There Is Nothing Rotten About This Apple

Apr.23.13 | About: Apple Inc. (AAPL)

As the investing world waits breathlessly to hear what Apple (NASDAQ:AAPL) has to say on Tuesday, let's take a step back and look at this company objectively. Apple derived 65% of its $68.6 billion in operating profit in FY 2012 from the iPhone, so let's first focus our attention on that product.

Smartphone Market and iPhone's Share

What is the iPhone's place in the global market for smartphones? According to IDC, for calendar year 2012, Android and iOS combined for 87.6% of the 722.4 million smartphones shipped worldwide, up from 68.1% of the 494.5 million units shipped during calendar year 2011. The iPhone comprised 18.8% of all smartphones shipped in both 2011 and 2012.

Year Total Units (millions) Growth iPhones (millions) Growth iPhone Share
2008 151 - 13.8 - 9.1%
2009 174 14.6% 25.1 81.9% 14.5%
2010 303 74.4% 47.5 89.2% 15.7%
2011 495 63.4% 93.1 96.0% 18.8%
2012 722 46.1% 135.9 46.0% 18.8%
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The iPhone's share of the global smartphone market has been climbing steadily from 9.1% in 2008 to a projected share of 24.4% in 2013. IDC forecasts that smartphone shipments will reach 1.5 billion by 2017. The growth of the smartphone market will slow dramatically over the next five years as it becomes increasingly saturated and crowded. However, the iPhone remains a premium brand in the space with a retention rate of 85% in the US and 75% in Europe. My conservative estimate is that iPhone sales will decrease to 16% of global shipments by 2017, with growth stalling out in 2016 as shown below.

Year Total Units (millions) Growth iPhones (millions) Growth iPhone Share
2013 919 27.2% 221.5 63.0% 24.1%
2014 1,069 16.3% 236.3 6.7% 22.1%
2015 1,219 14.0% 245.1 3.7% 20.1%
2016 1,369 12.3% 247.9 1.1% 18.1%
2017 1,519 11.0% 244.7 -1.3% 16.1%
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iPhone Unit Sales and Margin Forecast

The iPhone currently generates gross margins of 55 to 60%, compared to the Samsung Galaxy at 45 to 50%. Let's assume that iPhone gross margins fall by 10% per year through 2015 to reach 42%. Let's also assume the average selling price, which was $640 in Q1 2013, falls by 10% per year to reach $484 by 2015. Based on these assumptions, below is my estimate for iPhone sales and gross profit.

Qtr Yr Units (millions) ASP GM % Revenues (millions) Gross Profit(millions)
Q1 2013 47,789 640 55% 30,660 16,863
Q2 2013 50,538 624 54% 31,536 16,911
Q3 2013 50,978 608 52% 31,015 16,216
Q4 2013 39,731 593 51% 23,568 12,014
Q1 2014 80,309 578 50% 46,448 23,086
Q2 2014 69,448 564 48% 39,162 18,978
Q3 2014 47,350 550 47% 26,033 12,300
Q4 2014 45,174 536 46% 24,216 11,156
Q1 2015 74,327 523 45% 38,848 17,449
Q2 2015 67,928 510 44% 34,616 15,159
Q3 2015 60,125 497 43% 29,873 12,755
Q4 2015 41,616 484 42% 20,160 8,393
Q1 2016 75,431 472 41% 35,628 14,461
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I'm projecting the iPhone to generate total sales of $376 billion and $181 billion in gross profit for the fiscal years 2013 to 2015. This from the sale of 675 million units, of which 42% will be to recurring customers. I am estimating the iPhone customer retention rate to decrease to 62% by 2015.

Apple Product Line Sales and Margin Forecast

Now let's take a look at Apple's other product lines. Below are the actual sales from 2008 through Q1 2013, and my estimates through FY 2015 for total revenues and share by product line. My assumptions for annual revenue growth are as follows: 5% for Macs, 10% for iPads, and 10% for Other (i.e., software, services and accessories). I'm assuming iPod sales will decrease by 50% per year. Revenue growth over the last three years has averaged 9% for Macs, 38% for iPads, and 22% for Other, so my estimates are quite conservative.

FY

Revenues(millions)

iPhone Mac iPod iPad Other
2008 37,491 18.3% 38.1% 24.4% 0.0% 19.2%
2009 42,905 30.4% 32.3% 18.9% 0.0% 18.5%
2010 65,225 38.6% 26.8% 12.7% 2.0% 14.3%
2011 108,249 43.5% 20.1% 6.9% 2.3% 10.7%
2012 156,508 51.4% 14.8% 3.6% 1.4% 9.7%
2013 163,049 71.6% 15.0% 1.7% 1.5% 10.2%
2014 183,853 73.9% 13.9% 0.8% 1.4% 10.0%
2015 174,167 70.9% 15.4% 0.4% 1.7% 11.6%
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Gross Profit Estimates By Product Line

Using estimates by Asymco and Deutsche Bank for Gross Margins, we can estimate the gross profit contribution from each product line. The Mac and iPod lines consistently generate average margins of ~30%, the iPad generates 35%, and Other generates 70%. I am estimating declining margins for the iPhone as shown above. Assuming there are no new products announced between now and 2015, the iPhone will continue to generate 70% to 75% of Apple's gross profits.

FY Gross Profit (millions) iPhone Mac iPod iPad Other
2008 13,197 7.5% 32.5% 20.8% 0.0% 39.3%
2009 17,222 44.6% 24.1% 14.1% 0.0% 17.0%
2010 25,684 50.8% 20.4% 9.7% 1.8% 19.1%
2011 43,818 55.3% 14.9% 5.1% 2.0% 24.6%
2012 68,622 65.5% 10.2% 2.5% 1.1% 21.9%
2013 82,672 75.0% 8.8% 1.0% 1.0% 14.1%
2014 87,383 75.0% 8.8% 0.5% 1.1% 14.7%
2015 77,168 69.7% 10.5% 0.3% 1.3% 18.3%
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Total Revenue, Profit and EPS Forecast

Apple's operating expenses have been increasing between 8.5% and 11% for the last three years. I will assume an average increase of 10% per year through 2015. Taxes have averaged 25% of operating income, so I will assume the same rate going forward. The share count has increased 1.4% on average since 2008, so I will assume a further increase of 1.5% per year.

FY Revenues (millions) Gross Profit (millions) Op Exp (millions) Taxes (millions) Net Income (millions) EPS PE
2013 163,049 82,672 14,674 16,999 50,998 53.50 7.45
2014 183,853 87,383 17,466 17,479 52,438 54.19 7.36
2015 174,167 77,168 19,158 14,502 43,507 44.30 9.00
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Putting it all together, I estimate that Apple will generate $147 billion in net income between FY 2013 and 2015 on revenues of $521 billion at an average gross margin of 48% and average operating margin of 38%. On a diluted share count basis, the company will earn 53.50 per share this year, and is trading at a multiple of 7.45x 2013 earnings and 9x 2015 earnings based on yesterday's closing price of $398.67. Apple is trading at just under 3x book value and at a multiple of 2.3x this year's projected sales. By the numbers, Apple is very cheap.

What is Apple's Investment Moat?

Apple has several unique advantages over its often compared-to peers like Nokia (NYSE:NOK), BlackBerry (NASDAQ:BBRY), HP (NYSE:HPQ), Dell (NASDAQ:DELL), etc. The Apple ecosystem (i.e., iTunes and Apps) is very strong and provides a moat that Nokia and BlackBerry never had during their heyday. Once you are tied into the ecosystem, it's not very practical or necessary to change, and many consumers prefer the walled garden of the Apple ecosystem to the open nature of Android.

Apple has consistently maintained robust gross margins, even on declining volume products like the iPod. There are enough consumers who will pay more for the quality, durability, brand, and "out of the box" functionality of an Apple product. Technically, there is not much difference between smartphone brands. This does represent a real risk as the product is rapidly becoming commoditized, ubiquitous and cheap. However, like any other consumer product, whether a Nike shoe or a BMW, there is a tier of consumers that are willing to pay more for a higher quality product, and they tend to be higher income and loyal consumers.

This is not a zero sum game, the smartphone and tablet space are still growing markets, and there is sufficient room for two or more ecosystems to thrive for the foreseeable future. Apple doesn't need to dominate the smartphone space to be a viable investment (as shown above). Apple needs to continue doing what it does best, bring much needed evolution to other consumer products, and occasionally bring a revolutionary product to the market.

This Apple is Not Rotten

In the meantime, this Apple is most definitely not rotten. It's a tremendous cash machine, the likes of which the market has never witnessed. That kind of cash brings both challenges and opportunities. I personally do not want Apple to return more cash to shareholders, I would rather they spend it on smart acquisitions and research. I don't care if management is tone deaf to the market, I would prefer that they focus on execution and ignore the stock price completely. In the meantime, I hope the shares get even cheaper so I can buy more.

My estimates do not account for any new product categories, like the often rumored iWatch, iTV or iRadio. Apple management is not dumb, they know that iPhone sales will decline in a few years and that they need to replace the declining revenue with new products. I have every expectation they will succeed.

My target price on AAPL is $800 per share by the end of 2014, which would bring the valuation roughly in line with today's market valuation. If market multiples continue to expand, the price could reach $1,000 by 2015.

Disclosure: I am long AAPL. 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.