The Bear Case And The Bull Case For Apple: Which Is More Convincing?

Jul.15.13 | About: Apple Inc. (AAPL)

We all know that Apple (NASDAQ:AAPL) has disappointed investors for almost a year now. The stock reached its all time high in September 2012 at $705. At that point, many investors rushed in to buy the stock, only to see it fall ever since. Some analysts even projected a $1000 price target, citing that "Apple fever" is here to stay for a long time. Clearly, sentiment was driving the stock, and now we have seen a valuation reality check since then.

Sentiment and emotion are still driving the stock. Some investors believe that Apple is doomed because of competition from fellow tech giants Samsung (OTC:SSNLF) and Google (NASDAQ:GOOG). Competition in the smartphone market has caused profits and gross margins to fall. Apple needs to unveil a product that will sweep us all off our feet, just as the iPod did in the mid-2000s and the iPhone and iPad more recently. Investors are unsure where the innovation will come from, but potential catalysts include the iWatch and iRadio. In this article, I will provide the bear case and the bull case for Apple, both of which can be sound arguments. I will then provide my own thoughts on where the stock is headed. These cases are meant to be basic overviews of what the bears and the bulls are saying about Apple, so that you can have a basic understanding of where the company currently stands and make a sound investment decision.

AAPL Chart
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AAPL data by YCharts

The Bear Case

The bear case will be discussed in three parts: lack of innovation, analyst downgrades and pessimism, and increasing competition.

1. Analysts cite the lack of innovation as a reason for the stock's recent downfall. Apple certainly lost a part of this with the death of former CEO Steve Jobs. Simply put, Apple will never be the same without Jobs. This does not mean that current CEO Tim Cook is not fit for the job, but rather it means that Apple relied on Jobs' innovation and creative mind. He was a true leader and an inspiration for all. His presence will certainly continue to be missed.

Apple needs to release a "new" product, a product that fits the public's needs just like the iPod, the iPhone, and the iPad did. It needs to be a game-changer, one that will change the way we live our lives. I can speak from personal experience that the iPhone has in some ways changed my life. Apple's products have accomplished that so far, but it remains to be seen whether or not the company will continue the trend. It cannot simply refresh older products and expect to grow sales at current rates. Innovative products have allowed Apple to price their products at a premium and dominate market share. People wanted to buy the iPhone because everyone else had one, and they were willing to pay a premium to buy it. Apple needs a product that will force its competitors to play "catch up."

Where will this innovation come from? The new iOS 7 may not be it. It has become increasingly difficult to redesign iOS features in a significant, mind-blowing way. The new iOS 7 will bring new features, such as iBeacons and even motion detection, but the most striking feature may unfortunately be the change in how the iPhone's default icons appear. This may not be enough to spur growth and excitement for the iPhone. Other potential catalysts may come from the iWatch, iRadio, and even Apple TV, but these products are (with the exception of Apple TV, which has been out for a while) all in their early stages of development and cannot yet be properly evaluated in terms of their potential success.

2. Analyst downgrades have certainly contributed to the stock's decline. Brian Blair at Wedge Partners downgraded the number of iPhone orders by 20% due to softer demand than expected. Likewise, Peter Misek of Jefferies cut his price target from $420 to $405, citing higher inventory levels than expected. These higher inventory levels tell me that demand is weakening for the iPhone, as the company prepares for the release of the 5S later this year and the iPhone 6 in 2014. Furthermore, Ittai Kidron of Oppenheimer cited "mixed" iPhone 5 sales. These analyst downgrades suggest increasing pessimism for Apple's stock. Sentiment and emotion, as shown by Apple's steep rise and decline, play major roles in the stock market.

3. Competition in the smartphone market may be the most important reason for a gloomy future at Apple. The iPhone generates more than half of Apple's sales, and competition in this market may cause the company's most important product to struggle. Some investors even argue that Apple's next iPhone should have a larger screen in order to compete with Samsung's Galaxy products.

Net Sales by Product (millions) 3 Months Ended March 30, 2013
iPhone $ 22,955
iPad $ 8,746
Mac $ 5,447
iPod $ 962
iTunes, Software, & Services $ 4,114
Accessories $ 1,379
Total Sales $ 43,603
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The smartphone market is extremely competitive. Companies are constantly trying to find ways to innovate and change their smartphones' capabilities. The iPhone has led this market for a long time, but its competitors are catching up quickly. The important take away from this competition is pricing power. Because Apple's iPhone is no longer seen as the only popular smartphone on the market, consumers are no longer willing to pay a premium as they had in the past. They have other options, like Samsung's Galaxy products. Pricing competition has forced Apple to reduce its price in order to remain competitive in the smartphone market. This has caused reduced gross margins.

(millions) 3 Months Ended March 30, 2013 3 Months Ended March 31, 2012
Net Sales $ 43,603 $ 39,186
Cost of Sales $ 27,254 $ 20,622
Gross Margin $ 16,349 $ 18,564
Gross Margin Percentage 37.5% 47.4%
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(millions) 6 Months Ended March 30, 2013 6 Months Ended March 31, 2012
Net Sales $ 98,115 $ 85,519
Cost of Sales $ 60,706 $ 46,252
Gross Margin $ 37,409 $ 39,267
Gross Margin Percentage 38.1% 45.9%
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As you can see, it has become increasingly difficult for Apple to enjoy high prices. Although sales have increased every quarter, gross margins are decreasing, implying that the cost of sales are increasing at a faster rate than the sales themselves.

According to Apple's most recent 10-Q, it expects gross margins to fall between 36% and 37%. The company cites one major reason: "anticipation of a higher mix of new and innovative products with flat or reduced pricing that have higher cost structures." In conclusion, Apple's gross margins will struggle as the competition in the smartphone market intensifies.

AAPL Gross Profit Margin Quarterly Chart
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AAPL Gross Profit Margin Quarterly data by YCharts

The Bull Case

The bull case for Apple can be summed up into four distinct parts: cheap valuation, a fortress balance sheet, potential upside with a China Mobile (NYSE:CHL) deal, and returning cash to shareholders.

Mkt Cap (billions) Forward P/E ROE Dividend Yield Cash (billions)
AAPL $ 402.9 10.2x 33.34% 2.86% $ 144.7
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1. Financially, Apple has a very attractive valuation. Trading at a forward P/E of 10.2x, compared to its industry of 15.5x, it is very cheap. Its PEG ratio is .62. This number alone suggests that Apple still has plenty of growth opportunities ahead. Both revenues and earnings have grown steadily over the past few years, and Apple has proved to be very efficient at generating profits for the amount of capital shareholders put in. Apple generates an astonishing 33.34% return-on-equity and sits on almost $145 billion in cash. However, most of this cash sits on international soil, meaning that it is subject to federal taxes if brought back to the United States.

On a P/E basis, Apple is currently trading at a 35% discount (15.5 * .65 = 10.2). On a two-year historical basis, Apple has traded at 30% discount, which equates to a forward P/E of 10.9. This suggests that Apple is relatively cheaper than its historical average.

Using analyst estimates of $42.75 forward one-year earnings, Apple, on a historical basis, has an equity value of $464.31 ($42.75 * 10.9). When we ignore capital structure and use the Enterprise Value-to-EBITDA approach, Apple is currently trading at a 56% discount to its peers, relative to a historical average of 40%. The implied equity value using this approach is much higher at around $550. Regardless of which implied equity value method is used, Apple stock is currently trading at an attractive price.

AAPL Net Income Annual Chart
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AAPL Net Income Annual data by YCharts

Apple's financial ratios suggest that it is inherently undervalued and currently a bargain at $426 per share. It seems as though investors oversold Apple, and it should eventually revert to its intrinsic value.

2. Apple's balance sheet is unlike any other company in the world. The company seemingly has the best fundamentals, churning out more than $140 billion in cash, cash equivalents, and marketable securities. Most of this cash is overseas, but Apple has more than enough cash in the United States to be considered financially sound. According to the firm, their marketable securities investment portfolio is invested in "highly-rated securities and its investment policy generally limits the amount of credit exposure to any one issuer." Therefore, the only risk in Apple's portfolio is the fact that international cash bears a tax burden if brought back to the United States. To avoid this, Apple has the option to acquire businesses internationally. Apple's financial health is not a concern in the slightest.

3. Apple has the potential to strike a deal with China Mobile, a state-owned Chinese telecommunications that boasts one of the largest market capitalizations in the world. With over 730 million subscribers, China Mobile could be a potential catalyst for Apple's stock, as analysts believe that the introduction of a low-cost iPhone in China could very well be a success. China Mobile represents the largest market that Apple has yet to utilize. A deal with them would prove to be very significant. In order to realize the importance of this deal, the largest telecommunications company in the United States is AT&T (NYSE:T), which has over 100 million subscribers.

4. Apple is a shareholder-friendly company. They recently increased their dividend to $3.05 on a quarterly basis, and they post an above-average yield of 2.86%. With the amount of cash on hand, it makes sense for them to return it to the shareholders, and I am confident that Apple will be able to increase its dividend for the long-term investor, given their superior financial health.

Additionally, Apple announced a recent buyback of shares. This is another form of returning cash to shareholders by decreasing the number of shares outstanding. As Warren Buffett would say, investors who hold onto their shares will own a bigger slice of the pie. To show just how impressive the amount of cash that will be returned to shareholders is, here is an excerpt taken from Apple's website:

"The company expects to utilize a total of $100 billion of cash under the expanded program by the end of calendar 2015. This represents a $55 billion increase to the program announced last year and translates to an average rate of $30 billion per year from the time of the first dividend payment in August 2012 through 2015."

You read that correctly. Apple will return $100 billion to its shareholders by the end of 2015! The numbers speak for themselves.

Which Side is More Convincing?

This is the question that we all ask ourselves when it comes to Apple. Apple is a very difficult stock to understand, and it seems to be driven largely by investor sentiment. There are still investors out there who bought at $705 and are still waiting for the catalyst to bring the stock back to those levels. While we may never see Apple rise to $705 again, I am a firm believer in Apple, and I believe that the stock for the rational, long-term investor favors the bull case. However, I will note that the bear case is a very strong argument. Apple's gross margins and smartphone market share may be constrained forever, and it may never be able to generate earnings at its historical growth rate again.

I do believe in Tim Cook as director and chief executive officer of the company. He is a shareholder-friendly executive as indicated by his record capital return program. Although he is not the innovator like Steve Jobs, Cook was considered to be Jobs' right-hand man as the chief operating officer of the company. It is certainly fair to question Cook's leadership and creative abilities, but I think that this will become less of a factor as Apple moves on to different products. After all, Apple is still considered to be one of the all-time leading innovators of its time. I certainly do not believe that the passing of Jobs will limit Apple significantly over the long-term.

As an investor, I care about Apple's future. The company can no longer sustain double-digit growth in earnings like it had in the past, but there is still more room to grow. The deal with China Mobile is still a promising reality, and Apple will continue to create new products. I am excited about the iWatch, iRadio, the iPhone 6, and even the revamp of Apple TV. There lies much uncertainty with these products, but Apple has a consistent history of leading its industry in innovation with the iPod, iPhone, and iPad.

Finally, as an investor, I take note of Apple's fundamentally attractive valuation. Apple is extremely inexpensive right now relative to earnings, and I would recommend the stock to anyone considering a buy. I am confident in management's ability to increase earnings over the long-term and remain one of the leading innovator's in world. Furthermore, Tim Cook is optimistic about Apple's future, and if he is right about the company's future, the stock should start to increase in value over time.

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. Sources: Apple's most recent 10-Q report and Bloomberg