For years, Apple (AAPL) has handsomely rewarded investors due to the company's consistent growth from a string of revolutionary inventions. The stock has plummeted recently; potential reasons for the drop include: recent margin declines, long-term competition in primary markets, and inability to innovate. Due to these worries, investors may be overlooking the strength of Apple and its opportunities. Apple will likely take advantage of significant growth of smart devices across the globe. Apple has created an incredible brand name, and a uniquely integrated product line, which along with direct sales and leverage over producers, should allow it to maintain its profitability levels over the long run. Recent margin compression appears temporary because consumers are still willing to pay just as much for Apple products as they were before and increased gross costs were due to an inordinate amount of product ramp ups. These worries could be forgotten soon due to upcoming catalysts including potential product releases, margin stabilization, and deployment of the cash hoard. Apple is cheap from multiple perspectives, especially after separating the cash and the operating company. A very conservative DCF analysis illustrated a significant margin of safety with the potential for significant upside. Consequently, Apple represents the opportunity to buy a terrific business at a great price.
Company Description And Recent Results
Apple's business segments can be summarized by the following 2012 revenue breakdowns by segment and region, from the company's most recent 10-K:
In the first quarter of fiscal 2013 Apple broke out China from the Asia Pacific region due to growth there. Additionally, the company now reports an iTunes Software and Services, which is slightly different from the music and related products and services from before, and Apple has combined the peripherals and software segments into Accessories. For the purposes of this analysis, old categories shall be used because of greater availability of historical information.
The key takeaway from the graphs above is that the iPhone and the iPad are driving the company. This becomes more pronounced for segment profits. While Apple does not break out gross margin figures for individual product lines, they can be reasonably estimated notably from an article by Michael Fu (table below) and reports from the Apple vs. Samsung (OTC:SSNLF) case; on the gross profit level the iPhone and iPad represent over 80% of the company. Although not visible here, revenue growth for the Mac and Pod segments has either been slowing or turning negative. Consequently, the iPhone and iPad segments will likely determine the success of the company moving forward.
While results were strong on absolute level, they could be seen as poor due to the significant hits to the margins and slowing growth. Were margin declines to continue and growth to stagnate, Apple would be in significant trouble. However, it appears that uncontrolled margin erosion and flat revenue are unlikely moving forward.
The main industries in which Apple operates are poised to grow for some time.
The smartphone industry, relative to the tablet industry, is more mature. The phase of astronomical expansion during which the product moves from niche luxury to widely used has largely occurred. The sentiment is echoed by the following Financial Times article. A significant source of smartphone growth could come internationally where consumers have less disposable income, which could force Apple to offer a lower priced product causing margin compression within that line. Finally, a new innovation in the phone industry could render the iPhone obsolete.
These negatives, however, are outweighed by the positives. Compared to many other industries, the smartphone industry is still likely to experience strong growth. Industry growth estimates are quite varied. IDC estimates the market growing at about 13% CAGR. iSuppli estimates lower end smartphones growing at 50% CAGR versus high end smartphones at 12% CAGR. A recent Forbes article sites that the overall smartphone market may grow at 18.3% CAGR and Apple will grow at 18.8% CAGR. There is certainly no way to know which one of these is correct; but evidence suggests that smartphones and the iPhone have room to expand.
Another strength of the industry worth citing is replacement cycles. The typical cycle is 2 years; this creates a relatively recurring stream of revenue for anyone operating in this space. This cycle particularly benefits Apple because approximately 88% of Apple's customer base plans on its next phone being an iPhone.
Of the 3 worries above, compression of gross margin due to international expansion is most likely given the lower income levels internationally. Apple may or may not tap into this market; given Apple's focus on doing a few things well, management will likely be able to determine the best direction. The iPhone could certainly lose favor rapidly just as the BlackBerry did due to technological innovation; this is a risk one must accept with any technology company. Apple's products, however, are more directed at consumers, who while caring about technology also take into account brand names. This compares to BlackBerry (formerly Research In Motion) (BBRY), who focused on businesses with its secure mobile platform but lost when its features were duplicated or surpassed by competitors allowing businesses to shop around.
The tablet market is likely to grow faster than the smartphone market over the future. In the same article, 35%/year and 20%/year are given as estimates for the tablet industry. Other estimates include for tablet market growth are 28%, 19%, and 22%.
A major concern about the tablet is that it is significantly lower margin than the smartphone. The earlier article about the Apple - Samsung suit showed that the iPad has about half the gross margin of the iPhone. A major reason for the margin discrepancy is that the tablet competes against the laptop and desktop, each of which have advantages over the tablet, whereas the smartphone is inherently superior to superior phones except in price. While this hurts margins, the ability for the tablet to take market share from desktops and laptops gives the tablet market significant room to expand. Additionally, American phone companies subsidize smartphone purchases to sell phone plans. Finally, some tablet manufacturers, notably Amazon, do not sell tablets, to maximize profit on the tablet individually but to maximize profit for the whole business,
The rapid growth of the tablet and smartphone industry hurts Apple's iPod and Mac businesses. However, these business lines, in terms of revenue and especially profit, are relatively small compared the iPad and iPhone. This cannibalization is actually a significant net benefit to Apple.
This growth will result in consumers having more Apple products. This should fuel the growth of smaller lines of business such as the iTunes store, software, peripherals and the App Store.
The competition in the smartphone market can be summarized by charts of the current smartphone base in terms of operating system, hardware maker and shipments.
Apple has a higher subscriber base than shipments because it entered the smartphone industry earlier than competitors. Samsung is clearly a significant competitors reflected in both the higher number of shipments and shipment growth in 2012 compared to Apple. Samsung's success comes from successfully tapping into international markets, which has not been penetrated to the same degree as developed markets, especially America. Yet Apple has done well, increasing both shipments and market share over the past year.
More importantly, the iPhone is inherently more profitable than other smartphones. Samsung's Galaxy S3 gross margin of 35% pales in comparison to the iPhone's margin of 50%-60%. Samsung's margin is further diluted by its aggressive pursuit of the low end smartphone market, which generates lower revenue and margin per phone. While, Apple and Samsung control nearly all of smartphone profits, Apple dominates Samsung. This indicates that Apple has created either a better product than its competitors, or established a brand name, enabling Apple to charge significantly above cost.
Qualitative evidence supports the above figures. A recent article, citing JD Power, shows that iPhone users are the most satisfied with their phones compared to owners of other brands. A recent Barron's report illustrated that iPhone users are much more likely to buy an iPhone again (77%), than Android users (48%). As these customers shift away from Android, Apple could receive a significant boost.
Another trend aiding the iPhone is the App Store. While Google Play may be growing faster and have more apps than the App Store, the App Store is still much more profitable for developers. This is evidenced by the chart below:
This discrepancy should ensure that top app developers create iOS apps, ensuring a quality experience for Apple users.
The current tablet landscape is illustrated by the following 2 graphs from IDC.
Asus saw its shipments significantly increase due to the introduction of the Google (GOOG) branded Nexus. Samsung experienced tremendous growth because 2011 marked the beginning of Samsung's entrance into the market. While Apple may have a great product, there are certainly users who prefer the android system and were waiting for an Android tablet. Nonetheless Apple has still experienced quite strong growth.
Once again, Apple however is able to generate significant profits in comparison to competitors. Apple's profit margins compared to Asus and Amazon, which sells its Kindle to push its online store, are much higher. Microsoft's (MSFT) profit margin is actually as high as Apple's in the tablet sector, but the market has been much more receptive of the iPad than of the surface. Samsung's tablets actually have a strong margin; however, it is still to be seen if the market will be receptive in volume to Samsung's tablets, as it has been to Apple's.
The question becomes: why have Apple's products been more profitable than competitors', including the iPod in the past. First, Apple has been more innovative than competitors, namely Samsung, Microsoft, Nokia, BlackBerry (formerly Research In Motion) and others giving them a first mover advantage. It is interesting to note in this analysis that Google is actually not a direct competitor with Apple, yet. Google does not produce a smartphone and Asus actually makes the "Google" tablet. Google's developments encourage the uptake of Samsung and other manufacturers. While past innovation does not indicate future innovation, it appears that Apple has a special culture that encourages advances, largely because the company focuses on making the best product by doing a few things well. While Google has been quite innovative, it appears that it is focused on developing its online business (advertising, cloud, etc.) while Apple is more consumer focused. Even if Apple does not generate a major innovation, it will likely continue improving existing lines.
Another major advantage of Apple that still exists is the vertical integration of the consumer experience. Apple designs everything including the hardware, software, add ons such as the App Store, iTunes store, services such as AppleCare, to work together cohesively. Samsung, however, relies on software from Google and technicians from Verizon to work with its hardware; Nokia is in a similar situation, getting software from Microsoft and service mobile phone companies. Apple's design creates a consistent experience in which each part is optimized for each other in a cohesive manner, which potentially explains why consumers have been willing to pay significantly more for the Apple experience rather than a Samsung tablet or phone.
Finally, Apple unlike any of its competitors has retail stores. These support the aforementioned cohesive consumer experience because consumers can see how the whole Apple line works together in one place with the help of a knowledgeable sales person specifically hired and trained by Apple. Competitors sell largely through third party vendors who cannot provide the same experience; salesmen there are likely not as well trained and have to remember much larger product lines. The ability to have a retail store illustrates and perpetuates the strength of Apple's brand. It also allows Apple to cut out the middle man and earn significantly higher margins.
In comparison to its competitors, Apple appears to have the ability to continue generating outsized profits in its key existing product lines for the reasons mentioned above.
After the perceived lack of innovation, potential long-term margin declines due to increased competition, potentially supported by recent gross margin results, appears to be investors biggest worry. Given the significant decline in margins, the margins for the iPhone and iPad certainly dropped during this time period.
Gross margin deterioration can come from 2 sources: lower selling prices or higher production costs. Prices can decline without causing margin compression if costs decline proportionally. Margin compression from price declines would likely be a long term and permanent change for 2 main reasons. Apple would lower prices in response to competition or to tap into new more cost conscious markets; these 2 market changes would be long-term secular changes unlikely to reverse themselves quickly. Margin compression from increased costs is likely short term and temporary. Apple, due to its size, can squeeze suppliers for lower input prices, and can pass any long-term price increases onto customers. However, Apple, like any other company can do little with short-term input price increases. Additionally, Apple experiences higher costs during the debut of a new product or iteration of a current product because there are one-time costs, and the company operates lower on the cost curve; over time these costs abate.
While Apple does not release gross margin figures by product line, it does provide data to determine the average selling prices of the product lines as seen below:
Over the past 3 quarters, the ASP for the iPhone has held steady at $624, $636, and $642 (earliest to most recent), compared with an ASP of $644 for all of 2012. The ASP for the iPad over those 3 quarters went from $538, to $535 and to $467, compared to an ASP of $556 for 2012. The primary decline in ASP for iPad was the introduction of the iPad mini, which sells at significantly less than a traditional iPad. Since the only phone debut in 2012 was the iPhone 5, which had similar pricing to past models, the steadiness of the ASP over the past few quarters indicates that potential margin compression came from short-term increased costs, potentially tied to the iPhone 5 release.
Upon first glance, the precipitous decline in ASP of the iPad could be a significant source of margin compression, especially when Tim Cook said the iPad mini's gross margin is "significantly below the corporate average" (1Q Transcript). However, a teardown analysis of all iPads counters this.
Note that retails price is not the price Apple receives from retailers, which explains these margins do not agree with the margins from Michael Fu. However, retail selling price is likely proportional to the price Apple receives from retailers. Since the chart above indicates that the iPad Mini's margins are greater on a teardown basis than the traditional iPad, it is possible that the iPad Mini actually increases the overall iPad line's gross margin, and it is highly unlikely that it decreases it. The only way for the iPad mini to decrease the iPad line's gross margin is if Apple cannot leverage similar profits out of retailers with the mini than the traditional, which appears unlikely.
Consequently, Apple has not had to decrease the profitability of its main product lines in the most recent quarter, which is also the holiday season, to generate its sales. It appears that the company's explanation of the margin deterioration is reasonable:
"The year-over year decrease in gross margin during the first quarter of 2013 was driven by multiple factors including introduction of new versions of existing products with higher cost structures and flat or reduced pricing, introduction of iPad mini with gross margin significantly below the Company's average product margins, price reductions on certain existing products, and the impact of the significant number of product introductions during the quarter on product transition costs." (Apple 2013 1st Quarter 10-Q)
Price reductions likely occurred in other less important product lines such as the Mac or the iPod. While it would be terrific to see no margin erosion in these lines, it should not be a major concern to investors because losses in these segments are likely the result of cannibalization and provide a net benefit to Apple.
It is worth noting that the introduction of the iPad mini did decrease the company's gross margin. This occurred because the iPad's gross margin is below the company's average, and the iPad grew faster than overall revenue for the company. Investors should not be worried about this because Apple's bottom line still grows substantially.
While over the long term, competition and entrance into more price sensitive markets could erode Apple's margins, quantitative and qualitative evidence indicates that Apple has not had to decrease the profitability of its products, most notably the iPad mini, to sustain its business. This is particularly important given that major competitors such as Samsung and Google, have significantly increased competition over the past year. Rather the margin compression appears to be short term resulting from normal business events such as product launches and temporary supply shocks.
Risks And Weaknesses
Competition is the biggest risk for Apple. The impetus to create the next massively profitable product like the iPhone is huge for Samsung, Google, Microsoft and others. Were this to happen, Apple's fortunes would change precipitously if this innovation competed with the iPad or iPhone. Of potential competitors, Google is likely the most dangerous, but its entry into the tablet market was done through Asus, providing some evidence it may not compete directly with Apple. A market changing innovation is impossible to predict and is a risk that one must simply accept with an investment in Apple.
Less drastically, competition has already pushed competitors to make hardware and software systems of relatively similar quality as those of Apple. Additionally, some of Apple's competitors such as Google, who makes the android system free to drive advertising, and Amazon who sells the kindle at breakeven to push its online store, are not motivated by profit on the individual product lines and could further lower prices in an attempt to take share from Apple. While Apple aims to maintain profit levels and not market share, aggressive pricing or continued innovation by competitors could force Apple to deliver products at lower margins. This idea is echoed in the company's recent 10-K: "The Company's products and services compete in highly competitive global markets characterized by aggressive price cutting and resulting downward pressure on gross margin"
Due to the company's size, there are certain growth limitations. Since Apple already dominates many markets, especially the tablet market, it will have a difficult time growing faster than the overall market, as further major market share gains are unlikely. Furthermore, as product penetration increases, Apple will be dealing with customers who have less disposable income forcing them to offer a cheaper product eroding Apple's margins, which could have led the company to say in its 10-K, "the Company expects it will continue to take product pricing actions, which would adversely affect gross margins" Additionally, a potential innovation will likely not have as large of an effect on the company's profits as it did in the past because the company's revenue base is much larger now, and it is unlikely a product will have the same profitability as the iPhone. This may disappoint investors used to Apple's revenue or profits to double every 2 to 3 years.
Fortunately, investors can track these weaknesses. One can read the headlines and reviews for competitors' and Apple's products. Regarding increased competition, investors should play close attention to the gross margin and determine if changes are secular through price changes, short term through increased costs, or natural through shifts in product mix. If Apple does introduce a lower priced iPhone, investors should focus on the bottom line, as margin compression would be acceptable provided compression is outweighed by bottom line growth.
The company's current valuations along with competitors can be seen below.
In comparison to competitors Apple appears slightly undervalued given that it is in the middle of the valuations. However, Apple should command a premium because compared to most, because it has a stronger track record of innovation, possesses a brand name, can achieve outsized profits on its goods and provides a vertically integrated experience. This has historically been the case as evidenced by the chart of historical P/E ratios below Google may deserve a premium given its constant innovation and dominance of key markets, although it does seem pretty steep at more than 2X Apple. Apple certainly looks cheap compared to Microsoft. BlackBerry looks intriguing, but given the company's difficulties, further research would be necessary to determine if it's a value or a value trap. And Apple looks slightly cheaper than Samsung because of the large difference in the FCF yield.
P/E and FCF Yield do not take into account the cash on Apple's balance sheets. After taking this into account for all the companies listed, Apple actually looks even cheaper. On an absolute basis, Apple's valuations are cheap and normally indicative of a company with stagnating or declining performance. Yet, Apple's main business segments are poised to grow significantly over the coming years, and while margins could compress, they are unlikely to free fall and profits should continue to rise.
The graph above illustrates the premium that Apple has traditionally commanded. However, over the past year, it has gotten significantly cheaper in comparison to all its competitors. On the basis of a P/E ratio, Apple is historically cheap: the only time it traded cheaper than this was in the midst of the recession in early 2009. This is further supported by a graph of the company's historical FCF yield.
Apple is trading at extremely cheap historical levels. Given these figures, there is a significant margin of safety regarding valuations, as Apple's share price can increase by returning to a premium to competitors or no longer trading at a discount to historical or absolute market levels.
A DCF for a company like Apple is difficult and can be likely less accurate than those for other companies. Apple is likely to come out with some sort of product in the future but this is impossible to project. More importantly Apple releases very little information on its product lines so one has to piece together information to get more accurate predictions of the company's business segments. Given so much uncertainty, more conservatism is required than a typical DCF.
With that in mind numerous conservative decision were made. The most important of these are as follows:
1) No creation of a new product line
2) Yearly 2% and 1% deterioration of gross margin of iPhone and iPad lines
3) Growth rates that were on the lower end of estimates, and decline each year over the time horizon to almost zero
4) Decrease in Mac and iPod revenue at 15% per year, and deterioration of gross margin at 1%/year
Other conservative assumptions
1) Complete discount of cash held overseas for repatriation
2) Only inclusion of effect of deferred taxes on FCF and not changes in working capital, which typically have helped company, but could not be reliably predicted.
3) No inclusion of income from cash balances
4) Based GM off first quarter 2013 and did not assume rebound over rest of year due to less ramp ups
5) No expansion of EV/EBITDA multiple during exit period
6) 11.6% WACC
7) No financial engineering by taking out debt or issuing preferred shares.
Please note that the gross margins for the product lines were educated guesses given earlier findings. These assumptions led to the following revenue model for the various lines of business
There will undoubtedly be errors that can and cannot be observed. However, this should be quite conservative as seen by the low growth in the iPhone and iPad in the later periods, and the large decrease in gross margin of the company. For completeness, key model inputs were:
This led to the following statement of cash flows:
Which given an exit EV/EBITDA of 5.0X, a discounted cash balance of $104B, and a WACC of 11.6%, yielded an equity value per share of $549.05, or an upside of 24% to the share price as of 3/29/13 of $442.66.
This model was designed to be very conservative uncertainty due to the future of technology and the lack of figures Apple has given investors. The results illustrate that the market is pricing in a combination of significantly slowing growth and major margin deterioration in key product lines over the coming years, more so than conservative estimates of the model above. Qualitatively, it appears the market is pricing in a situation worse where the company can only grow by tapping into less affluent markets that grow more slowly than expected and are significantly less profitable.
Cases can be run with slightly more optimistic assumptions about possible upside. For example, if the gross margin decline in the iPhone and iPad is half as fast as predicted above, the predicted equity value jumps to $591.20 for an upside of 33.6%. However, these exercises are truly guessing games because there are so many inputs for Apple. Additionally, since the model above is an extremely bearish prediction, the effects of potential input changes have a positive asymmetrical skew.
There is one point about the upside that is worth mentioning. Because the model does not include any new product lines and there already is significant upside, an investor is essentially getting a call option on Apple's new product innovations for free.
From the analysis it is evident that investors are pricing in a precipitous deterioration of the company's fortunes; yet most investors would agree that Apple will be a strong company in 5 years. Thus, it really appears that Apple investors are comparing future growth with past growth, making future figures look poor, when relative to the who world of potential investments, Apple's future cash flows are superior to most. Fortunately, investor's attitudes could become positive due to a significant number of catalysts on the horizon.
In light of recent investor pressure, including from the likes of David Einhorn, Apple could make an announcement to return more to shareholders. Given Apple's history and its aim to make the best products and not be the best to shareholders, it is highly unlikely that Apple becomes extremely shareholder friendly. However, Apple's massive cash pile is doing nothing, and Apple would like to find good uses for it.
Another major catalyst could be the introduction of a new product. No one knows when this will happen. However, it would certainly assuage investor sentiment that Apple is no longer an innovative company.
Apple's margins are likely to stabilize in the coming quarters as the impact of product ramp ups decreases, and as the iPhone makes up a bigger portion of the company's revenue due to growth. Investors worried about margin compression would likely become more bullish upon seeing this.