Having seen Apple's (AAPL) latest earnings blowout, we wanted to take a different look and outline possible signs that the good times could be coming to an end for Apple. Looking at the longer term chart, AAPL has seen a spectacular run and the shares are seemingly due for a meaningful pullback (that we may be in the beginnings of currently).
We believe AAPL could at least trade in a range for a short time, but ultimately the catalyst of continued success of the iPhone 4S in China coupled with relatively modest earnings expectations for the next quarter will lead us to our 2012 price target of $750. After this impending consolidation, we believe there to be significant upside potential in the short to medium term, and will provide warning signs to help you determine the best time to exit the anticipated rise in share price.
This article will follow our previous SWOT format but will be significantly longer in length. All of the information in this article has been taken from the most recent quarterly and annual reports as well as the most recent earnings call.
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Ease of use. The products are simple, beautiful and easy to learn how to use. There is little need for a manual, just pick up the device and it intuitively makes sense. We have seen children as young as 2 years old pick up an iPod touch or iPhone and they are able to load an application. There is a reason cigarette makers aren't allowed to advertise to children, they are influenced very easily. Parents are putting iPhones and iPads into the hands of their young - and this early introduction to the Apple ecosystem would seem to increase the chances these kids will adopt the products, grow up with Apple's ecosystem and become lifelong customers.
The Ecosystem. Being more vertically integrated than its peers (like Microsoft (MSFT) and Google (GOOG)) has its advantages and Apple has done a great job making sure their products work extremely well together. Users with multiple devices can have their calendars synched, mail synched and music everywhere, all easily accessible. Buying a song on iTunes shows up on your computer or iPad seamlessly. This powerful attribute is illustrated at least in part by sales for iTunes and related software being up 32% compared to the same quarter last year which should continue to rise with the release of the iPad 3 in more countries and the millions of Chinese downloading new content to their new iPhones.
Marketing. This is a competitive advantage that may eventually fade, but for now the message they send is as simple, clear and beautiful as their products. We feel the, I'm a Mac vs. I'm a PC campaign was one of the greatest advertising campaigns ever. Apple's current cash hoard allows for hundreds of millions of dollars to be spent promoting a new product or service while barely making a dent in their pile of cash.
Knowledgeable Staff. A company this successful cannot do it on the backs of its engineers and designers alone. The Apple store provides the consumer an experience like no other. Every staff member knows every single product and accessory and can match a product to the customer's needs and help create the perfect Apple experience. For those of you who remember Circuit City - how often did you run into an employee who knew everything (or much) about a product? In contrast, the Apple experience increases goodwill (which should translate into future sales) and this marriage of sales and service is why the Apple Store is so critical to the long term success of the company.
Simple Product Line. There are only X number of products. More choices mean more inventory and greater chance for product write-downs. It is also very easy for the consumer - they don't feel overwhelmed and can just decide what color and size they would like, which should lead to fewer instances of buyer's remorse.
Apple Care. Finally, many companies lose current customers with the lackluster after-purchase service they provide. Apple Care is a full service campaign to ensure that first time customers are converted into repeat customers. Apple takes care of the whole experience from buying to servicing their products.
China. With the iPhone contributing the most to gross margins, it is very encouraging to see the company do so well in China. IPhone sales in China were between 6-6.5 million last quarter according to analysts on Wall Street and have room for 5x that amount by the end of 2013.
We continue to see tremendous momentum in Greater China, where iPhone sales were 5x the level of the year ago quarter, aided by the launch of the iPhone 4S in China in January and the addition of China Telecom as an iPhone carrier in March. IPhone 4S is now available in over 100 countries and is sold through over 230 carriers.
IPad. IPads are selling at an incredible pace and its growing usefulness in education and business are exposing more and more people to Apple's ecosystem. There is a magnetic pull to these products - once you use one you are hooked - and the lower price points on the iPad are just making it easier to bring more people over to the Apple way.
We've now -- through the last quarter, I should say, which is just 2 years after we shipped the initial iPad, we've sold 67 million. And to put that in some context, it took us 24 years to sell that many Macs and 5 years for that many iPods and over 3 years for that many iPhones.
More recently, Apple has been changing from a company that focused on producing revolutionary products like the iPod, iPhone and iPad, to a company who is focusing its financial efforts on promoting its "resolutionary" products, a.k.a. minor upgrades and spec bumps versus a truly market changing product. Tim Cook has done a fantastic job of continuing the international expansion of the company's products. We're just waiting for him to prove that he can lead a creative team to create the next product that helps Apple sustain its recent financial success.
Revenues have grown so dramatically since 2004 that Apple will eventually reach the point where revenues will be hard to grow by 50% (from a base of $145B). The more successful the company is, the harder it will be to continue beating expectations or maintaining the fantastic performance they have displayed during the past few years. This could all change with the introduction of a revolutionary product in 2012 or 2013, yet the recent success of the iPad in 40 countries (as of 4/24), with an additional 30 countries on May 12th, certainly buys Apple some time before a new revolutionary product would be desperately needed by 2014.
How will an Apple branded TV change things? Do you think those customers who have other Apple products will want to buy an Apple TV?
Apple TV is going to have a difficult time, as it's already failed multiple times (January 2007, September 2010 & March 2012). Television is viewed as a relatively passive form of entertainment and an Apple branded TV doesn't seem to provide enough of a differentiated viewing experience to warrant replacement of a consumers current TV. With robust competition from the likes of Netflix (NFLX), Redbox from Coinstar (CSTR), Hulu, Amazon (AMZN) Prime and more on devices such as DVD players, TVs, Xbox, Nintendo's Wii, PS3 from Sony (SNE), Roku and cable boxes, it leaves no reason to turn to Apple for a premium priced TV or additional TV box.
With a limited number of available sources for content and so many companies already providing access to that content it will be an uphill battle for Apple to differentiate its product and services to gain significant market share. Years ago when the iPod came out, it was clearly the best developed and fully thought-out MP3 player a consumer could buy.
It had a developed digital store in iTunes and was a whole new way to listen to music and became the obvious choice for this type of device. These days Apple isn't usually the first "out of the gate," they may do things differently and often better, but they have a lot of well-established competition in the digital distribution of movies and TV that also all have a reputation for being fairly priced. If Apple comes to market with something that isn't truly a great value, it will experience significant headwinds.
Apple has done very well over the past five years because it's more vertically integrated than its rivals, which enables it to maintain control over the entire consumer experience. Apple is focused on complete control because they believe that their way of doing things is the best. Apple's walled-in ecosystem leads consumers entranced into the Apple embrace. They have the power to make their own rules and tell consumers what is best for them.
Yet, seemingly more and more we see savvy consumers turning to companies with other offerings, such as Pandora (P) for constant free music with discovery options or Spotify, who for the price of a single album a month allows you to listen to any song you want, as much as you want, on any device. Consumers are in the age of free, cheap or ad supported media such as YouTube, Hulu, Netflix , Redbox or even illegal downloads.
When content is so cheap and easy to access, why would a consumer choose to pay $5 on iTunes for a 24-48 hour video rental of a HD film? Apple has always been able to charge a premium for its products because of their eloquent design and ease of use; their last few product revisions have been less than revolutionary, merely "resolutionary," which is not nearly as exciting.
More often than not Apple has been correct in that building its walled garden has made it easier for their consumers, but we believe the company is beginning to toe the line between creating a great experience for their customers by making their own software products and impeding the profitability of software makers like Adobe (ADBE) - creators of products that have helped make the company what it is today. We believe that Apple plans to continue its trend of complete control based on the information they released in their upcoming OS which will include a security feature called "Gatekeeper" that in the future might restrict you to installing software only from the Apple Mac Store.
The adoption of Apple products came to be for many different reasons, but one reason has been overlooked by those who cover the company. Creative professionals, such as filmmakers and graphic designers have always used Apple products because "it just works" and Apple products historically were designed for those in creative fields. These were the early adopters who always spoke highly of the company and promoted Apple to their peers. The introduction of the "Gatekeeper" security feature introduces an opportunity for competitors to take away Apple's early adopters and bring them into their ecosystems.
This problem would have been easily dismissed a few years ago during Apple's revolutionary lead, but is more likely to occur as their product's advancements level out and their competitors' products catch up. If Apple loses its focus on creative professionals - the people who helped the company turn into the success it is today - that would be detrimental to the long term success of the company.
There is recent evidence that Apple does not consider the creative professional a vital part of the Apple community. At the end of the 1990's and early 2000's it was known that artists, whether it be graphic designers or filmmakers, preferred Apple products because of their intuitive software, elegant design and focus on the needs of the creative professional. In 1999 Apple purchased Final Cut Pro, a professional editing system from Macromedia. It quickly gained market share among small production companies, independent filmmakers and students.
Apple's growing presence in the industry continued over the next 12 years until 2011, when Apple released their newest installment of Final Cut Pro called Final Cut Pro X, which was completely redesigned and re-imagined. It was immediately clear by the drop in price from $1000 to $300 that Apple was aiming to gain market share in the consumer market and not the professional one.
Examples of this include new "features" that involved words such as "Magic" and "Auto" over professional features such as backward compatibility. This switch in their focus for Final Cut Pro shows their lack of commitment to the professional market. After the release of Final Cut Pro X, which was met with customer outrage, Adobe jumped on the opportunity with massive promotion for anyone who switched to their software and gained market share.
If Apple is unwilling to create products tailored for the professional, they are creating roadblocks for the companies that provide the software creative professionals need. Historically, Apple "stores" have had strict demands of their content providers, including a hefty cut of the profits (30%). Adobe's software has a dedicated professional following who rely more on Adobe's creative products than Apple's operating system.
With Apple's expanding control with features such as "Gatekeeper," forcing companies to abide by their regulations and accept their profit sharing demands, at what point is it not worth it to develop software for Apple? We realize that iPhones and iPads make up the most significant share of revenues and earnings for the company and that the loss of creative professionals makes up an insignificant amount of money as a percentage of the whole pie, but we believe the migration of early adopters would be the most significant warning sign for the eventual decline in the company and its shares.
Price Targets for 2012 & 2013
Worst Case Scenario for end of 2012 is $600 per share.
Apple already has $26.17 per share in earnings on the books for 2012, and expectations for the rest of the year are for another $20-21 per share. This scenario assumes a conservative $40 EPS for 2012 along with an earnings multiple of 15, that of the computer hardware industry overall. Based on these very conservative assumptions we believe Apple to be currently undervalued based on its ability to grow earnings and the significant growth potential.
Target Price for end of 2013 is $750 per share.
Currently, estimates for 2013 are $53.63 per share. Using the same conservative multiple for the computer hardware industry overall and an earnings of $50 per share leaves us with a price target that is 25% higher than our worst case scenario for 2012 and 37% higher than Wednesday's close of $546.08.
Best Case Scenario for end of 2012 is $875 per share.
This is based on Apple beating estimates and earning $50 per share on continued sales of iPhone 4s in China and iPads everywhere. We chose to use an earnings multiple of 17.5 (our forecast for the broader market by year's end).
Best Case Scenario for end of 2013 is $1,020 per share.
This is based on Apple beating estimates and earning $60 per share mostly on iPhone 5 sales worldwide and a new (successful) "revolutionary" product yet to be released.
Apple's long term chart (shown above) is obviously the depiction of a robust uptrend. We can also see that AAPL has generally trended with the broader market (thin dashed line) and has been overbought for quite some time.
Looking at the monthly chart, the most obvious corrective move was the pullback of 2008 (-61.5%), which we can attribute to the severity of the financial crisis and the resulting recession (there was a corresponding move in the S&P 500 of -57.7% during this time period). From the bottom of $78.20 in January of 2009, AAPL has been on a 39 month winning streak while appreciating 723.5% (given the high of $644.00 on April 10).
The eventual depth of the current correction (15.2% to date) seems to be predicated on how the market continues to digest the uncertainty in Europe, slower growth in China and the lackluster recovery here in the U.S. It's unlikely the decade-long trend will be broken, but a pullback that touches or at least flirts with the trend line certainly isn't out of the question.
Looking at the weekly chart (below), we see the recent pullback more clearly as AAPL basically trades with the market and is currently reentering a multi-year channel that it had just broken out of in late February. If the current correction continues to have legs, possible levels of support are the rising 40-week MA (currently $460.37), or maybe even the lower trend line of the channel (currently around $425). Momentum on the weekly chart has cooled significantly and is nearing the neutral 50 reading, so price has plenty of room to move in either direction before momentum would reach an extreme and become a concern.
As the market continues to correct, we'll look for AAPL to react off its eventual support on the weekly chart with confirmation from other indicators. The monthly chart has shown it can defy gravity for extended periods, but we would like to see momentum indicators dip below overbought levels to feel really good about any new move higher being sustainable and leading us to our price targets.
AAPL has seen a spectacular run and the current market correction may be the perfect opportunity for AAPL to cool off and consolidate. We believe this run has been justified as EPS has grown at a fantastic rate. With the continued success of the iPhone 4S in China and the iPad 3 all over the world we believe the company has the product backlog to continue its fantastic growth for the near future. In the long term we realize that the company will have to innovate into new areas to continue its current growth rate. Embarking into new areas has its risks, but given Apple's increasing cash hoard we believe the company has the ability to market virtually any product successfully.
Given that our worst case scenario for the end of 2012 still provides a small margin of safety and our upside target for the end of 2013 is more than 50% higher than today's price, we believe an investment in Apple is warranted. We do believe that longer term investors should look for signs that the company is resting on their laurels, not doing anything revolutionary and giving the cold shoulder to their original end users - the professionals. There are already many reasons to worry about Apple: the competition has improved its products, Steve Jobs is gone and the concern that Apple TV could be a huge flop. These are all valid concerns, but they are nothing $100+ billion in cash and some great marketing can't overcome for now.