Apple - A Great Value Stock With Strong Upside Potential

Aug.20.13 | About: Apple Inc. (AAPL)

Apple, Inc. (NASDAQ:AAPL) is one of the most powerful global brands in computer hardware, mobile communication devices, consumer electronics, computer software, applications (apps), accessories and services. Apple shares, however, are currently trading at a discount to their real worth and are undervalued based on current earnings and strong execution, and offer significant near-term and long-term upside and dividend earnings potential based on earnings growth from a strong pipeline of products, enviable brand value and premium consumer mind share across the world.

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Selling Overdone

Apple shares were at their all time high of $705 as recently as September 2012 but then dropped 45% to $385 by April 2013 and were trading below $400 less than a month back, partly on excessive selling and partly on negative market sentiment tied to Federal stimulus tapering comments. Shares subsequently rose in anticipation of earnings and jumped an additional 5% ($21.52) to $440.51 the day after earnings were announced July 23rd (after market close) as results beat Wall Street expectations.

But even at $440.51, after the bounce back, shares trade at about 10.5 times trailing twelve month earnings and were still significantly oversold. From late July to now Apple share prices have climbed to just over the $500 mark. Major market players like Carl Icahn and George Soros have even taken healthy positions in the stock. See Carl Icahn's recent tweets below that helps support the shares and add more confidence to investors and shareholders.

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Robust Quarterly Performance - Third Quarter Ended 6/29/2013

Apple delivered solid third quarter (3Q13) results with revenues of $35.3 billion, earnings of $6.9 billion ($7.47 per share) and operating cash flow of $7.8 billion. Apple ended the quarter with $146.6 billion in cash and marketable securities, $17 billion in debt and a solid balance sheet. The company reported record iPhone sales of 31.2 million units and strong revenue growth from its iTunes, software and services offerings.

Quarterly figures did, however, lag 3Q12 results on higher cost of sales and higher R&D investments that led margins lower as Apple faces stiff competition from rivals such as Google's Android devices and manufacturers such as Samsung. But new product introductions in the fall and through 2014 could re-inject significant vigor in the stock if Apple moves to capture greater market share on existing product lines through innovation or price cuts, or introduces a new category of products.

Guidance, R&D, Inventory Suggest New Product Introductions - Could Light Up Shares

Apple's guidance for 4Q13 (end September) calls for revenues of $34 billion to $37 billion and gross margin of between 36% and 37% (vs. 26.9% in 3Q13). This guidance, with a mid-point that's marginally above 3Q13 in the quarter before a seasonally strong Christmas/Holiday quarter suggests new product innovations in the fall. In addition, R&D expenses have gone up considerably suggesting new product developments. And Apple CEO Tim Cook's comments on clearing out inventory also hint at changes that could make existing inventory less desirable. Apple rumors also indicate the filing of patents related to the iWatch name, a cheaper version of its wildly popular iPhone that could significantly capture market share at lower price points and sell millions of units in emerging markets such as India and China, and an iPad with a larger screen - all of which could propel revenues to meet or beat upper guidance. If Apple does indeed introduce a category killer like a cheaper iPhone or introduce an all new category, shares could light up again pretty significantly.

Strong Commitment to Shareholders

In the quarter, the company returned $18.8 billion to shareholders through dividends ($2.8 billion) and share buybacks (almost $16 billion), and announced a 15.1% sequential increase in quarterly cash dividend to $3.05 per share ($12.20 annualized, 2.8% dividend yield), payable 8/12/2013. Moreover, in April 2013, Apple increased its share buyback authorization by $55 billion to $100 billion through 2015 - the largest corporate buyback in history - suggesting the Board's view that shares could be undervalued relative to future prospects. Apple decided to partly finance the buyback with $17 billion in new debt as significant portions of Apple's cash hoard sit abroad and would be taxed heavily on repatriation to the U.S. (to 40% including state and federal taxes). So Apple's use of debt was a smart move in today's low interest rate environment. This cumulative buyback will reduce outstanding shares by about 15% and make them that much more valuable, intrinsically.

Shares Undervalued

As the graph below shows, Apple's P/E ratio has dropped significantly over the past year and shares now trade with a P/E of 12.5 - well below relevant peers in the consumer electronics, computer hardware and software categories. In fact, despite very strong brand and consumer mind share, Apple's P/E ratio has steadily declined, even as shares have rocketed, to levels seen around the year 2000, over a decade ago - again suggesting that Apple shares are oversold and undervalued.

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Moreover, as the chart below shows, shares could reach almost $600 by year end 2013 (that's a 20% gain from current levels) and top $1,000 by 2018, five years from now based on a steady growth in earnings and dividends. Estimates also call from Apple's dividend yield topping 5% by 2018 making this an attractive investment on dividend alone.

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Innovating its Way Out of Obsolescence

While Apple's traditional competitors - PC hardware and software makers such as HP (NYSE:HPQ), Dell (NASDAQ:DELL) and Microsoft (NASDAQ:MSFT) - are struggling with declining sales, loss of revenue and product obsolescence, Apple is thriving with products such as the iPad (that's eating out PCs) and the iPhone (with unit sales up 51%), complemented by services such as iTunes and the App Store that continue to grow revenue and earnings, and with potential new killer products such as a lower cost iPhone, a wider screen iPad (that would take a big bite out of the laptop market), Apple TV [which could challenge competitors such as Sony (NYSE:SNE) and Samsung (OTC:SSNLF)] and perhaps an iWatch wearable computer. Through these remarkable innovations, Apple has successfully morphed itself from an old world computer maker to the hippest consumer electronics brand. Apple's strengths lie in its ability to blend hardware, software and services under one roof, something none of its newer consumer electronics competitors are succeeding at. So Apple is solidly positioned to stay relevant and on top of its game for years to come with competitors struggling to play catch up. No other company has managed to build the corporate DNA that Apple has and this will be a key factor in Apple's future success.

Over the past few years, Apple's strong innovation and product design have propelled it to a position of global leadership and financial well being. Today, the company has 394 retail stores across 14 countries and is known for its iMac, iPod, iPhone, iPad and Apple TV products, and for digital content and applications via iTunes, the App store, iBookstore and Mac App stores.

With PC sales waning and tablet sales growing strongly, tablets are expected to beat PC sales by 2015. Laptop shipments fell 14% in Q1 2013 with HP and Dell losing market share and Lenovo (OTCPK:LNVGF) and Samsung reporting better growth as they were quick to diversify into tablets and mobile hardware.

Smartphone, Tablet Market Growing Strongly

Smartphones registered a 34% increase in sales in 2012; Apple sold 50% and Samsung sold 32% of total smartphones priced above $550, making these two companies the largest players in the high-end smart phone market.

While iPhone sales did better than expected, Apple knows it faces stiff competition from Samsung and other mobile manufacturers who are winning with lower cost smartphones but Apple could change the game with a lower priced iPhone. This would be a smart move for Apple because in 1Q13, smartphones priced below $300 accounted for more than 51% of total smartphone shipments. Lower priced devices are in significant demand in emerging markets, which accounted for 67% of total smartphone global shipments - a category that Apple lost out on but could reclaim with a lower priced iPhone.

Risks

Apple needs to adapt its strategy to changing consumer preferences and demand patterns. For example, consumers in emerging markets cannot afford Apple's high end iPhones and competitors with lower priced smartphones, such as Samsung, have significantly shut Apple out of these growth markets. While Apple has done a great job with category killers and new products, such as the iPhone and the iPad when they were launched, the company needs to morph its product mix to stay competitive as categories mature.

Wall Street has soured considerably on Apple stock of late, largely because Apple has failed to capitalize on lower end smartphone sales and partly because the Street is skeptical about Apple's ability to innovate without Steve Jobs. While the Street believes Steve Jobs had set enough in motion to keep Apple going for a while, it's taking a wait-and-watch approach to see if Apple sans Jobs succeeds at capturing consumer imagination the way Jobs did. If current CEO, Tim Cook, fails to thrill consumers over the second half of 2014, Apple stock and market share could come under attack.

Quarterly Results - Q3 2013 Ended June 29, 2013

For 3Q13, net sales were up marginally to $35.3 billion from $35 billion in 3Q12. The company sold 31.2 million iPhone units, a 20% gain over the prior year quarter but down 17% sequentially against 37.4 million iPhone units sold in 2Q13. On aggressive pricing, especially for older iPhone versions, and higher R&D expenses, gross margin declined from 43% in 3Q12 to 37% this quarter. However, the company's gross margin was still way above industry peers. Net income declined 22% to $6.9 billion or $7.47 per share from $8.8 billion or $9.32 per share in Q3 2012 on rising costs in a more competitive and price conscious landscape.

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By Segment

Americas, fueled by the U.S., remains the biggest contributor to revenue at 41% with $14.4 billion. Europe contributed 22% to sales followed by Greater China with 13%. Revenues from Japan jumped 27% year-over-year on signs of recovering Japanese consumer confidence. With the exception of Americas and Japan, revenue declined sequentially across regions.

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iPhones were the biggest contributor to revenue at 51% followed by iPads at 18%. Aside from iPhones, all product lines experienced sales declines over the prior year quarter. iPhone sales increased 15% over 3Q12 but were 21% lower sequentially. All product sales observed double-digit declines sequentially with the exception of iTunes.

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Balance Sheet

At quarter end, Apple held $11.2 billion in cash and cash equivalents, $31 billion in short-term marketable securities and $104 billion in long-term marketable securities. Total assets stood at $199.8 billion with net property, plant and equipment at $16 billion. Apple has strong liquidity and substantial working capital. In 2Q13, Apple took advantage of low interest rates and issued $17 billion in corporate bonds to partly finance its share buyback program without repatriating and paying taxes on foreign profits. Debt is still a small fraction of the company's assets (8.5%) and equity (13.7%). Total shareholders' equity increased 10% to $123 billion from $111.7 billion in 3Q12.

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Cash Flow

For the nine months ended June 29, 2013, Apple generated $43.8 billion in cash from operating activities, invested $34.4 billion in marketable securities and spent $8.8 billion on dividends and share buybacks. In 3Q13, Apple generated $7.8 billion in operating cash and spent $18.8 to pay dividends ($2.8 billion) and repurchase common stock ($16 billion). The stock currently has a 2.4% dividend yield.

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The company expects next quarter revenue in the $34 - $37 billion range and gross margin to remain near current levels of 37%. Tim Cook announced the release of iOS 7, OS X Mavericks and new products in the fall (Q4 2013) and across 2014.

Peer Group and Valuation

Apple, Samsung and Microsoft are the biggest players in computer hardware and mobile communication devices by market cap and revenue. As the smartphone market matures, Apple has experienced a decline in earnings growth due to the lack of low-end options while Samsung has thrived on lower cost Android devices. Apple, however, still has significantly higher earnings per share ($40.05 versus losses at $1.96 at Microsoft), return on equity (32% versus 21% for Samsung and 22% for Microsoft) and free cash flow ($45 billion versus $18 billion for Microsoft) than its competitors. Compared to its peers, Apple is more profitable and has lower debt ratios.

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Summary

Apple is the world's largest company by market capitalization, has an enviable cash and investments hoard of $146.6 billion and higher earnings per share and profit margins than its peers. Investors have soured on the stock of late and brought shares down to a P/E of 10 in the recent past. Current share price levels do not take into account Apple's strong execution, earnings growth potential and leadership in the nascent next-generation consumer electronics and entertainment space. Estimates suggest that Apple shares could rise 20% over the next six months (by year end 2013) and top $1,000 in the next five years. Apple has a strong moat and a steady and growing customer base. Moreover, consumers that taste Apple have little appetite to move back to other computing or mobile platforms and willingly convert to Apple's ecosystem of apps and services, with sales in one category leading to significant cross selling across others. Apple does, however, need to overcome competitive pressures from PC and mobile computing companies that are resorting to lower prices and margins just to gain market share. To its credit, Apple has an operational focus on higher profit margins which ultimately benefit shareholders more than market share.

With the demise of Steve Jobs, Apple is under the lens but shares are already oversold and have little downside risk at current levels. While Apple could make near term errors, investors must look beyond quarterly performance and focus on execution fundamentals over the long-term. At current share price levels, even skeptics will not challenge Apple's low valuation and investors stand to gain solid ROI with little downside. To sum it up, the stock has simply underperformed the market for quite some time but now the mojo appears to be back.

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.