Apple (NASDAQ:AAPL) followers are divided into two camps.
The longs are attracted to the company's low P/E, giant cash pile, and track record of success. The shorts argue that AAPL's business model relies on constant innovation, and that the company has lost its innovative edge. They predict competitor technologies will keep catching up, squeezing AAPL's margins and taking bites out of its market share and revenue.
In a sector characterized by new technology waves, short product lifecycles, and a need to constantly innovate to maintain your earnings stream, one thing is certain: uncertainty.
Valuation approach: Scenario valuation to model uncertainty
Given inherent uncertainty, I provide a scenario model to Seeking Alpha readers, which forecasts returns based on three events:
- Base - AAPL loses its innovative edge. Competitor technologies catch up, resulting in (1) lower revenue (2) lower margins (3) low exit P/E
- New product - AAPL launches a revolutionary new product resulting in (1) moderate revenue increase (2) constant margins (3) moderate exit P/E
- Obsolete - AAPL misses a new technology wave. For example, Nokia missed the smartphone wave, and Kodak missed the digital camera wave. Results in (1) much lower revenue (2) lower margins (3) very low exit P/E
For specific assumptions under each scenario, see table 1. To compare these assumptions to historic actuals, see table 2:
The forecasts are very conservative relative to AAPL's performance over the last five years, but seem fair in light of AAPL's Q2 FY13 result, which shows declining performance.
Forecast returns based on fundamentals: EPS, P/E, cash per share, & dividend yield
The model forecasts returns over a 2.5-year holding period to FY15, and assumes a $460 entry price. It sums returns from dividends and share price appreciation to estimate total shareholder return. Share price appreciation is forecast based on two components:
- Core business - Earnings per share multiplied by the P/E ratio
- Cash per share - As cash is a significant non-operating asset for AAPL, it should be valued separately to the core business
Image 1 illustrates the model's structure:
Table 3 breaks down the forecast return under the new product scenario:
Like any forecast return model, there are many inputs and assumptions behind these figures (even in addition to the scenario assumptions in table 1). For example, to forecast EPS required additional assumptions about operating costs, tax, and shares outstanding.
For this reason, I have provided a link to my model for the Seeking Alpha community to download. It also may be useful for anyone looking for their own AAPL valuation model, or who wants to tweak my assumptions.
The model incorporates recent announcements relating to AAPL's capital structure (I.e. repurchases, increased dividends, and the bond offer).
A quick overview of the core assumptions is provided in Appendix 1.
Forecast returns: High upside, low downside risk
Under these assumptions, forecast returns would range from negative 23.6% to 76.3% (table 4):
The table produces three observations:
- The downside is low at negative 23.6%. Compare this to the potential upside of 76.3% and you have a good risk / reward ratio. I expect the relatively low downside is due to AAPL's very low P/E (~6.5x for the core business), suggesting future shocks to earnings are generally priced in
- There is potential for a positive shareholder return under the base scenario, even though it assumes declining revenue and margins (21.1% forecast). To achieve this return relies on AAPL's P/E reverting from around 6.5x to 10.0x. This seems a conservative assumption relative to comparable company multiples and AAPL's historic core P/E. However, P/E reversion may not eventuate if sentiment remains negative, and investors expect earnings to continue declining
- A new innovation could lift the AAPL share price beyond its previous high of ~$700, to ~$775. After seeing AAPL's record repurchase plan and bond deal fail to reignite investor confidence in the company, it seems AAPL will need a new innovative product to win back the market's confidence
Divining the future: Which scenario will play out?
An investor with a 2.5-year holding period should only take a long position in AAPL if they anticipate a new innovation (since returns are negative, or minimal, under other scenarios). What are the odds?
AAPL's current valuation suggests the market expects a low chance of a new innovation. Possible reasons being:
- AAPL has not produced any new groundbreaking innovations since the iPad in 2010;
- new models, like the iPad mini and iPhone 5, show no giant leaps from their predecessors;
- CEO, Tim Cook, does not appear to possess the product-genius of Ex-CEO, Steve Jobs; and
- the capital return program admits that the company is out of new ideas, and is entering a maturity phase
However, I remain a contrarian. I anticipate a new innovative product from AAPL, within the next year, for three reasons:
- AAPL appears to operate on a three-year innovation cycle. For example, the iPhone was introduced in 2007, and the iPad was introduced three years later in 2010 (see timeline). Now we are in 2013, it seems a new innovation is due
- A very likely candidate is the AAPL television. An article released in April this year talks of an analyst who, after visiting AAPL suppliers based in Taiwan and China, has gleaned evidence that an AAPL television is under development. Television would be a classic AAPL play - it revolutionizes something in the electronic entertainment sector that has previously lacked innovation. A television would integrate with AAPL's existing product line up, and would leverage its Retina Display technology
- The capital return program appears to be in response to legal pressures (e.g. the Greenlight Capital lawsuit) rather than the company running out of ideas. If AAPL was running out of ideas, its R&D expense would not be at a record high
Whatever the future holds for AAPL (maybe the next Nokia, or conversely a return to its glory days?) I suppose there is one certainty: picking the correct position, long or short, could be a very lucrative trade.
Sources: tables and figures that are not referenced above are copied from my scenario valuation model. The model draws on financials from AAPL's 10-K filings dated between FY07 to FY12 and Google Finance. Some figures are my own calculations, using these sources.
Appendix 1: Key assumptions
- Revenue growth - as per scenarios above
- Gross margin - as per scenarios above
- Opex - $2.1bn fixed, and 7% net revenue variable (based on a linear regression with high explanatory power)
- Tax - ~25%, consistent with the effective tax rate from FY10 to FY12
- Operating cash flows - earnings (above) adjusted for working capital changes. Working capital is forecast based on stable historic relationships between net revenue and working capital accounts. Inventory, accounts receivable, and accounts payable, use days in inventory / payable (rather than net revenue), to drive forecasts
- Investing cash flows - estimated replacement capex (equal to depreciation, for consistency with low growth assumptions)
- Financing cash flows - dividends of 3.05 cents / quarter, $17bn debt raised with no repayment over forecast horizon, $60bn repurchases with timing as follows: $12bn FY13 and $24bn each of FY14 and FY15
- Repurchases - as above. All repurchased shares are cancelled
- Repurchase price - average of opening and closing forecast share price
- Shares issued - No shares issued to employees
A DCF model was considered but not used. This was to avoid making terminal value assumptions beyond FY15. For example, assumptions about the timing of AAPL's maturity phase, appropriate long-term growth rates, etc.
A DCF can be less credible for a company with a short-product lifecycle, and needs to constantly innovate, as it requires predictions about long-term performance.
Appendix 2: Selected outputs
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.