Apple: Bearish Case Keeps Me Bullish For Now

Jul.31.14 | About: Apple Inc. (AAPL)

Summary

Apple reported another solid quarter.

Bearish case highlights the ability to sell low-end phones and maintain margins.

Apple continues to offer intriguing value despite the concerns on market share.

Lately I've started thinking it was about time to unload the Apple (NASDAQ:AAPL) stock held in my aggressive model for years now. In previous articles, the focus has swung to concerns about the company missing the phablet market in Asia and the upcoming concern over the emergence of Xiaomi in China. Regardless, the general review has remained that Apple is an incredible brand trading at too cheap of a valuation to sell now. Sure the stock probably isn't going to soar to $150 in the next 12 months, but why not $115 along with a solid dividend?

After reviewing the second quarter numbers and other research reports on Seeking Alpha, I came across a bearish article that actually provided conviction for staying long.

Q314 Numbers

The Q314 numbers were typical of Apple these days with an obligatory earnings beat and questionable guidance. The company provided the following highlights for the quarter:

  • Revenue for the quarter of $37.4 billion, compared to $35.3 billion in the prior year period.
  • EPS jumped to $1.28 for Q214 from only $1.07 last year.
  • Gross margins increased 250 basis points to 39.4% from 36.9% in the previous Q2.
  • Operating cash flow hit $10.3 billion.

The numbers slightly exceeded estimates with EPS projections of analysts sitting at $1.23 versus the $1.28 reported. Even more concerning, revenue estimates are for roughly $38.5 billion that significantly undercuts analyst estimates that were sitting around $40 billion prior to the earnings release.

Overblown ASP Concerns

Michael Blair has an excellent article focused on the trends in average selling prices (ASPs) that leads him to short the stock. According to his thesis, Apple continues to sell more of the old phones at lower ASPs in the emerging world causing continual declines in the price of the average phone. In my opinion, the ability of Apple to continue selling the newest iPhone model at a price of $685 establishes a strong value for the brand. Even better, the company is able to unload older models at profitable prices in the emerging markets.

The previous concern was that Apple wouldn't be able to sell the lower cost phones, completely shutting them out of markets like China and India where consumers can't afford the higher prices. According to the analysis by Mr. Blair seen below, the company sold 12 million iPhone 4Ss for an average price of $349. In essence, the company is using an older generation phone to compete with the likes of Xiaomi and others providing mid-level smartphones.

Source: Michael Blair

The real key isn't whether Apple sells the older or newer products, but rather the margin on the product sold. If the company can sell a $360 device and make a nearly 40% gross margin companywide, a ton of money will fall to the bottom line. The real issue is having to sell the newest iPhone for a reduced ASP and an impact to the margins. Remember that Apple actually increased margins over the previous year by 250 basis points despite this theory that the ASP of iPhones are declining. When the iPhone 6 is released this fall, investors should expect the iPhone 5S to replace the iPhone 4S in the emerging markets supply chain. The price for that phone will decline over the next year to where it hits that $350 price point.

The following chart shows that margins have bounced around for the last five years with a bottom of 37% during that period. If anything, it appears that the ability to ramp up sales of the lower price iPhone over selling the iPod is helping improve margins.

AAPL Gross Profit Margin (Quarterly) Chart

AAPL Gross Profit Margin (Quarterly) data by YCharts

Valuation Proposition

As always, the value proposition with Apple remains off the charts attractive. The company has over $164 billion in cash and after accumulating debt over the last year, it has roughly $134 billion of net cash. Subtracting this cash, the company has an enterprise value of $455 billion. At that enterprise value, Apple trades for roughly 10x forecasted EPS for 2015 of around $7.

Conclusion

Apple remains a value proposition offering a cheap stock and a strong brand. Unfortunately, a ton of questions exist regarding future growth and market share, but the Q314 earnings report and the corresponding bearish analysis convince me that finding a cheaper stock with fortress balance sheet isn't possible.

For the time being, I'll continue owning Apple stock because it's too cheap to unload and the relative success in selling low-end phones will keep the ecosystem building for years.

Disclosure: The author is long AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.