Apple (NASDAQ:AAPL) is my largest holding and has been for well over one year now. In the few previous articles I've written on the company, I described first my intent to take profits off the table after one year (that was Oct. 2012), and then my change of heart one month later as the stock began to drop significantly and I believed it was just too cheap to sell. After all, we should buy low and sell high. This decision at the time was based on both fundamentals but also potential catalysts for 2013. Putting my money where my mouth is, I even added to my position after the last earnings release when the stock dropped to $450, as I saw that expectations have now really gotten significantly lower, and as a value investor I love stocks with lowered expectations but still strong fundamentals.
Looking at Wall Street, analysts still overwhelmingly have buy ratings on the stock, but price targets have been slashed significantly, earnings estimates lowered, and the number of analysts now rating the company a hold instead of a buy has doubled from 5 to 10 in the past few months:
Concerns for Apple - The Fickle Consumer
So what are some of the major concerns? One thing we know about technology is that users are very fickle and tastes are constantly changing. I think one concern that we are seeing here is that consumers are getting "bored" with the company, and for the stock to get another jolt upward we really need to see the next big innovation. A recent note by well known Apple analyst Peter Misek discusses how at this year's Mobile World Congress the Apple craze was much more subdued, and in particular the hot item was the sudden surge of recent "phablet" products. Basically these are smartphones with much larger screens, some well over 5". Now there are almost daily reports released from analysts dissecting potential Apple threats and competition like this one and many are no more than a minor distraction. But this is one that I think we should take some note of. Just this past weekend, I was at a friend's birthday party where 2 different people were showing off their new phablets. Admittedly I don't even know which brands or models - but immediately it made me realize that if I had been at this same party 1 or 2 years ago the product being flashed around for everyone to see was likely to have been the latest iPhone or iPad. I definitely have seen an inflection point, and it appears times have changed - 1 year in the consumer tech world can be like a lifetime in some other industries. Nobody is so excited anymore about recent Apple products. The iPhone 5, iPad 4, and even the iPad Mini have been received more as evolutionary products and not great new innovations or revolutions. With some of this "wow" factor being lost to competitor products it leads to concerns of increased competition, lower margins, and further slowdown in the company's earnings and growth rates. These concerns have driven the stock price downward more than 35% from its all time highs in September 2012.
Valuation - The Market Seems to Expect a 0% Growth Rate
Sometimes an interesting way to look at the valuation of a company is to work backwards, and to use a DCF model and play with different growth rates and discount rates until you get the current market price for the company. Then you can analyze whether the growth rate being priced in by the market is really realistic or not.
For Apple you can do this quickly, by using the DCF calculator at GuruFocus. To arrive at $448/share, I have given these inputs:
- EPS of $44.56 (TTM earnings)
- Growth Rate in Next 10 years: 4.3%
- Terminal growth: 3% for 10 years
- Discount Rate: 12%
Now, 2 factors I would say you could definitely be more aggressive on:
- Use a lower discount rate especially considering the cost of debt for Apple
- Subtract out cash, which even if you take into account taxes that would need to be paid if the cash was repatriated, there would still be close to $100B. The cash is also growing rapidly at close to $30-$40B/year. Anyway you look at it, this is more than $100/share in cash.
Point #1 is debatable, especially in the world of high technology and rapid changes. So to be conservative, I will leave the discount rate at 12%. However point #2 is not as much. So if you were to subtract out the cash, and drop the share price to say $350/share, then the DCF would look like this:
- EPS of $44.56 (TTM earnings)
- Growth Rate in Next 10 years: 0.2%
- Terminal growth: 3% for 10 years
- Discount Rate: 12%
So in other words, the market is expecting almost 0% growth out of Apple. Just thinking about that for a moment - does that really make sense? Granted, their earnings and margins are likely to be under increased pressure from competition, so looking at that alone you could conclude they might have some negative years in earnings growth. But looking at the bigger picture, will they really stop growing earnings completely? I find this highly doubtful, for several key reasons:
- Share Repurchases - The company is under increasing pressure to use more cash to repurchase stock. This could really boost earnings per share and offset margin pressures. A recent article from Bernstein Research analyst Toni Sacconaghi makes a very good case using IBM (NYSE:IBM) as an example of how compelling this could be to drive value for shareholders. IBM paid out more than 100% of FCF to stockholders in the past 5 years largely driven by buybacks. The share price is up 77% in that time period. Microsoft (NASDAQ:MSFT) paid out much less, around 60%, and we all know how well MSFT stock has done in the last decade. Remember, Apple has not only a huge cash pile, but also no debt! What's to stop them from using leverage and doing massive buybacks/special dividends? There are several options they could do here, and as pressure continues to grow they will be pushed to act.
- Overall Growth of Tablets and Smartphones Just too Strong - Although I can believe that the likes of Samsung (OTC:SSNLF) and other major competitors will take market share and perhaps hurt Apple's margins, remember that this market is still showing exponential growth. I expect all players to continue to benefit on both the top and bottom lines. Year over year growth of the market from Q3 2011 to Q3 2012 was still a whopping 44% - 120 million to 173 million units shipped, as I mentioned previously. According to the China Observer, the global middle class is set to grow from 1.8 billion people in 2012 to 3.2 billion in 2020. This is a 7.5% CAGR, and should continue to drive overall growth for consumer electronics such as smartphones and tablets.
New Innovations - For sure Apple is working on new products. There is a lot of rumor and speculation out there, and nobody knows for sure what is coming next. Is it an iWatch? Will it be an iTV? Any of these products catching any significant market share or adoption, will be positive for earnings. According to this analyst article, a successful iTV launch could generate as much as $14B in revenues and $4.50/share in earnings growth in the first year of release. That hardly seems like a 0% growth rate to me. Of course this is all speculation and nobody knows when and if these products will be released - but one thing is for sure, and that is with more than $3.4B in R&D spending in 2012, the company is not sitting still and there will be new product releases.
The Bottom Line
Apple has really become a true value stock. There is a general feeling in popular media that the company is losing its mojo. The stock price has dropped more than 35% in less than 6 months. Meanwhile, the company continues to make a boat load of cash, and for sure has new innovations on the horizon. The release of a new product, whether it be an iTV, iWatch, or something else we haven't thought of will ignite the stock. In the mean time I recommend investors be patient, and even consider accumulating shares if you have spare capital to do so. Just think about it:
- The market is essentially pricing in a 0% growth rate
- The prospect of huge dividend increases/share buybacks is getting stronger by the day
- The prospects for new innovations is definitely real, as the Apple R&D machine is quietly churning in the background
These points alone make this stock one of the best bargains you can find in 2013.
Disclosure: I am long AAPL, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.