It is tempting to interpret Apple's (AAPL) soaring share price as another facet of the marketing hype and breathless anticipation that surrounds Apple's new product release. As Apple's share price keeps rising we wonder - how high can it go?
We are wary of momentum plays. Here we do a fundamental analysis of Apple's core businesses, look at prospects of future growth and create an estimated valuation based on a discounted cash flow basis. We find that, just as in the case of Apple products, there is real substance behind the hype. Based on our model, Apple is substantially undervalued at current prices with a fair value of $1200-$1800/share.
Looking at the numbers
The Apple story for investors is hinged around two questions - can Apple continue to grow on the currently huge base and what is the upside for investors from here? To gain perspective on the recently released Q2 2012 numbers here is the revenue growth over the last ten quarters.
Source: Apple Earnings Releases, $ in millions. Figures include related revenue for each category. (click to enlarge)
Note that the three biggest items are the iPhone, the iPad and the Mac. While the iPhone consists of the biggest revenue category with $22.7 billion of revenue in the latest quarter, the growth of the iPad is nothing short of phenomenal. iPad revenue grew 132% yr over yr from Q2 2011, surpassing the yr/yr growth of 99% last quarter. This was when sales were supply constrained, according to Apple CEO Tim Cook.
Apple said they sold iPads as fast as they could make them. Another figure is remarkable. In under two years since the iPad launch, it is making more revenue, at $6.6 billion in the latest quarter than the entire line of Mac computers, that have taken nearly 28 years to get to the $6 billion quarterly mark. This is incredible by any metric, incredible compared to even the second most successful ramp, that of the iPhone.
Can the Growth Continue?
Apple has delivered incredible growth, but can this continue? There is reason to be bullish.
- One word - China. iPhone sales were up over 400% in China, according to the earnings call. Was this because we had small numbers? No, revenue in China was at $7.9 billion for the quarter, described by CEO Cook as "mind-boggling." This is when the new iPad has not even been shipped in Mainland China. The iPhone is still under-penetrated in many international markets.
- The iPad is a phenomenal product that is just taking off. According to the Apple CFO on the earnings call, "I have to tell you new iPad is on fire, selling them as fast as we can make them. Education buying is looking terrific." Remember, this is barely the second year of iPad's growth.
- How many more iPhones can be sold? According to Nielson, overall smartphone penetration in the US has reached about 50% - the percentage among new acquirers is even greater. The same article shows that the iPhone has been increasing its market shares. However, global smartphone penetration is only about 10% and the US at about 327 million phones is less than 6% of the global mobile market. So Apple has a long way to go before saturation.
- Apple is continuing to gain market share in the PC market with its Mac offerings thanks to what Cook describes as a "halo" effect from adoption of the iPhone and iPad.
- Apple is able to sustain larger gross margins than its competitors. While the iPhone has 40%+ margins, Samsung (SSNLF.PK), its nearest competitor in smartphone shipments has gross margins of only 17%. Apple's gross margins increased to 47.4% in the latest quarter and reflect the premium pricing Apple is able to sustain for its products plus the economies of scale in its manufacturing.
- While Apple has guided Q3 2012 lower, if you look at the chart, Q2 has been its weakest quarter for the last 3 years. There is tremendous potential for upside in the Q3 guidance.
What is a Fair Value?
How much would one pay for a category defining market leader that has increased net profit 94% yr/yr, is gaining market share, generated $14 billion in cash from operations in the last quarter and has $110 billion of cash on its balance sheet? We are wary of momentum stocks and over-priced media darlings. So let us run the numbers on a net present value of cash flows, not accounting for any premium for Apple's brand leadership.
We use $50 billion of free cash flow for CY 2012 as the starting figure. We believe Apple will handily exceed this number based on its current run rate of nearly $30 billion of cash flow in the preceding 6 months. Despite the 94% increase in net profit, and the 5-year average growth of 67%, let us assume a more modest rate of growth of 20% yr/yr for the next 5 years, 10% for years 6-10 and 3% thereafter.
With a WACC of 11% we get an intrinsic value of $1.58 trillion, not including the cash in hand. Using 932 million shares outstanding, this yields a share price of $1695/share or about $1800 with the cash in hand. Even if we slowed the growth down to 10% yr/yr over the ten year period we get a share price of over $1100 per share. Cash in hand would increase this to about $1210 per share. Growth of 10% for just 5 years and 3% thereafter would yield share prices upwards of $1000.
These are astronomical numbers. No company on the planet has done anything like this ever before. We hesitate to project any higher growth rates, not because we think they may not be achievable but because they would be difficult to publish credibly.
In any case, we believe that at current prices Apple shares are at least 50% undervalued and there remains significant upside for investors at the current level. I would get in line to own shares of the stock with as much enthusiasm as owning its latest product offering.
Disclosure: I am long AAPL.