Apple (AAPL) is the world's largest company by market capitalization and is also one of the most followed and traded stocks in the world. The company had run up substantially last year with analysts setting targets of $1000 and greater. We had advocated a short position when the stock was trading near its all-time highs above $700. The stock has gone down substantially since that time and is now trading at ~$450. The sharply bullish sentiment has now turned quite bearish and many of the disadvantages and risks have been discounted in the current stock price. We think that Apple now makes a decent buy at the current levels, given that the company is still a dominant force in the consumer technology markets. Apple is also poised to come out with new products such as an iWatch and a new Apple TV, which can serve as catalysts for the stock price. Currently the market is totally neglecting the possibility that the new products can be a success. Also the valuation has become quite attractive especially since the company has more than ~$137 billion in cash and investments. Investors are pressuring Apple to return some of this cash through dividends or buybacks.
Why Apple is a Buy
- Presence across all major consumer products - Apple has a dominant presence across all major product categories having pioneered some of these segments. While the iPhone 5 was not a game changer as expected, the earlier versions of the iPhone are still selling quite well. Apple has a large market share in the U.S. smartphone market and the company seems poised to increase its market share in China and India as well. The company also sells most of the tablets being sold globally, having created this category with the launch of the iPad. The company is also increasing its market share in the PC market with its Macintosh range of laptops and PCs.
- Valuation is Cheap on both Absolute and Relative Basis - Apple is already being valued like Microsoft (MSFT) and Intel (INTC) with a P/E of less than 10x. The market has already assumed that Apple's growth and earnings are going to slow down drastically. The company is trading at a big discount to both technology industry valuation average, as well as the S&P 500 valuation. The forward P/E is quite low at 8.4x and the company is already giving a dividend yield of 1.7%, with a payout ratio of just 12%. While the probability of earnings going down drastically in the technology industry is quite high (Nokia (NOK), BlackBerry (BBRY) etc.), we think the market is already discounting most of those risks.
- Innovation and Marketing Strengths - Apple has decimated entire industries and ecosystems by creating disruptive products, which have delighted customers. The company is the main cause why the Wintel players have declined precipitously. Apple has become the most valued company through introducing revolutionary new products and marketing them effectively. Most of the other big technology companies such as Microsoft, Yahoo (YHOO) etc. have failed quite miserably on these fronts. While Apple has not introduced any new products since the departure of Steve Jobs, the company still possesses the potential to do so. There are already indications that the company is about to launch a digital watch with many of the capabilities of a smartphone.
- Sentiment is highly negative now - When the stock was trading above $700, the sentiment was highly bullish with most analysts giving it a buy rating with targets of $1000. However, now that the stock has fallen to the $450 level, the sentiment has turned quite bearish. We think Apple is a good contrarian play due to these reasons.
- Fortress like Balance Sheet - Apple has got a massive cash hoard, which is bigger than every other technology company. Due to the billions of dollars in FCF generated every quarter, Apple has managed to accumulate a mind boggling ~$137 billion in cash and investments. This gives the company the luxury to explore new growth areas through outright acquisitions. Apple has not been a big buyer of other companies, unlike other technology majors such as Cisco (CSCO), Google (GOOG) or even Microsoft. The company has managed to grow at a rapid clip on a frugal R&D budget.
- Enterprise Entry - Apple is tremendously strong in the consumer technology markets but has a negligible presence in the enterprise technology segment, which is dominated by MSFT, Oracle (ORCL), HP (HPQ) and others. However, the introduction of the 128 GB iPad and adoption of iPhones by companies for their employees, show that Apple is starting to make inroads into this untapped segment. This is a huge area to grow, if Apple can leverage the BYOD trend in enterprises to its advantage.
- Expand into Emerging Markets - Apple has not really concentrated on increasing penetration into emerging markets like India. The company only recently increased its sales force in India where it already has a top-of-the-mind brand recall. The emerging markets such as China (deal with China Mobile (CHL)) and India present a great opportunity for Apple to keep growing through increased sales and marketing efforts.
- Competition keeps on Rising - Competition is growing at a rapid pace across all the major product categories such as tablets and smartphones. Google's Android operating system has enabled even small time hardware vendors in China and India to compete with the big boys. I was stunned by the feature set of the new HD Canvas phone (at just ~$260) introduced by India's largest local supplier of smartphones - Micromax. Even the current Android leader Samsung (SSNLF.PK) is feeling the heat from these low-cost vendors. Apple will have to drop its prices to match these smartphones, as they are offering compelling value at a fraction of the iPhone price. Apple will have to keep coming out with blockbuster products, as rivals are copying Apple's product and designs at an ever faster pace.
- Margins will Decrease - The company has seen continuous growth in its Operating Margin from ~4% in 2004, to 35% in 2012. Apple manages amazingly high margins for a hardware company, thanks to its premium pricing. Customers have been willing to pay high prices for Apple products due to their quality and reliability. However, we see increasing evidence that competitors are starting to match the design and quality of Apple products at much lower price points. Apple had come out with the iPad mini to fight the competition in tablets from much cheaper Amazon (AMZN) Kindle and Google Nexus tablets. The arrival of a cheaper iPhone is also imminent in our view. This will lower the high operating margins that Apple makes from its current iPhone segment.
- Cook has yet to prove himself - Matching Apple's last CEO Steve Jobs is almost impossible for any new CEO in our view. The new CEO Cook has yet to introduce any radical new product. The snafu with the in-house map application has also damaged Apple's reputation of only introducing very high quality products.
- Law of large numbers - While scale and size is a good thing for a company to have, the flip side is that it is difficult for a company of Apple's size to grow anything beyond low double digits on a sustained basis. It is tough to grow on a ~$150 billion revenue base, especially in an industry which is as competitive as the technology industry.
Apple's stock price is pretty much at the same level where it was a year ago even though revenues, earnings and cash have increased quite a lot. The stock is down almost ~35%, from its peak value reached in September 2012. The company dropped sharply by ~15% after its 4Q12 earnings, after the margins and guidance was not up to market expectations. The company has been trading at nearly the same level since that point of time.
We think that Apple is a good buy now, given that sentiment has turned bearish, valuation is very attractive and there are potential catalysts related to new product introductions in 2013. The company has the opportunity to grow by expanding into enterprise technology and emerging markets. The company's valuation is already assuming a low to a no growth rate. This gives a good time to enter the stock as the downside is limited and investors have the opportunity to participate in the upside if the company delivers on new products.