Apple, Inc. (AAPL) is one of the world's largest designers, producers, and manufacturers of consumer electronics, with business segments comprising of desktops, laptops, tablets, smartphones, and portable media devices. The company also manufactures its own networking and service solutions as well as develops and maintains software such as its iTunes digital media platform. At one point in Q3 2012, Apple was known as the most highly valued publicly traded company in the world with a market cap of over $600 billion. However, the company's stock has performed very poorly since its all-time high, sinking to a low of $385 within a span of 7 months.
While there is some understandable anxiety in investors over the company's shrinking margins mainly due to increasing competition and a shift in product mix, I strongly believe that these negative beliefs in Apple have been vastly blown out of proportion. This article will walk through my valuation of Apple in length, and I hope that it will both outline Apple's long line of growth prospects and show that the company is completely sound fundamentally.
After selling 72 million units, which made up ~42% of its total revenues in 2011, Apple followed up with an even stronger year in 2012 as it posted sales of over 125 million units (~50% of revenues). While many "experts" have been concerned over Apple's market share loss, Apple still owns a majority percentage of its targeted premium segment, both in developed and emerging countries. The last statement was of utmost importance - Apple is not losing market share because its products are being deemed inferior or outdated. It is losing market share due to a global shift in smartphone demand from developed countries to emerging countries - a shift from Apple's premium market to Samsung's and other competitor's lower end markets. Therefore, Apple is simply "losing" because it has strategically decided not to compete in a lower margined segment (which I estimate will change with the introduction of a low-end iPhone).
If you observe the charts below, you can see that 93% of Apple's market is the premium segment, with the remaining 7% comprising of discontinued iPhone 4s and 4Ss being sold at a discount to the high segment. Taking this into consideration, it makes sense that Apple would only have a sizeable market share in the premium segment (42% vs. Samsung's 26%), as it is the only segment for which Apple specifically makes products. This is contrasted to the high segment where Samsung controls 46% of the market share compared to Apple's 5%. Furthermore, Apple has yet to develop a strong, competitive distribution network in emerging markets. Apple is still in negotiation with telecom operators such as China Mobile (which has over 700M and growing potential subscriptions). Striking a deal could significantly expand Apple's reach in these areas.
Let's take a look at Apple's recent Q3 FY2013 results in regard to the iPhone. According to Peter Oppenheimer, iPhone sales increased from 26M to 31.2M YoY, with the biggest increases coming from the US (51% YoY) and Japan (66% YoY). This translates into an overall increase of 5.2M (or 20%). On another note, at a time when several "experts" are using decreasing innovation and customer loyalty as reasons to support an Apple bear thesis, the iPhone's customer loyalty and satisfaction rates are near all-time highs.
According to data from Kantar, Apple has a 93% loyalty rate, which Oppenheimer said was "significantly higher" than the company's competitors. In another study by Yankee Group, due to Apple's increasing loyalty and retention rates in the smartphone market, iOS will overtake Android in the US smartphone market share race by 2015. According to Yankee Group's study, 91% of iPhone owners indicated they would buy another iPhone, while only 6% said they would switch operating system. This is a huge contrast to Android, where only 76% of users said they planned to buy another Android phone while 24% indicated they planned to switch. Furthermore, a recent report from CISP showed that 78% of iPhone users upgrade to a new iPhone, while only 67% of Android users upgrade to a new Android phone. You can find the source material in the links below:
Looking ahead, iPhone sales for the next quarter will likely flatten as both the iPhone 5S and iPhone 5C are due out by the end of this year - my valuation is based on a mid Q4 2014 launch for both products, and an iPhone 6 launch in the summer of 2014. I believe that a low-end iPhone (iPhone 5C) will be a positive inflection point for the company. Margins will likely continue to contract, but I estimate that the upside to Apple's bottom line will more than make up for it. While my initial valuation does not include earnings data from a low-end iPhone, the last section of this report will explain why I believe such a product could significantly boost Apple's bottom line.
The iPad has become Apple's fastest growing segment since its release in 2010, selling 8M, 32M, and 58M units in 2010, 2011, and 2012 respectively. However, increasing competition from Android competitors have put a serious damper on Apple's tablet dominance.
According to the latest report put out by Strategy Analytics, Apple's market share in the tablet space has fallen to a record low 27.2%, down from 47.2% at the same time last year. This attributes to a YoY decline of a staggering 42.4% in market share. The numbers become understandable when we take the iPad's Q3 FY2013 results of a 14% YoY decline in shipments and combine it with Strategy Analytics' estimated 43% growth in the overall tablet market. While this can certainly be viewed as a major concern for Apple, there are a couple things I would like to call to your attention.
At this time last year, the iPad 3 had completed its first full quarter of sales, while this year the iPad 4 and iPad mini have been out since Q4 2012. This could easily have caused a disparity between Q3 FY2012 iPad sales and Q3 FY2013 iPad sales.
If we compare iPad unit sales for Q3 2012 (first full quarter for iPad 3) and Q2 FY2013 iPad unit sales (first full quarter for iPad 4/iPad Mini), we can see there actually was an increase in unit sales. The Q2 FY2013 results of 19.5M unit sales corresponds to a 14.7% increase over Q3 FY2012's unit sales of 17M. I feel that this is a much better comparison, and it helps to smooth out the volatility (both the highs and lows) in Apple's tablet market share. When Apple releases its FY2013 earnings, the results should be much clearer, as I believe we will see a modest YoY growth (2012 vs. 2013) in iPad sales as the company maintains its status at the top of the tablet industry.
The data may also present a clear path to future gains in unit sales and market share. In the latest Apple earnings call, Peter Oppenheimer lauded some iPad numbers, stating that the iPad "accounted for 84.3% share of tablet web usage by customers in the U.S. and Canada, its highest level this year" and "represent 88% of all tablet activations." While this data only accounts for U.S. and Canada, it makes sense to me that Apple could potentially duplicate this feat in emerging markets, much like I believe they will do so with a low cost iPhone. Obviously, there are some large obstacles in doing this, such as pricing difficulties and the development of distribution networks, but I do believe that it can be done - especially by a company with a strong brand name and almost unlimited financial means. In the meantime, there will likely be a fall launch for both the iPad 5 and iPad Mini 2, leading to a probable pause in demand for current-gen Apple tablets until a spike in sales occurs later this year as a result of the updated versions' release.
I want to start off my discussion of this segment by stating that I am a PC, not a Mac. A large reason of this is due to my programming and gaming (a very serious gaming) background. Macs do not support the level of customization and compatibility that I am used to with PCs, and I happen to be a fan of recent Windows releases (excluding Vista). However, Windows does not have a very wide economic moat with me, as I would be willing to pay more for a Mac if the compatibility issues were resolved.
In Q3 FY2013, Apple posted unit sales of 3.8M Macs, a decline of 7% YoY. However, keeping with a trend it has set in previous quarters, Apple beat the overall PC market decline of 11%. This is promising, as this trend shows slow, yet continuously steady market share growth for Apple in the PC market - which in my opinion is far from being dead. Furthermore, there are several new recent and upcoming product launches for the Mac segment that have me very excited for Apple.
The first slew of products is an updated MacBook Air laptop featuring Intel's Haswell chip, which vastly improves battery life and integrated graphics. Improved Wi-Fi, a thinner, lighter chassis, and faster flash memory highlight other upgrades that the new MacBook Air brings.
Second, and something that I believe is truly revolutionary, is the new Mac Pro. If you have not seen the Mac Pro yet, you absolutely must check it out. It is an insane evolution of current desktop towers. I have posted the link to Apple's official Mac Pro page below. Visuals aside, the new Mac Pro, with up to 12 cores and dual GPUs, can deliver over twice the performance and bandwidth as the last generation. In addition, a revolutionary thermal core and fan system should allow the Mac Pro to handle the most intensive computing tasks - including high-level gaming. As Apple states, it's "Radical. Yet completely logical."
Even with this slew of innovative products, I estimate the Mac line will still likely suffer declines in growth. However, I think the trend of declining less than the overall PC market will continue. Best case scenario is that these new Mac products cause as close to flat growth - and increased market share - as possible.
I'm combining the rest of Apple's segments, including the iPod and the Software & Services segment, under the "Other" category as they comprise of approximately 15% of Apple's revenue all together. The iPod, which was Apple's original path to stardom, has seen steep declines in unit sales and revenues in recent years due to near-total market saturation. It is likely for this trend to continue - even more so with the release of a low-end iPhone that could very well cannibalize iPod Touch sales. Apple still maintains a vast majority of the market share in portable media players (~75%) and will likely continue to do so as the market for such devices is becoming less and less significant.
Apple's Software & Services segment, while comprising a relatively small percentage of total revenues, is actually vital in the fact that it is the reason for the Apple economic moat - also called the "Apple Ecosystem." With products such as iTunes, Siri, iCloud, and FaceTime, Apple has made the switching costs for some customers - including myself - near insurmountable, and is a primary reason for the company's high consumer loyalty and retention rates. This segment is where we will really see the aspects of innovation - a new fingerprint sensor, enhanced Siri integration, etc. Therefore, continued improvements in this department is absolutely crucial in order for Apple to maintain its appearance of delivering cutting-edge, innovative products.
Lastly, there has been much speculation regarding new Apple product lines, such as iWatch, iTV, and iRadio. Such products are not factored into my valuation due to the lack of details, but I believe they present solid upside to the company's long-term growth prospects. Remember, from the iPod to the iPhone to the iPad, Apple has a history of extraordinary innovation. Even with the loss of Steve Jobs - who I consider to be an icon and a model for success as a CEO - I believe Apple can still innovate better than anybody.
Breaking Down the Fundamentals
If you read my previous article or my profile information, you would know that I place a large emphasis on a company's financial standing. Obviously, much has been made of Apple's cash hoard and, up until recently, the company had no long-term debt. So let's take a quick look at some ratios that breaks down Apple's fundamentals:
- Current Ratio of 1.50x when excluding foreign cash holdings.
- Quick Ratio of 1.48x when excluding foreign cash holdings.
- Cash Ratio of .28x when excluding foreign cash holdings.
- Ratios including foreign cash holdings (minus 30% to tax) are 3.42x, 3.40x, and 2.20x respectively
- For FY2013, I estimate an Operating Cash Flow/Liability Ratio of 2.88x.
As you can see, Apple is 100% fundamentally sound and in no danger of financial distress. Furthermore, for a company of this size to have financials this austere is extremely impressive, and Apple receives the highest mark I give when judging the fundamentals of a company. A snapshot of my model's informational statistics (as well as hints to my valuation) can be seen below.
At Last, the Valuation
To start off this section, I'm going to post my model's projected income statement through 2017.
Next, I'm going to explain the two different methods I use to evaluate companies. I like using these two methods, as they give slightly different stories as to how a company will both perform in the immediate term and the long term.
1) Intrinsic Value (IV) refers to how much the stock is worth by projecting future EPS and/or DPS growth. The IV is theoretically what the company's price would be in a fully rational market where stocks trade at exactly the amount they are worth and multiples, such as the P/E, moved at a relatively stable rate. Therefore, stocks do not necessarily have to trade at the IV. The IV is calculated by forecasting 4 to 5 years into the future, then discounted back at the present value. Thus, the IV places a higher emphasis on companies that are estimated to have sustainable earnings and/or dividend growth.
2) Target Price (TP) refers to what we believe a stock will sell at given a particularly time frame - such as a 12-month TP. The TP may differ from the IV as it could be higher or lower due to investor perception and/or less than efficient markets. Theoretically, at some point within the long term (4-5 years), the long-term Target Price will equal the long-term Intrinsic Value. The TP does not take into account a company's long-term growth potential, but is likely a more accurate depiction of a company's stock price in the more immediate term. Theoretically, a TP multiple, such as P/E, will be higher than an IV multiple, as company's growth tend to slow over time.
Now that the explanations are out of the way, let's take a look at the P/E Multiple Analysis below.
The two lines you really need to focus on in the above exhibit are the two "My Estimate" rows. The first of these two rows forecasts the Intrinsic Value, while the second forecasts the Target Price. Without trying to bombard you with any more quantitative and technical jargon, here is how I calculate both the IV and TP P/E multiples. The TP multiple comes first, and is comprised from several factors of information: 5-year historical high and lows (I take out abnormally high and low values), consensus estimates, and a slew of ratings that I personally assign to the company - financial standing, growth prospects, industry outlook, management grades, and profitability.
These factors all boil down into what I call the "Modified P/E ratio" which in this case is 14.1x. This is what I believe the stock should trade at, not necessarily where it will trade. The next step is to take into account a company's historical P/E trend and forecast a P/E (which comes out to 11.8x). I also take into consideration the average of the P/E multiples of a company's peers (which I calculate to be 12.2x). Finally, I combine the "Modified P/E," historical trend P/E, and the peer P/E, which leaves me with a final P/E ratio of 12.7x. This becomes my TP's P/E multiple. You can see a visual of the process in the chart below.
The last step in the process is to calculate the IV P/E multiple. Quite simply the IV P/E is the TP P/E discounted at the company's Weighted Average Cost of Capital, or the WACC, which I will very briefly discuss in the next section. The discount process results in an IV P/E multiple of 11.7x. Think of this as what the average P/E multiple would theoretically be (based on an initial P/E multiple of 12.7x) for Apple over the next 5 years. Remember, like I discussed earlier, as company's growth typically declines over the years, so should its P/E multiple (which is often viewed as a reflection of growth).
Therefore, my Target Price is calculated by using the P/E multiple of 12.7x my 2014E EPS of $46.01 - giving me a valuation of $585.
The Intrinsic Value calculation is a little bit more complex, but it boils down into applying the P/E multiple of 11.7x to forecasted EPS and DPS that run through 2017 - which results in a valuation of $660. In a very similar manner to a Free Cash Flow Analysis, this is what I believe Apple's per share value is when taking into consideration future earnings and dividend growth.
One last thing I would like to point out is just how much of a discount Apple is trading relative to the overall market and to some of its more prominent peers. Currently, Apple is trading at 9.8x my 2014E EPS. When excluding cash (I am assuming a tax rate of 30% on foreign cash holdings), Apple trades at an astoundingly low 7.8x my 2014E EPS. Considering the S&P 500 is currently trading at 14.9x and peers Microsoft (MSFT) and Google (GOOG) are trading at 12.4x and 25.7x respectively, it appears to me that Apple is trading at an almost absurd discount. Does it honestly make sense that the overall market and/or Microsoft have higher expected growth rates than Apple? To me, this is almost all the validation I need to assume Apple is undervalued.
Taking a Quick Look at the WACC
Above, you can see my brief, yet thorough analysis of Apple's WACC.
- Wd and We - weight of debt and weight of equity - are calculated by determining what percentage of capital is debt and what percentage of capital is equity.
- Cost of debt (Kd) is the average coupon rate Apple pays on its bonds - typically an investor would use the after-tax rate here, but since the WACC does this for you, it is unnecessary.
- Market premium is calculated by taking the estimated annual growth of the market (9.3%) less the yield on a 10-year U.S. Treasury Bond (2.6%), or the risk free rate.
- The cost of equity (Ke) is calculated by adding the risk free rate to the product of the beta times the market premium.
- The beta is the correlation of the changes Apple's stock price to the S&P 500's on a daily basis over five years. This includes adjustments due to dividend payments.
- Using all of these calculations, I calculate the WACC to be 7.9.
How Does a Low-End iPhone Affect Valuation
I have a couple things to point out regarding the above charts. First, the calculations assume a Q4 2013 launch. Second, I estimate that the best way for Apple to release a low-end iPhone (5C) would be to direct the launch solely at emerging markets. This will protect margins in developed markets where the current-gen iPhone is selling well. And third, there are two scenarios I present in regards to Apple's ability to capture market share in emerging markets: one for a less optimistic bear case and one for a more optimistic bull case.
Okay, so let's take a walk through my calculations. Starting in the 2013 - 2014 range, I estimate an average 1% growth in population in Apple's targeted emerging market, which I believe can be relatively conservative given population explosions in countries like India. By the end of 2013, I predict that smartphone penetration will be approximately 12% and will grow to 30% by the end of 2017.
Now here is where the two scenarios differ: given multiple factors, including the development of distribution networks, subsidy and pricing agreements, and contractual negotiations with telecom operators, how well will Apple be able to grow market share in emerging countries? I present two scenarios to exhibit possible outcomes.
I am predicting that a low-end iPhone's ASP will be around $329 and have a gross margin of 35%. Applying the current-gen iPhone's operating expenses, depreciation expenses, and tax rates to the low-end iPhone, I estimate that Apple can make $68 in net earnings per low-end iPhone sold. This translates into an immediate Q4 2013 EPS boost of $1.23 - $1.65. However, cannibalization will likely occur in these markets, which currently purchase discontinued iPhone 4s and 4Ss. I estimate this cannibalization will reduce Apple's Q4 2013 EPS by $0.61 - $0.72. This results in a total increase in Apple's Q4 2013 EPS of $0.51 - $1.03.
Furthermore, depending on how Apple's market share in emerging markets plays out, I estimate that a low-end iPhone could boost FY2017 EPS by $17.14 - $21.08.
In my opinion, the bottom line is that a low-end iPhone will likely have a significant effect on Apple's earnings potential.
As you can see, I believe Apple has tremendous opportunity for growth. Combined with its pristine fundamentals, Apple meets all of the requirements for a place in my portfolio. I hope this article did a good job of explaining why you too should be anticipating an Apple bull run.
Additional disclosure: Many of the financial models presented in this report were first developed by the Louis Wilson Fund of Millsaps College, where I served as Lead Analyst and Portfolio Manager from 2011 - 2013. All data, estimates, exhibits, and opinions are my own.