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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.

YearTotal Units (millions)GrowthiPhones (millions)GrowthiPhone Share
2008151-13.8-9.1%
200917414.6%25.181.9%14.5%
201030374.4%47.589.2%15.7%
201149563.4%93.196.0%18.8%
201272246.1%135.946.0%18.8%

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.

YearTotal Units (millions)GrowthiPhones (millions)GrowthiPhone Share
201391927.2%221.563.0%24.1%
20141,06916.3%236.36.7%22.1%
20151,21914.0%245.13.7%20.1%
20161,36912.3%247.91.1%18.1%
20171,51911.0%244.7-1.3%16.1%

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.

QtrYrUnits (millions)ASPGM %Revenues (millions)Gross Profit(millions)
Q1201347,78964055%30,66016,863
Q2201350,53862454%31,53616,911
Q3201350,97860852%31,01516,216
Q4201339,73159351%23,56812,014
Q1201480,30957850%46,44823,086
Q2201469,44856448%39,16218,978
Q3201447,35055047%26,03312,300
Q4201445,17453646%24,21611,156
Q1201574,32752345%38,84817,449
Q2201567,92851044%34,61615,159
Q3201560,12549743%29,87312,755
Q4201541,61648442%20,1608,393
Q1201675,43147241%35,62814,461

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)

iPhoneMaciPodiPadOther
200837,49118.3%38.1%24.4%0.0%19.2%
200942,90530.4%32.3%18.9%0.0%18.5%
201065,22538.6%26.8%12.7%2.0%14.3%
2011108,24943.5%20.1%6.9%2.3%10.7%
2012156,50851.4%14.8%3.6%1.4%9.7%
2013163,04971.6%15.0%1.7%1.5%10.2%
2014183,85373.9%13.9%0.8%1.4%10.0%
2015174,16770.9%15.4%0.4%1.7%11.6%

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.

FYGross Profit (millions)iPhoneMaciPodiPadOther
200813,1977.5%32.5%20.8%0.0%39.3%
200917,22244.6%24.1%14.1%0.0%17.0%
201025,68450.8%20.4%9.7%1.8%19.1%
201143,81855.3%14.9%5.1%2.0%24.6%
201268,62265.5%10.2%2.5%1.1%21.9%
201382,67275.0%8.8%1.0%1.0%14.1%
201487,38375.0%8.8%0.5%1.1%14.7%
201577,16869.7%10.5%0.3%1.3%18.3%

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.

FYRevenues (millions)Gross Profit (millions)Op Exp (millions)Taxes (millions)Net Income (millions)EPSPE
2013163,04982,67214,67416,99950,99853.507.45
2014183,85387,38317,46617,47952,43854.197.36
2015174,16777,16819,15814,50243,50744.309.00

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.

Source: There Is Nothing Rotten About This Apple