Conclusion first: Apple (AAPL) is selling at an incredibly cheap price, and it is in the view of the author that the depressed price is driven by unfounded fears.
Apple's recent drop in market valuation has left a deep impression on many investors, even prompting the Wall Street Journal to publish an article titled "Coping With the Pain of Souring Apple Shares." In my view, people's opinion of Apple the company has been negatively tainted by the results of Apple the stock.
In this article, I assess the value of Apple the company as a potential investment in a two-part analysis:
- First, objectively assess Apple's current "market valuation" and "fair market value".
- Second, subjectively assess the factors driving Apple's stock price.
Part 1: Assessing Current Market Valuation
Let's start with a quick n' dirty review of Apple's balance sheet and earnings. Let me walk you through the chart below:
A Financial Portfolio Worth $137 Billion
Apple has no debt and a "portfolio" of cash, cash equivalents, and marketable securities worth ~ $137 billion, or ~ 22.5% of the company's current market capitalization. Given the company's tremendous cash flow, growing cash position, and liability-light balance sheet, I assume this amount can be paid out to investors without impacting operations (of course, actually paying out this amount is more theoretical than practical, but the point is to separate it from other essential operating assets). I adjust this amount down by 30% for potential tax liabilities and capital destruction (such as unwise acquisitions).
Modified Enterprise Value: $330 Billion
Per Crowell, Weedon's calculation, Apple's enterprise value is $284 billion, which may be viewed as the company's private market or theoretical take-over price, but I want to leave room for error by using a modified version of enterprise value by subtracting my adjusted cash and securities (line 5) from the current market capitalization (line 7), arriving at a modified enterprise value of $330 billion.
Modified Earnings Yield: 12.6% vs. S&P 500's 7% Average
Since FY13 Q1 net income is approximately equal to FY12 Q1 net income (though FY13 Q1 net income is materially higher after adjusting for the extra week in FY12 Q1), I divided FY12 net income by our modified enterprise value to arrive at a modified earning yield of 12.6% vs. the company's 10% unmodified earnings yield. This is a very attractive earnings yield, modified or not, vs. the S&P average of 7%.
Attractive Earnings Yield vs. Capital Gains Upside
According to the value investing school of thought, the market is there to serve you. Essentially, price fluctuation can be viewed as an option: exercise it when it is in your favor, forget about it otherwise. Given this view, and without making any growth assumptions, I assess the attractiveness of Apple's current market valuation in terms of income upside, and capital gains upside.
Income upside: Given the 10-year Treasury's ~2% "risk-free" yield, the equity risk premium rewarded by the market for holding Apple shares is effectively over 10% per year, and Apple's stockholders will have an average annual margin of 10% accruing in his favor vs. bonds, and an average annual margin of 5% accruing in his favor vs. S&P 500 (note that the S&P 500 accrues 5% vs. 10-yr Treasuries). Thus, if we take no view on future earnings, Apple clearly offers substantially more value than the S&P 500 or Treasuries.
Capital Gains upside: Adjusting Apple's current market capitalization to a level such that the stock offers a 7.7% earnings yield (or a PE of 13) and adding 50% of Apple adjusted cash and securities portfolio (a rough "normalization" so it is more comparable to peers such as IBM), I arrive at a rough "fair market value" of ~ $591 billion. This implies a 39% capital gains upside just from multiple expansions to somewhat below market multiples.
Part 2: Assessing Subjective Factors
As stated in the beginning, this part of the analysis is subjective and highly uncertain since we are not dealing in the realm of the future. This is by no means a "complete" analysis, and I intend to leave this section open-ended, and open to interpretation and debate.
"Growth Story" or "Sob Story"?
After adjusting for the extra week in FY12 Q1, AAPL's FY13 Q1 revenue increased 27% y/y. FY13 Q1 revenue by region and products:
For the five-year period through 2016, IDC estimates the market for smartphone shipments will increase 18% compounded annually, and tablet shipments will increase 23.3% compounded annually, both of which are lower than Apple's FY13 Q1 growth.
It's a growing market, but will AAPL continue to be the driving force? Assuming constant ASP and margin, Apple's current earning multiple does not even price in a substantially below-market growth rate, and obviously does not price in Apple's stellar current growth rate.
Of course, there is fear of falling ASP and margin compression.
Contrary to worries, Q1 reported the average selling price of iPhones remained around $640. However, the introduction of the iPad mini has lowered the average selling price of the iPad to $467 from $535 in the previous quarter.
Apple reported FY13 Q1 gross margin of 38.6%, beating both management guidance and analyst consensus. FY13 Q2 gross margin guidance of 37.5%-38.5% was better than expectations.
Gross margins are the envy of competitors, but pale in year/year margin comparisons against record levels of 44.7% (FY12 Q1) and 47.4% (FY12 Q2) that benefited from a high mix of iPhone sales (the highest margin product), and high margins from the iPhone 4S because its manufacturing process utilized the same equipment as the prior generation. AAPL's current gross margin was impacted by 1) a lower mix of iPhone revenue (sales grew, but other products grew more), and 2) higher costs related to new product launches for iPhone 5, iPad mini, iMac, etc.
But the biggest worry is not what happened, but what is to come.
The future of the iPhone is the center of negative attention. Will Samsung's much cheaper smartphones eat Apple's lunch? Will Apple's cheaper iPhones hurt the company's brand image and margins?
Also, I venture to guess, deep down inside, everyone is asking the same question: "Without Steve Jobs, will Apple be less like Apple and more like everybody else?" Certainly, looking at recent quarters, the lack of disruptive innovations and plan to offer "cheaper" products appear as if this fear is playing out.
However, how fair is this kind of fear to Apple? Even if Steve were alive, could we expect him to manufacture a revolution every couple of years like he did with the iPod, iPhone, and iPad? I also note that consideration for making a cheaper iPhone began under Steve's leadership. According to Bloomberg, "Apple, which had been working on a more affordable smartphone since at least February 2011, is weighing retail prices of $99 to $149 for a device that would debut in late 2013…" Recall that Steve was CEO until August, 2011.
The fierce competition in the phone and tablet space did not change. Apple's growth did not slow to a crawl. Apple stores are still teeming with people, and the supply chain continues to be a bottleneck due to strong demands. Apple's ecosystem of apps, music, etc. will only grow better as more people and organizations buy iPhones and iPads. In my view, the biggest change is the market's perception of Apple. Yes, Apple lost a visionary and irreplaceable leader, and Tim Cook will not get Apple a "Steve Jobs multiple". But Apple today is selling at an unadjusted PE multiple that is right between Dell (DELL) and HP (HPQ), and even Dell has reached a rock bottom level (relative to cash flow) to become a prime LBO/MBO candidate. There are risks to be sure, and I suspect margins will come down over time. But given the current price of the stock and the company's continued dominance in the phone and tablet space, in my view, the upside far outweighs the downside.