For Apple (AAPL), most arguments surrounding the valuation and future growth trajectory for the company center around iPad and iPhone sales. On the surface, this makes sense as these two products accounted for 72.4% of total revenue in FY2012. However, the contrarian in me feels that the potential growth for the Mac products is being overlooked by the market. Some refer to PC's as Windows based computers and the Mac product as something entirely different. In this article, references to the PC market will include both Windows and Mac computers. Before going further, I should note that many now believe that the definition of PC should include products such as the iPad. I tend to disagree with that point of view. Spending my day in the business world I see that the iPad certainly has a complementary role to play in certain lines of work. However, it is not debatable that the traditional laptop or desktop still has a far more dominant role in the vast majority of businesses. Just think of every time a company hires a new employee. In just about all instances, the employee is given a laptop or desktop. Companies do not forgo giving their employees a PC in lieu of giving them only a tablet. On this note, Apple has a robust lineup between the MacBook Air, MacBook Pro, and iMac to compete in the PC market. The company has seen market share gains in this market over the years. Yet they still do not even make it onto the chart when discussing market share by vendor. The global PC market saw over 350M units shipped in 2012. Unequivocally, this number will continue to face downward pressure as consumers continue to convert to the tablet form factor. However, the market share opportunity and financial gains as detailed below are there for the taking should Apple make a definitive push to capture them.
The Personal Computer Market
It is necessary to understand that this article assumes that the personal computer market refers to notebook and desktop computers only. The notebook category specifically does not include tablets.
As noted in the opening paragraph, the death of the PC is vastly exaggerated in my opinion. However, the end of the growth era of the PC market is without a doubt at hand. Even so, that still leaves a global addressable market of 350M units a year based on 2012 shipment volume. Apple in 2012 shipped roughly 18M units between their desktop and portable computer product lines. This equates to just over a 5% market share globally.
A study published this week by Gartner, one of the most reputable companies in the information technology research field, predicted that the global PC market would decline to roughly 272M units by 2017. If this prediction were to come to fruition, that would entail a 22% drop in PC shipments over the next 5 years. It is exactly this type of research that presents a significant opportunity for Apple in multiple ways.
Apple's Opportunity In The Personal Computer Market
There is a strong argument to be made that a declining PC market is an overall positive for Apple. The table below shows unit sales for Apple desktop/laptops, iPads, and worldwide PC unit sales from 2007 to 2012:
It should come as no surprise that the introduction of the iPad, and the copycat products from competitors has caused PC sales to begin their decline. The takeaway from the above table is that tablet sales are cannibalizing Microsoft Windows based PC sales and not Mac sales. Again, not quite earth shattering news until you begin to extrapolate on what these numbers mean. The dozens of PC manufacturers of Windows based computers are essentially dead men walking. Their business models will not allow them to compete in a shrinking market. There have already been rumors about one of the largest PC makers, Hewlett-Packard (HPQ), exiting this market altogether. This provides a glimpse into the structural deficiency of the Windows based portion of the PC market. Ultimately, the greatest casualty of this declining market will end up being Microsoft (MSFT). All of this still begs the question of how Apple benefits.
Apple will benefit from the lack of innovation that will accompany a smaller PC market. An entire new generation of consumers will not be brought up only using Windows based computers. Businesses and specifically their IT departments will adopt Mac products at a much more rapid pace as they become more mainstream. Today a Mac computer in the business world exists in the realm of the creative services, marketing, Internet, and executive departments. In the future, this addressable market expands to finance, human resources, and any other department you imagine. Research from Forrester supports the fact that businesses are already willing to deploy Macs in a limited nature. This study was completed in early 2012 with thousands of IT enterprise decision makers and consumers included in the survey. At the time of the study, it was found that close to 50% of enterprises already deployed Macs. However, the size and scope of this deployment is extremely limited. For more insight, see the graphic below, produced by Forrester, which shows their research regarding Mac usage in enterprise today:
This study contained some fascinating insights into Mac adoption. Some of the specific highlights were:
- Director or Executive level employees were significantly more likely to be using a Mac than lower level employees
- Younger employees were significantly more likely than older employees to be using a Mac
- Out of all the companies that issue Macs, only 7% have adopted the platform exclusive of any other types of PC's
This research serves to confirm a number of bullish arguments for why Mac growth is set to explode. First, as executive adoption of Macs increases it will lead to support at the top of the company for more widespread Mac adoption. Second, the research showing younger workers are far more likely to use a Mac is a clear cut positive. As the demographics of the work force change, and workers age, new workers who enter the work force will be more apt to be proficient in the use of Macs. Finally, the small portion of companies that only support Macs today is bullish for future growth opportunities as more companies convert to the Mac platform entirely.
Even though Macs have a place in the business world today, it is still an extremely small presence when compared to the amount of Windows PC units. However, just as companies have become device agnostic with regards to smartphones, the same driving forces behind that trend should follow through to the PC product.
The significance of business adoption of Macs is because, within the four corners of an office the PC is still king. Whereas the home is quickly becoming the realm of the Tablet. Thus, the ever increasing importance of PC manufacturers to conquer the business world. Whereas noted by graphic above, the upside opportunity for Apple is tremendous.
Supporting The Enterprise Adoption Argument
It is beneficial to point out that the Forrester study referenced above is over a year old. In the world of technology, a year can sometimes be a lifetime. The naysayer's will probably point out that Mac shipments suffered a large decline in Q1 2013, dropping 18% and over 1M units YoY. However, the reason for this decrease seems largely to blame for supply constraints of newly released Mac products. A prelude to the Q1 2013 decline in Mac shipments was predicted by Apple CEO, Tim Cook, on the Q4 2012 earnings call, which turned out to be an accurate assessment. Additionally, the wait time for the new iMac that would have positively impacted Q1 2013 unit sales was close to 4 weeks at one point in time. This wait time would have been a deterrent for those looking to order the new iMac in time for the holiday gift season.
On the other hand, you do not hear the CEO's for Dell (DELL), HP, or Microsoft saying that their PC based revenues are declining due to supply constraints. All of these companies do face structural issues that support the Forrester findings from early 2012. The table below details the fall in revenue from 2011 to 2012 for these companies within their PC categories:
Note that these results encompass an entire year of sales for HP and Dell. With regards to Microsoft, the 2 quarter period shown is significant because it encompasses an entire quarter of their new Windows 8 operating system. Windows 8 was released in late October 2012.
While Apple fights production issue, the other companies noted above fight structural demand issues that they show no signs of overcoming. As these companies and their PC offerings become less relevant, Apple by way of default has a prime opportunity to further ingrain itself into the PC market previously dominated by Windows based machines.
Financial Opportunity For Apple
To understand the financial opportunity for significant growth from Mac unit sales it first takes an understanding of the current profit profile for this product. Apple does not make it easy to know what gross margin % they realize for their various product lines. We do, however, know the revenue and unit sales by product line and thus can determine an average sales price (ASP). Using the ASP along with reasonable gross margin % assumptions for the iPhone and iPad we can begin to determine how profitable the Mac products are. See the below table showing FY2012 revenue and estimated gross margin by product line:
Note that using the estimated gross margin % by product line as shown in the table above, you are able to essentially back into the total gross margin $ and % for Apple in FY2012. What is vital to note about these gross margins is, although they cannot be 100% accurate since they are not disclosed, they are directionally accurate and in-line with what analysts estimate.
With regards to the desktop and portable, or the Mac products, the key factor to understand is contribution margin. Note that the ASP for the Mac products is significantly higher than that of the iPhone or iPad. Contribution margin is a term that essentially refers to the absolute dollars realized from the sale of a product. It incorporates the ASP and gross margin %. The table below shows the contribution margin per unit based on the estimated gross margin % for the product lines being compared:
An example of how to understand contribution margin would be to compare the Mac product with the iPad. You see in the table above that each iPad in theory delivers $192 in cash back to Apple. A portable product such as a MacBook, for example, delivers $439 in cash to Apple. It takes 2.3 unit sales of an iPad to equal the cash produced from 1 unit sale of a MacBook. All things being equal, having a high gross margin % is noteworthy, but the total cash generated from a product sale is the consequential figure of the two.
The story today continues to be all about the iPad and iPhone. These are also the two product lines that will continue to see the bulk of innovation from competitors. With increased competition, ASP for these products will fall and along with it so will gross profit % and contribution margin. Already, you can see today this dynamic weighing heavily on the market outlook for the company by way of its declining stock price.
Extrapolating on the Apple story further, my thesis is that the market is too focused on the iPhone and iPad outlook. The shifting dynamics of the PC market will create an opportunity for Apple to gain outsized market share. Is it that unreasonable to assume that Apple cannot garner a 15%-25% of the total PC market share by 2017? That would be up from the roughly 5% market share the company has today. As traditional PC vendors fall by the wayside and Mac products continue to become more mainstream, I feel this is entirely feasible.
Summarizing The Opportunity
It is easy to surmise that the competition in the PC market could implode even without Apple doing much to take the fight to them. In this case, Apple can continue to operate the Mac business under the status quo and let the growth come to them. I am assuming that, in the below scenario, Apple is able to grow Mac sales at 18% annually. That may seem high when compared to the sales growth in 2012, but it is below the rate seen in 2010 and 2011. This assumption also assumes that the secular change in the overall PC market drives additional Mac adoption.
In this scenario, assuming a global PC market of 272M units in 2017, Apple would capture a 15% market share. Assuming they are able to maintain their price point and gross margin % the growth translates into over $18.5B in gross margin in 2017. That is a $10.4B increase from the estimated gross margin from the Mac products in 2012. Critically, this growth would most likely come without significant incremental R&D or other SG&A costs. The company is not having to invent a new product or do anything else that would necessitate a ramp in overhead spending. Thus, the bulk of this incremental gross profit would fall straight to the bottom line. If you assume that the company needs $2B of overhead to generate $18.5B in gross margin, they would recognize operating income from the Mac product line of about $16.5B in 2017. After paying 25% in income taxes (2012 tax rate per 10-K) on this profit, they would be left with $12.4B in net income. This is over $13 a share in EPS from the Mac products alone based on the shares outstanding at the end of FY2012. Even at a multiple of 10x EPS you would be able to argue that the Mac business within Apple is worth $130 a share. Consider this in the context of the financial position Apple is in today with a cash balance of close to $145 per share. Apple trading at just over $420 a share begins to look more and more like a huge bargain.
This is not meant to discount that the iPad, iPhone, and the next (I) product invented will continue to be the headline grabbers in the Apple story. The Mac growth story is one that receives little attention due to the overall state of the PC market. However, when you change that perception into how Apple can benefit from the declining PC market, you begin to see the enormous earnings power still to come from the Mac product line. While the market focuses on every headline related to the iPhone and iPad, dig a little deeper into the existing product portfolio and see the enormous potential for growth that is being overlooked.