Seeking Alpha
Profile| Send Message|
( followers)  

The slide in shares of Apple (NASDAQ:AAPL) have been going on for quite some time now following the quarterly earnings release from a few weeks prior. Many shareholders are left scratching their heads as shares trend downward and continue to look cheaper and cheaper. 12x trailing twelve month earnings is attractive, 11x trailing twelve month earnings is better, 10x trailing twelve month earnings looks even better yet. So when do you go long Apple?

Depending on your investment goals and time horizon will dictate initiating a position at current price levels. In my opinion, the whirlpool of fear surrounding the fiscal cliff has sent shares tumbling downward and appears to be overdone at this point. Many investors have acquired significant gains in this stock and prefer to realize those gains in the current year rather than pay potentially higher tax rates in the future. Additionally, as Wall Street analysts who had $800+ price targets begin to cut their estimates, we appear to have a barrage of "panic selling" taking place. Some of the best profits can be made when others are heading for the exits, and digging deeper into Apple's coming fiscal year could offer investors the alpha they are seeking. The purpose of this article is to highlight the rationale for the stock's recent sell-off, provide fiscal year 2013 earnings projections, and determine if Apple still offers value to investors.

Quick recap of what went wrong

Apple has been the "darling child" of Wall Street for the past few years. The company that could do no wrong was supposed keep growing earnings well into the future and nothing could stop this giant from reaching $1,000 a share. Unfortunately all good things must come to an end (or at least slowdown). Apple operates in the technology sector, which is characterized by declining prices as competition increases. This does not mean that Apple will be extinct, look at Microsoft (NASDAQ:MSFT) or IBM (NYSE:IBM) and the incredible levels of cash flow they still produce. Apple has tattooed its brand image on the hearts and minds of many consumers, and this will likely remain in place for years to come.

What the new story of Apple is becoming is one of lowered profit margins. For the past few years Apple has enjoyed tremendous growth in profit margins. Gross, Operating, and Net profit margins have all moved up and to the right (see graph below). This has pleased investors and ballooned Apples share price over the same time period.


(Click to enlarge)

Source: Apple SEC Filings

Apple really spooked investors when they projected fiscal Q1 revenue of $52 billion. The company is projecting revenues to grow just 12% quarter over quarter, very light, especially considering the holiday season is Apple's best quarter. Additionally management projected diluted earnings per share of $11.75. Compare this with a diluted EPS of $13.87 in the same quarter last year, and managements projection of a 15% drop gives a clear picture as to why investors are headed for the exits.

But digging a bit deeper into management's projections and the story is not that dismal. For one, the current fiscal quarter will only cover 13 weeks, versus last year's 14 weeks. If you factor in the extra week, Apple would likely grow revenues by over 20%. Still not as robust as prior quarters, but very impressive nonetheless.

So why the drop in EPS? This can be attributed to one thing, a significant drop in gross margins, roughly 8.68% from FQ1 in 2012! Apple stated "We expect gross margin to be about 36% reflecting approximately $90 million related to stock-based compensation expense." This is a 400 basis point drop from FQ4 2012. But what about the other 468 basis points? This is where I believe the selling pressure has come from. The speculation surrounding Apple's new product launches with lower prices is really eating into profit margins. CFO Peter Oppenheimer said the following on the company's recent earnings call:

"This is the most prolific product period in Apple's history. We have an unprecedented number of new product introductions over the last six weeks ... But there are costs associated with such dramatic change and demand. The iPhone 5, iPad Mini, iMac, MacBook Pro 13-inch, iPod Touch and iPod Nano have completely new form factors with great new features, and we've never before introduced so many new form factors at once. All of these products have higher costs than their predecessors, and therefore lower gross margins as they are at the height of the cost curve."

The recent surge in new product issuance has caused a spike in cost of goods sold, couple that with a lower selling price and you put a squeeze on gross margins. The CFO goes on to say "This has been the case with new products in the past, so nothing new." My honest opinion is that Mr. Oppenheimer is correct and this shock to margins should slowly faze out over the next few quarters.

Fiscal Q1 Estimates

Management gave tremendous clarity as to what the current fiscal quarter will look like. Given managements estimates, the table below displays projections for FQ1 compared with last years FQ1. You can see the massive margin compression which is spooking investors.

Q1 2012

Margins

Q1 2013

Margins

Revenue

$46,333,000,000

$52,000,000,000

Cost of Revenue

$25,630,000,000

$33,280,000,000

Gross Profit

$20,703,000,000

44.68%

$18,720,000,000

36.00%

Research and Development

$758,000,000

$1,000,000,000

Selling, General and Admin Exp

$2,605,000,000

$3,050,000,000

Operating Income

$17,340,000,000

37.42%

$14,670,000,000

28.21%

Other income/expense, net

$137,000,000

$380,000,000

Pretax Income

$17,477,000,000

$15,050,000,000

Provision for income taxes

$4,413,000,000

$3,913,000,000

Net Income

$13,064,000,000

28.20%

$11,137,000,000

21.42%

Basic Shares Outstanding

931,041,000

938,000,000

Basic EPS

$14.03

$11.87

Diluted Shares Outstanding

941,572,000

948,000,000

Diluted EPS

$13.87

$11.75

Source: Apple SEC Filings and Management Projections

Full FY13 Estimates

Depending on which Wall Street analyst you prefer to follow, projections for Apple's fiscal year 2013 earnings will certainly vary. There are projections for negative EPS growth to +30% EPS growth. I am very conservative in my assumptions and do this for a specific reason, if a stock appears undervalued using conservative estimates, than any upside surprises will likely lead to outsized returns. The table below lists out last year's income statement and a combination of managements estimates along with my estimates for the current year's income statement. Some noteworthy assumptions made are as follows:

*Revenue growth of 17% (compared with 44.58% last year)

*Gross Margins declining by 48 basis points (not as drastic as Q1 would predict)

*No change in share count (the company is beginning a $10 billion stock buyback program in 2013)

FY2012

FY2013

Full Year

Common Size

YOY Growth

Full Year Estimate

Common Size

YOY Growth

Revenue

$156,508,000,000

100.00%

44.58%

$183,114,360,000

100.00%

17.00%

Cost of Revenue

$87,846,000,000

56.13%

36.34%

$103,658,280,000

56.61%

18.00%

Gross Profit

$68,662,000,000

43.87%

56.70%

$79,456,080,000

43.39%

15.72%

Research and Development

$3,381,000,000

2.16%

39.19%

$4,211,630,280

2.30%

24.57%

Selling, General and Admin Exp

$10,040,000,000

6.42%

32.12%

$11,755,941,912

6.42%

17.09%

Operating Income

$55,241,000,000

35.30%

63.48%

$63,488,507,808

34.67%

14.93%

Other income/expense, net

$522,000,000

0.33%

25.78%

$640,900,260

0.35%

22.78%

Pretax Income

$55,763,000,000

35.63%

63.03%

$62,847,607,548

34.32%

12.70%

Provision for income taxes

$14,030,000,000

8.96%

69.38%

$15,711,901,887

8.58%

11.99%

Net Income

$41,733,000,000

26.67%

60.99%

$47,135,705,661

25.74%

12.95%

Basic Shares Outstanding

934,818,000

934,818,000

Basic EPS

$44.64

$50.42

Diluted Shares Outstanding

945,355,000

945,355,000

Diluted EPS

$44.15

$49.86

Assuming my projections are correct and Apple earns $49.86 per diluted share. If the stock traded at 12x earnings, shares would be worth roughly $600. Using a multiple of 11x TTM earnings would warrant shares trading at roughly $550 per share. This does not factor in the $10.60 dividend investors would receive over that period. Again, my projections are done in a conservative manner, so any upside surprises would potentially mean higher earnings per share or the market awarding Apple with a higher price multiple.

Any Value in Apple?

So here is the most important question, is there money to be made in Apple or are shares fairly valued? To answer this question you need to first question the business model of Apple:

  • Has anything materially changed inside the company?
  • Are they selling less products?
  • Has the macro environment changed?

My answer to all of these questions is No. While some may argue my response and many pundits claim the company is running out of people to sell iPhones and iPads to, I still believe the international growth story is where sales expansion lies. Apple has not penetrated emerging markets to the same degree it has in the United States. You can witness this by observing geographic segment sales, which the company breaks apart in 10-Q and 10-K fillings. The opportunity in the Asia-Pacific region is extremely promising.

Another point to keep in mind is the record pile of cash on the balance sheet. The company ended FY12 with over $120 billion in cash and investments on the balance sheet. All assets will eventually become an expense, so this cash will ultimately flow somewhere. I believe two options make sense for Apple to begin deploying this capital. First is share repurchases. With the company awarding stock options each year, the share count continues to climb (see table below). Initiating a large scale share buyback program will give a boost to EPS and offset any stock option awards.

Diluted Share Count

2009 Q1

901,494,000

Q2

902,993,000

Q3

909,160,000

Q4

912,000,000

2010 Q1

919,783,000

Q2

922,878,000

Q3

927,361,000

Q4

929,000,000

2011 Q1

933,154,000

Q2

935,944,000

Q3

937,810,000

Q4

940,000,000

2012 Q1

941,572,000

Q2

944,893,000

Q3

947,059,000

Q4

948,000,000

Source: Apple SEC Filings

The second option is increased dividends or a special onetime dividend. The company generates significant cash flow and earnings to cover the current dividend payment. An increase would not put any financial strain on the company. A strategy of growing the dividend over time would give Apple a fresh look to investors and possibly open the door for a new wave of income seeking investors.

Conclusion

In my opinion Apple has the ability to overcome the current struggles it is facing and will continue to grow its operations into the future. One change that will need to occur from the company is becoming more shareholder friendly. By this I mean more clarity in guidance (which the company did this quarter), increased dividend payments, and share repurchase programs. Investors have long feared the day Apple will no longer be the dominant provider of smartphones and tablets, that day may be fast approaching. As the technology industry becomes more crowded, Apple will face numerous challenging quarters in the years ahead. Depending on how the company "preps" investors, it could provide for a much smoother stock chart in the future.

*Note: All data reported and graphed is pulled directly from Apples SEC filings and press releases.

Source: What's In Store For Apple Investors In FY13