competitive advantage. Apple trades at a relatively low P/E precisely because of fear their huge margins and ROE will buckle under competitive forces. I believe this fear is warranted.
Any smart owner of Apple should be continuously monitoring the competitive landscape. Apple's products have met worthy rivals this past year and if Apple cannot maintain its technological lead this will lead to pricing pressure and a reduced income stream going forward.
Where Will Future Growth Come From?
Over the past two years Apple has grown at a 55% clip. I think it's obvious this growth rate cannot be sustained and Wall Street strongly agrees.
Peter Lynch believes a company is fairly priced when the P/E ratio matches the growth rate. Apple currently has a P/E of just 11.5 despite a 55% growth rate.
In my opinion, Apple is on a treadmill. Because their sales are based on one-time purchases they need to constantly replace their revenue by either creating new products or updating old products. Apple's revenue growth of the past few years has been based on the huge success of the iPhone and iPad. Apple is meeting the combined problems of product saturation in these segments and worthy rivals as discussed above.
For Apple's sales to grow from here they would need to not only successfully replace old revenue, even in the face of product saturation and fierce competition, but also successfully innovate and launch new products that add to current sales.
In a world of 0% interest rates, Apple offers a 9.2% earnings yield. This is quite amazing for a company whose success over the past decade has captivated the world, let alone investors. While I believe Apple is facing headwinds for the first time in the past five years, I also believe the shares are oversold and represent good value.
Short-term I believe the effect of January tax loss selling has pushed Apple down, and as this pressure is relieved in January/February we will see Apple drift back above $600. Another catalyst in the short-term is the December earnings release which is Apple's strongest quarter by far.
Long-term I believe Apple is facing some headwinds but at the current P/E it offers compelling value. Not often can a business with a 42% return on equity and a 55% historical growth rate be bought at an 11.5 price to earnings multiple. Apple is now generating so much cash they are having trouble reinvesting it in their core business and I expect to see Apple transition to a maturity stage. We should see strong dividends and share buybacks going forward.
While Apple offers compelling value there are warts to be wary of. Apple's competitors are gaining strength across almost the entire product range. While Apple holders should be happy with a 9.2% earnings yield, smart owners will monitor Apple's competitive position like the cards in a poker game.
Ultimately at an 11.5 P/E ratio not a lot of good is baked into Apple's price, certainly not a lot of growth. However this low price leaves a lot of room for upside, particularly if Apple can sustain margins and even engender a modicum of growth going forward.