Only six months ago the Apple (AAPL) share price was stretched to 30% above my 500 USD target from last October. Despite a hot stock market, the pendulum is now swinging in the other direction. Apple's valuation is now 15% below my target price. There has not been any material news over the last six months that impacted my financial model. I have however tweaked my numbers after the last Mobile World Congress in Barcelona. Although Apple did not participate to the WMC-event in Barcelona, there were some trends visible that will force Apple's hand in the near future. Apple has a more important strategic choice to make than whether or not it pays more dividend.
The Halo-effect is fading
The company is caught in a catch-22 situation between protecting iPhone margins and market share. The iPhone single-handedly generates 72% of the gross profit. Apple has refrained from introducing a lower priced iPhone. However the MWC in Barcelona made it clear that affluent users in the emerging markets demand smartphones with price points between 150 and 200 USD. Also, recession stricken European consumers have become much more price sensitive. The Nokia Lumia 520 on Windows 8 and the ZTE open on Firefox OS are some outside contenders for the next wave of smartphone adoption. The bulk of the competition is however Android-based, with Samsung (SSNLF.PK) leading the charge. These smartphones can perform the same tasks as a 600 USD high-end phone, but react at a slower pace and show a lower resolution. Apple now stands with its back against the wall and risks losing potential users for its iOS ecosystem. The iPhone has been driving the Halo-effect that has hooked hundreds of millions of users into the secluded walls of iOS and iStore. Missing out on the emerging customer will cost Apple more than just the iPhone margin. Once users get used to a platform, the barriers to churn to iOS increase dramatically. A lower priced iPhone, not just a discounted 4S, seems inevitable to defend its worldwide iOS market share.
Market share has peaked
Although the growth in the smartphone market is slowing down fast since the 2010 peak, it is still well above current economic growth. The introduction of cheaper smartphones will support the growth for another three years between 32 and 15%.
The meteoric market share gains of the iPhone came to a halt. However, I believe that the iPhone market share will not decline suddenly over the next couple of years. The need for a cheaper iPhone is however key to protecting its market share.
As the Apple user base matures, the company will soon sell more replacement units to current iPhone users than units to new iPhone users. It is inevitable that the replacement cycle will lengthen at the same time. The ASP or average selling price of the iPhone will have to come down over the next couple of years. Apple has been able to delay this trend by adding new features and improving the user experience.
Although the iPhone unit sales have peaked, the total unit device sales for Apple is still growing faster than the market. The iPad success keeps Apple's share up in the consumer technology wallet. My overall sales expectation calls for a small decline over 2014 and 2015.
Gross Margin squeezed
Over the next three years, the ASP decline will accelerate at a faster pace than the decline of the component prices. There are few cost advantages to manufacturing a cheaper iPhone. This will eat into the gross margin of the iPhone and the group's margin. Unfortunately, Apple does not report margins by division. This lack of transparency is now playing against Apple as the market seems to be pricing in a stronger margin decline than my cautious expectations.
Capex demands increase
Apple will have to spend more capital on its supply chain. Its plan to cut Samsung out of its list of suppliers will be a costly exercise. It is also likely to invest more in its working capital as it introduces more models and builds its own retail network.
Not cheap on a P/E basis, but who cares?
The tax rate is likely to increase a couple of percentage points as Apple repatriates more foreign cash. The dividend yield will increase significantly, but that does nothing for the valuation. At 14.5x P/E 15, the stock is not really cheap compared to the market. On the other hand, the secure cash-flow yields 15% upside in my DCF model. If exaggeration in the market has a symmetric profile, the stock could get a bit cheaper before it recovers. I have reversed my short and taken a small position as a long-term holding. I wonder whether this Apple article will get as much hate-mail as my previous ones. They urged investors to sell the shares. In the meantime it has become very fashionable to bash the company while it is down.
DCF shows 15% upside
Disclosure: I am long AAPL.