Apple Remains Undervalued, But I Was Wrong - The Moat Is Not That Compelling

| About: Apple Inc. (AAPL)

I've written about Apple (NASDAQ:AAPL) a few times in the past couple of months, as the market price for the company continues to baffle my mind. I continue to believe that the current trough that the stock is in leaves the company undervalued, and I continue to be an investor in the company through thick and thin.

So when I first started writing this article more than a week ago, I put together some of the standard Apple statistics to explain why I thought the company was undervalued. This included things like how the company was continuing to grow market share, and how there is a general "out of favor" mood by Wall Street that is providing a good opportunity. After submitting the article the SA editors gave me some critical feedback on this approach, and challenged me to offer something new to the readers. I took this feedback to heart, as it was the first time I got this kind of remark on any article submitted. I decided to go back to the drawing board and do some soul searching.

While thinking further on Apple, I put out an article on Microsoft (NASDAQ:MSFT) which I think really lays out a strong case for an investment in Mr. Softie. I won't go into details on Microsoft in this article, but in summary my position is that everyone tends to underestimate how strong a competitive moat the company has built over the past few decades in the enterprise.

Switching Course on Apple

After writing on Microsoft, and continuing to think about Apple, something occurred to me as a value investor. Although I love Apple and its products to death, and it continues to have a place in my portfolio, I've had it wrong. In fact very wrong. One of my favorite quotes from Seth Klarman of the Baupost Group, a legendary value investor, goes along these lines:

In investing you need to balance arrogance and humility. When you buy a stock you are doing an arrogant act. You think you know more than the person on the other side of the trade. You need to have this arrogance, but at the same time you need to have the humility to know that you might be wrong.

In the case of Apple, up until now I've had the arrogance to overweight it significantly in my portfolio. This was because I felt I really understood the company and its products, including a belief that the company had a durable competitive position. However after writing in depth on Microsoft, I now realize that believe it or not, it is Mr. Softie which deserves to be overweight, because it has a genuine margin of safety and a clear economic moat which has been built up over several decades. Apple's competitive advantages on the other hand are far too exposed to the powerful forces of the fickle consumer.

I believe that investors in Apple should be aware of the potential problems in its competitive position, and should keep this real risk in mind before deciding to allocate too large a position to the company in their portfolios.

The Apple Ecosystem Does Give Some Competitive Advantages

First let's look at a few positives on Apple, which for me starts with the company's product ecosystem. How much would you pay for the ecosystem of Apple? It's an interesting question that several analysts have tried to answer. One thing is for sure though, and that is that there is a tangible cost for users to switch once "locked in" to Apple. Myself personally I bought my first Apple product ever, an iPhone, about 3 years ago now, and since then I've added an iPad and MacBook Pro to the mix. The ease of transferring between the devices, and connectivity between them with apps like FaceTime and Photo Stream strengthen the ecosystem. Also probably most compelling is the shear amount of apps available, which has grown from 35k in 2009 to about 800k today. For the casual user of smartphones and tablets, particularly non-techies, the usability of the products and breadth of the ecosystem are primary deciding factors that hold more weight when determining which brand to buy.

Recently, I asked two colleagues at work who use Windows based Lumia phones, what the biggest drawbacks of their devices were. Both use Lumia phones not out of personal choice, as they were supplied by their employer. The immediate response I got from both colleagues was that they were sometimes frustrated with the lack of app selection and the absence of a complete working ecosystem. Both cited this as a major advantage of the iPhone.

Despite the Appearance of a Competitive Moat, Times Can Change Very Fast in the Market for Fashionable Consumer Products

Although it is clear Apple has advantages with its product ecosystem, times can change fast. In fact very fast. Just think about it for a moment - who heard of an iPhone in 2006? In fact nobody, because the first one wasn't even released until 2007. In less than 6 years, a consumer product grew from something unheard of into a business which in 2012 sold 125m units and generated sales of more than $80B. Nobody could have ever imagined this.

However just as shocking, nobody could have imagined that a company like Nokia (NYSE:NOK) would see a historic fall at the expense of superior technology from companies such as Apple. Look at the gross margin of Nokia over the past decade compared to Apple:

NOK Gross Profit Margin TTM Chart

NOK Gross Profit Margin TTM data by YCharts

Looking at the past 6 months on the chart, is the recent dip in margins for Apple from 44% down to 41.9% the start of a larger fall? As competition increased and technology changed, Nokia was not able to command such high prices for its phones and margins steadily fell. Although I still see strong prospects for Apple going forward, there is a very real risk that it will need to lower prices and/or offer more lower end products in order to compete effectively. As more and more cheaper and functionally equivalent phones flood the market, it is no longer so clear that the iPhone is a runaway superior product. The table below shows a few sample competitor phones with their Amazon (NASDAQ:AMZN) retail prices and average CNET rating:

Phone Retail Price on Amazon CNET Star Rating (1-5)
iPhone 5 $725.00 4
Samsung Galaxy S3 $423.00 4
BlackBerry z10 $634.00 3.5
HTC One $899.00 4
Nokia Lumia 920 $527.00 4

All of these phones are on the high end of the smartphone market, and all have received good reviews both from editors and users. Functionally a case can be made that they are all nearly equivalent, with each one having some specific strengths and weaknesses. It is not clear at all from a cost perspective that the iPhone or HTC One in this case are worth a premium price over the others. Sure, Apple has a powerful brand name and a dominant ecosystem, but consumers are notoriously fickle and unpredictable, making it exceedingly difficult to determine how strong a moat Apple really has. Also the ability to switch from one ecosystem to another may not be really that difficult for many tech savvy users. For example, as one commenter pointed out on my recent Microsoft article, his daughter decided to dump her iPhone for a Samsung Galaxy and she had all of her identical apps up and running on the Android device in a matter of 2 days. Stories like this really make me question just how strong the Apple moat really is.

I find it exceedingly difficult to be really sure of a strong margin of safety in a company's valuation, when the future growth of earnings is highly dependent on the unpredictable trends in the consumer market. As a general rule of thumb, unless you are really sure of the durability of a business, you should not over allocate it in your portfolio.

Valuation - Not an Easy Question, But For Sure Much More Than $430/share

So where does this leave us? The most difficult problem with valuing Apple today is the uncertainty of technological change and how this will impact the purchasing trends of consumers. Five years from now it is anybody's guess how many iPhones will be sold, or if anybody will even remember the iPhone for that matter. At that point the next greatest innovation could be out on the market.

With this in mind I think it's difficult to pinpoint an accurate growth rate for Apple's earnings going forward. But let's break down a simple calculation, and see what the current market price implies:

  1. The tangible book value currently is about $129/share. The company still has an amazing cash pile well over $130B and counting.
  2. Using most recent annual FCF of $44.64/share, a conservative discount rate of 10%, and assuming 0% growth going forward, a DCF valuation gives a share price of just under $400/share.
  3. Adding the DCF valuation and net cash together and we can easily justify a valuation of about $530/share. This assumes a continued slow down in earnings growth including margin compression. Probably not as dramatic as Nokia experienced, but for sure margins have nowhere to go but down at this point. It is an inevitable fact of how competitive markets work. That being said, I think 0% growth is extremely unlikely in the near term, as sales and market share remain strong and it is very likely that the company will release at least 1 major new product in 2013. Whether it be an iWatch, iTV, iRing, or iXYZ for that matter (to be honest to me it makes no difference), due to the brand strength and current ecosystem power of Apple any new product will positively influence the bottom line. So growth this low is exceedingly pessimistic. Even if you think growth will decline -5%/annum, the valuation would still be right about the current market price when you factor in the cash. This to me is not very logical.
  4. How much growth we can expect going forward is uncertain, but factoring in the large chance of increased share buybacks, steady market share, and the creation of new earnings streams from new product launches I think 5% is a reasonable figure. Discounting this earnings at 10% would imply an intrinsic value of about $550/share. Factoring in net cash and a valuation in the high $600s can be justified. This is an upside potential greater than 50% from the current market price.

The Bottom Line

Apple is an undervalued company today, and for those who don't currently have a position I think there is nothing wrong with buying in at these price levels. The company remains a very good business with returns on capital in excess of 40% and an attractive earnings yield of 14%. With the US treasury rates still in the low single digits, this is a very good value for your money.

That being said, there are significant risks involved when investing in companies who are completely dependent on consumer technology trends. This means that the margin of safety against downside risk is much thinner than it appears at first glance. It is for this reason that I think some of the more "boring" old tech companies such as Microsoft are actually a better value investment today than Apple. Just think about it - due to its strength in the enterprise, we can be 100% confident that Microsoft will still be a powerful and profitable company in 5 years time. Apple more than likely will still garner significant smartphone and tablet share, but how can we be sure?

Putting my money where my mouth is, my sell order has been submitted and I will be reducing my Apple position to equal weight. I won't sell out completely, because as stated I believe the company is still undervalued and has favorable prospects in the coming year. But looking out a few more years down the road, my advice is to be careful with Apple. This is not a Buffett kind of stock, as there is no clear durable competitive advantage.

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.