Over the last couple of months, the share price of Apple (AAPL) has stabilized somewhat in the $400-450 range. But is this new "low" really a fair estimate of the fundamental value of the stock, or is it based on irrational fear? In this article, I will try to assess whether the bears are justified in their pessimism by estimating the fair value of the stock through a DCF analysis.
In a DCF analysis, the fair price of the stock is determined by estimating the present value of the future free cash flow. While this is a relatively simple task in itself, the quality of the DCF-model is completely dependent upon the assumptions you make in the process.
To make the forecasting process easier, I have made separate gross profit forecasts for each business segments. To keep the article at a reasonable length, I have only discussed the assumptions for the iPad and the iPhone segments. In the bottom of the article, you can find the assumptions for the other business segments.
To forecast the future gross profit of the iPhone business segment, I will assess the following 3 metrics
- Units sold
- Average selling price
- Cost of producing one iPhone
By multiplying units sold with the average selling price, we can calculate the revenue of the iPhone business segment. To obtain gross profit, we subtract the costs of producing iPhones from revenue.
Let's begin with units sold. As can be seen in the below graph, Apple's global market share has actually been somewhat stable over the last 1-2 years at roughly 20%. However, since the size of the smartphone market has grown rapidly. iPhone sales have increased significantly as well.
Apple is especially popular in the US, where it had a market share of 55% in 2012. Unfortunately, for Apple, developed markets are expected to grow at a less significant rate than emerging markets. In China for instance, Apple's market share is "just" 9%, and therefore Apple's global market share will decline in the future if it doesn't become more popular in emerging markets.
"Luckily" for Apple, I see 3 factors that could lead to a higher market share in emerging markets.
- A new cheap iPhone is expected be released soon. This will sell relatively well in emerging markets where the income elasticity is higher.
- Over the last couple of quarters, Apple has gathered momentum in China (as its market share has increased) and I believe that the trend will continue over the next couple of years.
- As emerging markets become wealthier, they will be more likely to prefer more expensive phones rather than Samsung's sub $200 phones, which currently are very popular.
When that is said, I don't expect that the combination of these 3 effects will make Apple dominant in emerging markets, but it is enough to partially offset the expected decline in the global market share.
In developed markets, I believe Apple will maintain its market share over the next 2 years. Over a slightly longer time period, I think its brand value will decline and competitors will arise with new innovative products which will put a downwards pressure on its market share. Overall, I assume that Apple's global market share will decline from 20% in 2012 to 16% in 2018.
By using IDC's smartphone forecast for emerging and developed markets with my own market share estimates, I have estimated the future amount of iPhones sold in the below graph. As can be seen, I expect sales to double from 2012 to 2018.
The other metric needed to forecast revenue of the iPhone segment is ARPU (average revenue per unit). As seen in the below graph, Apple has done a pretty good of maintaining its ARPU, which is quite impressive as many of its competitors have reduced their prices in order to increase their market shares.
Source: Apple's quarterly earnings reports
But with the launch of a "cheap iPhone," the ARPU will definitely decline in the future. It is still unknown exactly how much it will cost, some speculates that it could be priced as low as $100, while others believe in a higher price of $400. I think the latter is much more likely as Apple could risk a deterioration of its brand value by selling a $100 phone, which likely would be of relatively low quality.
In terms of mix between "expensive iPhone" and "cheap iPhone," I assume a 75%/25% mix in favor of the expensive iPhone. That will cause the ARPU to decline to roughly $600 from the current $630. Longer term, I assume that the ARPU will decline further due to my expectations of a weakened competitive position.
The last input variable needed before we can calculate gross profit is the cost of producing one iPhone. In the below graph it is seen that it has gradually become more expensive for Apple to produce iPhones. This is likely a consequence of the increased competitive pressure, which has forced Apple to produce phones of higher quality.
Source: iSuppli and my own estimations. My own estimations take into the account other COGS than just the bills of material.
Assuming the trend (of higher costs) continues, we can now forecast the gross profit of the iPhone business segment. In the below graph, it is shown that I expect it be somewhat flat over the next 12 months, then increase a bit over the next couple of years, followed by a decline in 2017.
Unlike the smartphone market, where Apple is second in terms of market share to Samsung (GM:SSNLF), Apple is the leader in the tablet market. However, that lead has diminished somewhat with new competitors entering the market. While neither Microsoft (MSFT), Amazon (AMZN) nor Samsung have developed a tablet that is considered to be as good as the iPad, the increased competition is still putting a downward pressure on Apple's market share.
I estimate that Apple's tablet market share will decline from 52% in 2012 to 42% in 2018 as competitors will catch up to Apple in terms of quality. For instance, I believe Microsoft has made a few miscalculations with its Surface, but I believe it eventually will fix the flaws, and as I believe the tablet market is too important for Microsoft to "lose," I think it will sell tablets at a zero margin if that's what it takes to get a foothold into the tablet market.
By multiplying market share with the expected market size, I obtain the following sales estimations for the iPad.
Unlike the iPhone, Apple hasn't managed to keep up the ARPU of the iPad, which has declined from $690 to $530 in the most recent quarter. This is mostly due to the fact that Apple has been offering larger discount on older models to attract more price-sensitive buyers. In the future, I do not expect the ARPU of the 10-inch model to decline as the prices of the old models are unlikely to be reduced further.
Source: Apple's quarterly earnings reports.
It actually surprised me that the iPad mini was released at a price above $300 as I had imagined that it would be seen as unattractive compared to the cheap Nexus 7 and the Amazon HD. However, once again Apple developed a product, which was superior to its competitors, and it managed to sell pretty decently. In the future, I believe the ARPU of iPad mini will decline for the same reasons the ARPU of the 10-inch iPad declined (discounts on old models).
Another concern for Apple, is the fact that it has become increasingly costly to produce iPads. I estimate that the gross margin of the iPad business segment is currently just 20%, which is significantly below the 50% gross margin of the iPhone business segment.
Looking forward, I don't think Apple will be willing to produce tablets that are more expensive than the current models. Instead, I think Apple will be sacrificing a potential loss of market share for a higher gross margin. Therefore, I expect the cost of producing iPads to remain constant in the future.
Source: iSuppli and my own estimates.
The fair value of Apple
I think many bears are looking at Apple in the wrong way. They are seeing quarters with no year-over-year growth due to declining margins, and have therefore come to the conclusion that Apple is a "bad" company.
But after having crushed the numbers, I conclude that Apple is still a very attractive investment. This is primarily due to the low P/E ratio of the company (it is priced very cheaply) and the expectations of increased tablet- and smartphone market sizes. Taking everything into account, I estimate that the fair value of Apple is roughly $621.
However, it is important to note that this is a long-term investment as I don't see any short-term catalysts for Apple. Therefore, I am personally waiting for a good opportunity before I put my money in the stock. An investor with a longer time frame could buy it now.
If anyone is interested, below are the assumptions I used for the other business segments.